Leading analyst Jamie Rollo at Morgan Stanley has published a comprehensive note on the five-year plan from Enterprise Inns to completely change the shape of its pub estate. He calls the plan bold and says that the company is “embarking on, probably, the most ambitious transformation a pub company has ever undertaken”. He also gives a comprehensive overview on the group’s plans for three managed house models.
He said: “Enterprise’s five-year plan to completely change the shape of its pub estate is very bold, but it also highlights how much needs to be done to fend off unprecedented regulatory and structural pressures. FCF is weak, leverage high. We cut 2018e EPS 15% and downgrade our rating to Underweight. The combination of the ‘Market Rent Only’ regulation (gives pub tenants that are tied for beer the right to elect for a free-of-tie rent), tough trading conditions, growing competition, and structural pressures lead Enterprise to embark on probably the most ambitious transformation a pub company has ever undertaken.
“It plans to sell c. 20% of its 5,200 pubs, convert another c. 20% to a free-of-tie commercial propco, and another c. 15% to managed pubs, leaving it with c. 45% of its current pubs under its existing tied tenanted model. This should leave it better able to optimise its assets, with a higher quality income stream, and additional value could be created by separating the different businesses. If all goes well, our bull case is 220p.
“A new managed business will require upfront overhead, higher capex, and profit sharing with third parties, and even then its pubs appear too small to warrant direct management. The free-of-tie pubs will likely see a drop in income as the rent increase will not fully cover lost beer margin, the remaining tied pubs may have to be offered incentives to stay, and Enterprise may struggle to reduce overheads in line with the 55% drop in tied pub numbers. We see a U-shaped profit profile with Ebitda falling from £297m in 2015e to £273m in 2018e before a return to sustainable growth, and we cut our 2018e EPS forecast by 15%.”
Enterprise is targeting 750-850 managed pubs by 2020, and 400-500 by 2016.
Rollo said: “This would be a major achievement, from just 22 pubs currently, given the different retail skill set and overhead required in managing rather than leasing out pubs.”
The company plans to be flexible in its approach and use three different managed house models, with differing degrees of complexity in relation to the retail offer and potential of the pub.
Its Managed Community (Craft Union Pub Company) has a target of c500 pubs, with the company converting 100-125 pubs a year. The concept is a community, value-orientated offer in predominantly urban and neighbourhood locations, using the concept of the company’s trial Beacon operation.
Rollo said: “This allows existing tenants to enjoy the support and protection of the managed model, whilst outsourcing the infrastructure, as managers receive a proportion of revenue from which they fund the pub’s labour costs, which also means little fixed cost to Enterprise.
“Enterprise already has 185 Beacons, and other companies like Marstons have successfully rolled out a franchised model. Guidance is for £7,000-12,000 sales per week post conversion, very small for a managed pub business (listed peers range from £17,000-30,000), with a 19-20% house EBITDA/EBITDAR margin (also low versus peers at 24-30%), and overhead at 3.0-3.5% of sales. Average initial capex is £75,000 per pub, also modest for a managed pub. This implies £60,000-95,000 EBITDA per pub post conversion for this pub group.
“Enterprise’s guidance is that these pubs currently generate £50,000-55,000 average net income, and the £25,000 mid-point increase thus implies a 33% ROIC (or large LfL improvement), which looks ambitious to us given some of the capex will be non-revenue generating (e.g. buying the fixtures & fittings, catch-up maintenance). Current net income levels imply weekly retail sales are c. £6,000-7,000 pw (in line with the group average), so the company needs a 40%+ sales increase to hit targets. We assume these pubs are each currently generating £67,000 net income, a little below the group average, and get to £83,000 EBITDA, or £68,000 post central costs, implying a neutral impact on profits post conversion.”
Its Managed Mainstream (Bermondsey Pub Company has a target of c200 pubs, converting 35-50 pubs a year. There are two concepts, “Meeting Place” and “Friends and Family”, both offering a mainstream offer with a balanced mix of food and wet sales.
Rollo said: “Guidance is for £12,000-18,000 sales per week post conversion, still small for a managed pub business, with a 22% house EBITDA/EBITDAR margin (also low versus peers), and overhead at 4.0% of sales. Average initial capex is £200,000 per pub. This implies £110,000-170,000 EBITDA per pub post conversion. Enterprise’s guidance is that these pubs currently generate £80,000- 85,000 average net income, and the £55,000 mid-point increase thus implies a 29% ROIC, which also looks ambitious to us.
