Initiating coverage of Marston’s, leading sector analyst Simon French at Cenkos says that the pub operator and brewer offers the fastest earnings growth and the highest dividend yield in the pub and restaurant sector; he also highlights why there is scope for the group to consider disposing of its c340-strong Leased pub estate for c£250m and reduce debt or recycle capital into higher growth markets; and explains why the group is well positioned to deliver further growth over the medium-term despite macro-economic uncertainty and cost headwinds.
French said: “The group is improving returns by sweating assets harder, for example adding bedrooms to existing pubs with a target of 550 additional rooms by 2020. We think the stock is more defensive than many of its peers and through multiple routes to market can allocate capital more efficiently without compromising on overall group returns, which are on an improving trend. Trading towards the bottom of its 52 week range, in our view the current share price provides a compelling entry point, given the reliable income and relatively attractive growth prospects with the potential to unlock value through corporate action.
“Marston’s is also considering extending its new-build programme into its Taverns segment. Whilst this appears a bold move we believe the model is proven to a large degree by Amber Taverns which has successfully evolved its wet-led community pub model to include developing pubs from previously non-licensed premises. If this initial trial is successful we believe there is scope for many hundreds of pubs in a model which effectively replicates Wetherspoons less food plus sport.”
French said: “Marston’s offers the fastest earnings growth and the highest dividend yield in the pub and restaurant sector whilst trading on a modest adj EV/EBITDAR premium to its peers and at a c13% P/E discount. Whilst adj net debt/EBITDAR is high, fixed charge cover remains comfortable at 2.5x and above that of Wetherspoons and Restaurant Group. We believe there is scope for the group to consider disposing of its c340-strong Leased pub estate and reduce debt or recycle capital into higher growth markets. The group is improving returns by sweating assets harder, for example adding bedrooms to existing pubs with a target of 550 additional rooms by 2020.
“The group’s management team is highly experienced with Ralph Findlay having held the positon of CEO since 2001 whilst Andrew Andrea has been CFO since 2009. They are supported by Pete Dalzell (20 years industry experience, all at Marston’s) who runs the pubs and Richard Westwood who runs the brewing operations (40 years industry experience, all at Marston’s). We think the stock is more defensive than many of its peers and through multiple routes to market can allocate capital more efficiently without compromising on overall group returns, which are on an improving trend. Trading towards the bottom of its 52 week range, in our view the current share price provides a compelling entry point, given the reliable income and relatively attractive growth prospects with the potential to unlock value through corporate action.”
French said that the group’s £176m rights issue in July 2009 provided the firepower with which to pursue its new-build pub restaurant strategy. He said: “The market was sceptical, rightly in our view, given the lack of track record in developing new-build pubs and the industry’s history littered with failed rollout plans. However, to the immense credit of management the group has skilfully added 134 pub restaurants across a variety of geographies and trading locations, tweaking the format to the specific site and local market but focussing on value concepts such as Two for One, Generous George, Carvery and Rotisserie.
“The introduction of the Retail Agreement in 2009 into the Tenanted estate was again viewed sceptically, at the time, by the market and indeed by the group’s competitors. However, the idea to provide targeted investment and free the pub manager of the burden of day to day administration to concentrate solely on targeting the top line was inspired at a time of significant pub closures. What was initially presented as a short-term stabilisation strategy at wet-led community pubs was quickly copied by others who developed their own franchise agreements. As such it has become a key plank of the group’s strategy with 200 further pubs still to be converted and plans to trial new-build pubs.”
The decision by the company to accelerate disposals of non-managed pubs manifested itself in the disposal of 202 pubs to NewRiver Retail, as announced in November 2013, comprising 158 community pubs from the Taverns estate and 44 Leased pubs.
French said: “The innovative deal structure saw Marston’s strike a five-year management agreement for which it has provided a minimum income guarantee until December 2017. Whilst arguably this saw Marston’s dispose of valuable real estate at the bottom of the cycle, it freed up management time and provided capital to redeem expensive securitised debt, reduced interest payments by £6.7m and reducing group leverage by 0.1x. Whilst the £10.4m operating profit foregone meant this disposal was profit dilutive we think the group has been left with a superior quality of earnings and a better balanced business.”
French said that the acquisition of Thwaites’ beer business as announced in April 2015 demonstrated the group’s willingness to accelerate earnings growth through acquisitions. He said: “In our view this was a highly complementary transaction broadening the group’s range of premium ales through Wainwright and Lancaster Bomber and entered into a long-term exclusive agreement to supply all beer, wine, spirits and minerals to Thwaites’ c300 strong pub estate. With EBITDA post overheads of c£5m it also accelerated growth in the group’s Brewing division providing momentum in the free trade market and capitalising on renewed consumer enthusiasm for beer.
“In our view the combination of these four strategic initiatives has reshaped the business into a leading UK pub retailer and brewer with significantly increased control over its pub operations and overall group profitability. As such the group is well positioned to deliver further growth over the medium-term despite macro economic uncertainty and cost headwinds.”
French said he saw three of the group’s four divisions offering material growth potential over the medium-term. He said: “However, whilst Leased pubs (the fourth division) remains a strong generator of cash flow, we do not believe the value is adequately reflected by the current share price. Securitisation rules and costs permitting we believe the group should consider selling these assets and using the proceeds to initially reduce debt before recycling the capital into the higher growth divisions.”
Since 2009 the group has opened 134 pub restaurants, including 25 in 2015 across its Destination & Premium (D&P) pubs division.
French said: “LFL sales performance has been impressive over the past three and a half years with a tailwind from the new build pub opening programme establishing its LFLs as amongst the best in the sector. This is even more impressive when considering the group has minimal exposure to central London which has outperformed the rest of the UK over the same period.
