Jamie Rollo – what are Mitchells & Butlers options?: Morgan Stanley leisure analyst Jamie Rollo has set out the strategic options for Mitchells & Butlers in the wake of chief operating officer Phil Urban taking over chief executive this week. Rollo stated: “A new CEO (Phil Urban), weak like-for-likes, rising restaurant competition and wage cost pressures mean M&B is likely to consider a range of options. Mergers and acquisitions or a propco split are conceivable, but perhaps a more plausible route could be to run the business for cash to fund a high dividend yield. We cut our estimates and price target but stay Overweight given the optionality the company has and the deep value its shares offer. Taking a more conservative view on like-for-like sales. M&B has now reported three consecutive years of like-for-like sales growth between 0.4-1.0%, a material slowdown on its pre-crisis average of 3-4%. Not only has the hoped-for improvement in the company’s sales not materialised with the improving UK economy and household income, but the recent data has been deteriorating, with the last seven weeks of FY15 a disappointing -0.7% despite easy comparatives (50 weeks +1.0% vs MS +1.3%). Hence, its trailing 12 month figures have been slowing on both a one and a two year basis. The company also continues to underperform the wider market, with the Peach Tracker sample averaging 1.5% for FY15 and other quoted operators averaging 2.0%, albeit partly explained by M&B operating in different geographies and segments. Note that these are ‘invested’ like-for-like figures, so ‘uninvested’ like-for-like sales excluding the benefit of capex are likely to be negative (certainly in real terms). We now assume 1% like-for-like sales growth for both FY16e and FY17e (from 2% previously), and we think a more conservative view is appropriate given M&B’s recent trading experience, the growing competition in the eating out sector, and ongoing on-trade beer volume declines.

Why aren’t pubs enjoying the economic recovery? It is not just M&B that is struggling. Pretty well every national pub company is experiencing dull like-for-like sales growth, relative to what might be expected at this stage of the cycle, even ‘category killer’ JD Wetherspoon. Conversely, operators with a focus in the south east, an original format, or a successful national restaurant concept are generally enjoying life. This reflects a revolution in the UK eating out market where the number of restaurants has just overtaken the number of wet-led pubs for the first time ever, with the former seeing 22% growth in units since 2010 (including an acceleration to 7% in the last 12 months), and the latter a 16% decline over the same period. We also think consumers are spending less time going out (do young people go to the pub any more?), switching spend from meals to snacks (‘grab and go’ and breakfast the only segments seeing real growth), and switching household spending from eating out to higher ticket items (e.g. ONS data shows double digit growth for tourist expenditure abroad, DIY, other major durables for recreation and culture, accommodation services, and personal effects). Needless to say none of these trends bode well for the larger pub groups.

Meanwhile, cost pressures are growing and we now assume a gentle Ebit margin decline: The compulsory National Living Wage for workers aged 25 and over will be introduced in April 2016 at £7.20, a 7.5% increase from the October 2015 National Minimum Wage level. The government’s target of over £9 by 2020 would be a 5.7% CAGR in the NLW over 2016-2020. As discussed in our report on the issue, labour is circa 28% of M&B sales, most of which is at or close to the current NMW, and around half this is for over 25 year olds. Hence a 6% annual increase is a circa £15m annual headwind (2.5% to the wage bill excluding pay increases for under 25s). M&B has not been as explicit as others on how it can mitigate this, but it does have a good track record of wage cost control (2005-15e labour ratio up from 26.1% to 27.9% despite its more labour-intensive food mix growing from 31% to 51% of sales. We now assume a 3.0% annual wage cost increase in our forecasts, and 1-2% for other operating costs. With 1% like-for-like sales growth insufficient to offset cost inflation we now see 20-30bps annual Ebit margin decline, with the exception of FY16e (+10bps) which should benefit from the Orchid cost savings.

This leads to some material forecast cuts and our new 430p price target: A combination of a weaker sales trajectory and higher cost inflation leads to FY15-17e EPS downgrades of 3%, 7% and 17% respectively. While our 2017 cut appears aggressive, in reality we are just assuming flat profits for the foreseeable future. We think this is a reasonable if conservative assumption. If like-for-likes do remain dull, we think this would make Option 3 below (retrench) an even more plausible scenario, with plenty of scope to focus more intently on its core estate rather than on new investments, and reduce overheads.