“Current net income levels imply weekly retail sales are c.£10,000-11,000, so the company needs a 40%+ sales increase to hit targets. We assume these pubs are each currently generating £100,000 net income and get to £150,000 unit EBITDA, or £125,000 post central costs, implying a small positive conversion impact.”
Managed Expert: the target is for c100 pubs in this model, converting 15-25 pubs a year.
Rollo said: “These are large, premium pubs, with high quality food, and more akin to the average managed pub for the listed operators given guidance for £20,000+ sales per week. The model will involve partnerships, such as that announced with Rupert Clevely, whereby expert managed house operators are provided by the operational resource and get a share of the profit in return. Average capex guidance is £400,000 per pub, and pub EBITDA margin guidance is 23- 25%, with overheads at c. 4% of sales.
“The company estimates these pubs are currently generating £100,000-120,000 net income, equivalent to c. £15,000 retail sales per week (i.e. both around double the group average). They also therefore need a substantial sales uplift to hit the targets. We assume these pubs are each currently generating £120,000 net income and get to £145,000 EBITDA post central costs, implying a small positive conversion impact.
“This suggests the managed business could generate £74m of EBITDA post conversion. This compares to our assumption that these pubs generate £66m of net income currently. However, these pubs also have c. £6m of tenanted overhead currently (at the group average of £7,000 per pub), and our analysis assumes this is reduced. If not, the pubs are at a profit parity.
“More important, Enterprise needs to generate a 40% increase in retail sales in order to get to these figures, which seems ambitious given many of these will be fairly average community wet-led pubs facing structural decline and growing competition. Normally, pubs are converted from managed to tenanted once they become too small to manage, which creates cost savings. Enterprise is attempting the reverse, and we think this will only work if it sees substantial revenue uplifts in the pubs.”
Rollo assumes managed central costs of £17m by 2020. He said: “Enterprise only expects this overhead to grow c. £2m in 2016, but we think it will need to grow sharply from there, and likely in advance of the managed pubs converting and contributing. Central costs of other companies range from £20-50m. Enterprise guides to c. 3-4% of sales on central costs, or £20,000/£25,000/£35,000 per pub for the three different formats, suggesting £15-20m.
“We do not assume any profit shortfall from temporary closures or pre-opening costs as the pubs are invested, converted and relaunched. We also assume depreciation on these pubs rises from c. £4m under their current tenanted model to £18m, as fixtures and fittings transfer to Enterprise Inns, and it adopts the less generous depreciation policies of managing pubs (where the responsibility for repairs and maintenance shifts back from the tenant to the owner). This is 4% of sales, which compares with 4-6% at its managed pub peers, reflecting a lower level of branding and more modest investment.
“This gives £55m managed pub EBIT. This is equivalent to a 12% EBIT margin, below its mainly freehold peers at 16-20% (M&B, Greene King, Marstons) reflecting its smaller scale. If we were to increase our assumed profits in these pubs, it would imply the pubs moving across were bigger and more profitable than we assumed, and so we would reduce the profit in the tied tenanted estate accordingly, with little net impact to our forecasts.”
Rollo points out that running an integrated managed and tenanted business brings mixed fortunes. He said: “On the plus side, it allows a company to maximise how best to run its assets, allows overhead and purchasing scale to be leveraged, and retail skills can be shared with tenants and lessees and allow the company to quickly step in to prevent failure. Another advantage is that Enterprise can now choose to deny renewal on the basis that they want the property back for their own management, either to take advantage of good quality pubs that are under-rented and can be more profitable under a managed model, or allow the company to dispose of the property with vacant possession. It would not be able to do either of these without a managed operation.
“Regional brewers like Greene King, Marstons and Fullers are good examples of running a combined managed and tenanted estate, and pure tenanted companies like Punch and Star Pubs and are also setting up managed operations. On the negative side, the skill set and arguably the culture is very different between the two models (one more about 24-7 retail skills, the other more about 9-5 five days a week support), and managed pubs bring a significantly higher complexity and overhead (£20-30,000 per pub versus £7-8,000.”