“The group plans to add 20 new build, predominantly freehold, Destination pubs per annum. Whilst this a reduction on the previously achieved 25 it recognises that build costs have increased c£150k per site since the strategy was formulated in 2009 thus making some potential developments uneconomic. Furthermore the group will add 2-3 new leasehold Premium sites per annum. Management sees a bigger opportunity in developing adjacent accommodation. D&P currently has 850 rooms across 51 pubs and plans to add five lodges per annum with up to 40 rooms each. There is also an opportunity to consider co-located lodges with third-party operators such as Premier Inn or Travelodge where Marston’s can utilise its real estate whilst benefitting from the halo effect a national branded operator brings to customer demand.”
The group is also considering whether it is possible to develop a franchised model for Destination pubs which could accelerate its roll out and enable penetration of smaller catchment areas we believe.
In terms of its Taverns division, French said: “Similar to D&P, LFL sales growth has been impressive again benefitting from the tailwind of conversions to the franchise model, which incentivises operators on the top line. The benefits of the franchise model are demonstrated by the fact Marston’s now has at least 50 franchise pubs generating AWT of >£10k which compares to a handful in FY2012 and highlights the scale of the opportunity for growth.
“There remain 200 pubs operating under a traditional tenanted model that will be converted to the franchise model over the short-term as the existing tenancy agreements expire/lapse. This should at the very least stabilise profitability in the division, even net of disposals. The franchise model is relatively transparent with the franchisee/pub manager retaining 15% of the pub’s net weekly sales to pay him or herself and all staff costs. Management also believes there is an opportunity to develop new-build Taverns pubs and will trial the first of these over the next 12 months. If this initial trial is successful and can be scaled the group will have a further roll-out proposition on its hands.”
French said he was extremely positive on the prospects for the group’s Brewing division given the strong brand portfolio it has developed across five breweries and augmented by the acquisition of Thwaites’ beer division.
He said: “Given renewed consumer interest in craft and premium ales, we think the division’s focus on provenance and authenticity provides it with a clearly differentiated offering amongst other vertically integrated pub companies. The group’s 13-strong depot network enables it to retail beer brewed not only in its immediate region but also in other Marston’s pubs and provides genuine scale opportunities for otherwise localised beers. This chimes with consumers’ increasing enthusiasm to discover new drinks but which have heritage and are not mass produced. We believe Marston’s can accelerate organic growth through increased marketing and investment in research and development where it has had significant success with FastCask. The group is the clear market leader in the take-home Premium Bottled Ale market but we believe this leadership can be extended to other channels and categories too. We do not believe there are any capacity constraints at the current breweries but would welcome the addition of further breweries where the group is not represented, such as London.”
The group has not added any pubs to the Leased division since FY2008. Indeed pub numbers have fallen by c60 since FY2013.
French said: “However, the group has reintroduced moderate capital investment into this division which has been able to sustain rental income through the downturn, we believe. It is a high quality estate reporting £76k average EBITDA for the 12 months to April 2016, with profits growing 3% on a LFL basis, driven by rental growth of 2%. Bad debt is less than 0.1% of revenue and over 90% of licensees have been in position for five years or more.
“In our view, the division does not possess the adequate scale (just 6% of group sales and only seventh largest Leased pub estate in the UK) to make commercial sense for it to be retained and we do not believe the market recognises the value within it. If the division could be sold, preferably with a beer supply contract retained for the Brewing division, we think the group could accelerate earnings growth through a combination of retiring debt and/or recycling capital into the other three, higher growth, divisions. Given the high quality nature of the estate and its 100% freehold ownership we think the group could command a price of at least £250m, which we value it at in our sum-of-the-parts analysis (p12-13).
“The potential restraint on sale is the group’s securitisation. The group has five tranches of securitised notes, A1-A4 and B totalling £853.1m outstanding principal at 2 April 2016 and amortising at c£27m in FY2016 and increasing by c£2m per annum. Debt service peaks in FY2020 at £80.7m following the step up in the A2 and B notes. There is a precedent for redeeming its bonds as when the group sold 202 pubs to NewRiver Retail in 2013 it used the proceeds to redeem the £80m AB1 securitised note; however, we expect the subsequent fall in gilts would make the cost more expensive although this will reverse over time.”
The group continues to add new rooms to its Inns estate with 850 now trading across 51 sites and plans to add five additional lodges per annum.
French said: “We are positive on the additional revenue and higher returns such a co-located model brings and the ability to develop on a leasehold basis also minimises the capital intensity and further propels returns, even on a lease adjusted basis, we estimate. However, we believe the group will need to further invest in the central infrastructure to maximise distribution in what remains a highly competitive, albeit growing, regional hotel market.
“Marston’s is considering extending its new-build programme into its Taverns segment. Whilst this appears a bold move we believe the model is proven to a large degree by Amber Taverns which has successfully evolved its wet-led community pub model to include developing pubs from previously non-licensed premises. If this initial trial is successful we believe there is scope for many hundreds of pubs in a model which effectively replicates Wetherspoons less food plus sport.”
Recent trading has been encouraging and whilst at its last update the group had seen no discernible impact from Brexit, French said he remained cautious given the “likely pullback in investment and the lag effect that will have on other industries and ultimately household disposable income”. He said: “We expect this to manifest over the medium-term and therefore our LFL sales growth assumptions are below that achieved in recent years. We expect the Market Rent Only (MRO) option to have little impact given the group only operates c540 pubs under the leased and tenanted model and 200 of these will be converted to franchises. Indeed we view the introduction of MRO as a potential benefit for its Brewing division given the enhanced ability for tenants to purchase free of tie.
