Jamie Rollo – 2013 could be the year for sector consolidation: Morgan Stanley leisure analyst Jamie Rollo has argued that 2013 could be the year that sees sector consolidation. He said: “The managed pub sector is relatively fragmented. Like-for-like sales have been relatively resilient in the sector, but if we remove the benefit of investment, they have barely been covering cost inflation. Bolting together large managed pub estates can lead to savings in central costs (these range from four per cent to six per cent of revenues, and perhaps half can be removed) and purchasing synergies (cost of goods c.30 per cent of revenues, with perhaps a five per cent saving). This means that savings can total four per cent to sales, significant on businesses where operating margins broadly range from ten per cent to 20 per cent. While small bolt-on deals are likely (there are a large number of small operators reportedly for sale), we think 2013 could see a large transaction. Indeed, according to Propel (Morning Briefing), M&A activity in the pub industry in the last four years has averaged 10 per cent of the annual volume in the 2000-07 period. Only last week, a new private equity player, Cerberus, entered the UK pub industry with the £200m acquisition of Admiral Taverns (a tenanted operator). Rollo lists a number of possibilities: Mitchells & Butlers: “The company has around £400m of firepower (if we assume it invests its £200m PLC cash and raises a £200m bank loan, effectively reinvesting the £370m Stonegate disposal), it now has a permanent CEO, and has a track record of buying high quality assets (e.g. from Whitbread). In the past, it has been linked to a potential nil-premium merger with Greene King (source: FT 7 October 2011), which could lead to material savings, as well as dilute the influence of M&B’s private shareholders (neither company commented). However, Greene King’s interests in tenanted pubs and brewing, as well as its relatively higher valuation, could both be deterrents for M&B. M&B’s two large private shareholders own 49 per cent of its shares so would be instrumental in deciding if anything gets done. M&B has said there are a number of options for its cash, and that it is more focused on individual additions than large transactions; Whitbread: The company still owns nearly 400 pub restaurants, which are largely situated adjacent to their hotels and run together. The profitability of the pub restaurants is no longer provided, but they used to have below-average margins, particularly for a 90 per cent freehold estate. The company has sold two tranches of pubs to M&B, and we think investors on both sides might welcome another transaction. M&B has a broad brand range and strong pub retail skills with which it could improve the pubs’ performance further, while Whitbread, although it has seen a recovery in trading in its pubs, is more focused on its hotel and coffee shop operations. Whitbread has said its pub estate is a core business and not for sale, though it is not interested in buying more pubs; Spirit: Spirit straddles both Managed and Leased pubs, and has a single securitised debt structure covering the entire estate, which makes it hard to sell or break the group up. However, the company has improved the trading and profitability of its managed pubs, and is keen to increase the size of this business. With the shares having rerated, the company could feasibly use its equity to do a deal. An acquisition of pubs generating cash outside its securitization net would also help it generate sufficient PLC cash flow to keep the equity dividend sustained. Spirit has discussed selling the Leased estate before, but there have been few obvious buyers for this (although we note Cerberus’ acquisition of Admiral last week). Even if it did exit, it would need to reinvest the cash in other pubs under the terms of its debt structure, and a deal with Stonegate has been discussed in the press, though not confirmed by either party (the Times, 8 September 2012). Spirit has not made any acquisitions since its demerger from Punch, but is considering adding a new funding structure to facilitate investments. Greene King and Marston’s: The largest regional brewers straddle managed pubs, tenanted pubs, and brewing. In the past there has been speculation about a combination between the two without confirmation from either party, but they been pursuing increasingly divergent strategies, with Greene King focused on small, bolt-on but high quality acquisitions, and Marston’s organically developing large suburban food-led outlets. Greene King has also been linked with M&B, as discussed above; Stonegate: The TDR-backed pub company consists of M&B’s high street and late night venues, and part of the old Laurel estate (Slug). It sees upside in wet-led pubs that have been ignored by larger food-led operators, and in the past has been linked with a merger with Spirit (the Times, 8 September 2012, though it has not commented). TDR is one of the few private equity operators still doing deals in the managed pub industry, the other being LGV (which acquired Novus); Wetherspoon: The company has made only one major acquisition (Lloyds No. 1 in 2000). It regularly buys single sites and small packages of second hand pubs, but has stated that it is not interested in major acquisitions and prefers to grow through organic additions. The chairman owns 27 per cent of the company; Restaurant chains: As managed pub companies push more into food (which is now 50 per cent of sales at M&B), they are likely to start acquiring more restaurant brands. M&B, for example, owns Browns, and Greene King owns Loch Fyne. The restaurant sector is even more fragmented than the pub industry, and there are many private equity backed companies, so potentially a lot for sale. The difficulty is that it is hard to scale up many restaurant brands, and there is an element of entrepreneurialism and even faddism with smaller brands that could be lost once the brand goes national. There is some overlap the other way, with The Restaurant Group, for example, owning a small group of pubs. What could prevent consolidation? A deteriorating economic environment, tougher financing conditions, disparate strategies, and valuation differences could all block potential consolidation.”