New CEO means all options likely to be considered: This week M&B also announced the replacement of CEO Alistair Darby with COO Phil Urban, the company’s sixth CEO in as many years. We think this can be expected to trigger a review of the way the company not only operates, but its long-term strategy and structure. It has done various reviews with previous incoming CEOs, and the deteriorating sales and cost trajectories suggest another one is likely. We think the company has various potential options:

1. No change: The current strategy, focusing on ‘people, practices, guests and profits’, sounds sensible, but there has been no noticeable benefit to Ebit from the improving KPIs (net promoter score, staff turnover, food hygiene scores, technology). At minimum it needs to get its like-for-like sales line moving to at least +2% if it is not to face the margin pressure we forecast. More of a focus on driving volumes, more innovation, more focus and maybe more front of house capex would all help. Even then, though, the investment case at M&B is not that clear. It is not a top-line sales growth story, at least for now. It is not, realistically, a margin recovery story, as although margins are below peak (FY15e Ebit margin 15.5% versus 18% ten years ago and old margin target of 17.3-18.3%), wage cost pressures make the next five years tough. It is not a roll-out story, with organic unit growth of around 1% per annum, and a plethora of brands and concepts making focus difficult. It is not an income stock, as there is no dividend, yet. The investment case is further complicated by its ownership structure (Piedmont, Elpida and Smoothfield, all representing a few private individuals, together own 47% of the shares) and large pension deficit (£572m pre-tax at the March 2013 triennial valuation). We therefore think this option is the least plausible.

2. Aggressively reposition: Since 2005 M&B has sold 720 pubs (35% of its estate) and acquired 400 new pubs (19%), a high level of churn given the estate of circa 1,800 pubs today. This has led to an increased focus on food-led pubs, with food up to half group sales, and drink accompanying food another 25-30%. While eating out is a growth market in absolute terms, supply growth is growing at a fast pace, and M&B is arguably positioned in some weak segments such as value food pubs. Its ‘Heartland’ estate, consisting of circa 500 pubs and including concepts such as Sizzling and Crown Carveries, has struggled, reflecting the enormous amount of capacity coming into that segment (e.g. Hungry Horse, Fayre & Square, Flaming Grill). Selling this estate, or part of this estate, is in theory a conceivable option, as it did its 333 drinks-led bars to Stonegate in 2010. However, the company has previously dismissed this. Hypothetically, however, if the company was to sell Heartland and recycle the cash into an acquisition, say in the restaurant space, then it would not suffer as much dilution, and it would not necessarily need as much drinks purchasing scale post a restaurant acquisition as its reliance on drink would shrink. One issue with this is that M&B’s restaurant skills are somewhat untested. While its Miller & Carter steakhouse chain sounds very successful, it only has 38 outlets (2% of M&B’s estate), does not have a site in Central London (the most cut- throat market), and there is a risk that a fashionable chain could quickly lose its edge when swallowed up by a national PLC. The other problem is that restaurant chains such as Cote, Byron and PizzaExpress have been sold for significantly higher multiples than the 7x the Stonegate estate was sold for, meaning a back to back disposal and acquisition could still be quite dilutive (the Stonegate disposal was 20% EPS dilutive for M&B, and it took four years to reinvest the case in Orchid). Another alternative could be to acquire something in the Pub Restaurant space. Speculation that Whitbread’s estate could potentially be non-core and of interest to M&B has been perennial amongst the press and investors, but neither company has ever commented, and in any case it is not clear to us that acquiring assets such as Brewers Fayre and Beefeater would really help.

3. Defensively retrench, restructure the balance sheet, high dividend payout: M&B is run with a growth mind-set, we think. It has invested circa £780m of capex over the last five years, excluding the £266m Orchid deal last year, which is 40% more than its depreciation charge. This also consumed 37% of its Ebitda, giving a fairly low 63% FCF conversion, the rest going in interest, tax, pension and acquisitions, meaning net debt has been flat since the Stonegate disposal in 2010. It also has a £60m annual head office cost (£80m including area managers), double some managed pubcos, and a range of pub concepts it aims to roll out. We think another option is that the company could reconsider. If it were to rigorously target maintaining cash profits, whether that be through driving volumes or focusing on cost, then this resilient income stream would likely be rerated by investors, in the same way that other ‘ex-growth’ businesses like WH Smith have. In this scenario it could even consider renting out some pubs to third party operators in return for a rental yield (exchanging lower trading profit for higher quality rental income), or converting more of its pubs to its franchised model where the pub manager is highly incentivised and a quasi tenant. Finally, if it were to curtail capex on new pubs and major conversions, this could also create higher FCF conversion. We forecast a steady £460m of Ebitda from 2017, once the benefit of the Orchid conversions are done. Post £110m maintenance capex (= depreciation), £120m net interest, £40m tax and a £45m pension charge, FCF should be £145m or so. Currently, in an agreement that lasts until mid 2017, the pension fund trustees only allow a dividend to be paid once FCF post the c. £70m of securitised debt amortisation is a net positive (this year it is touch and go, depending on working capital, but we estimate net FCF c. £50m in 2016 and £75m in 2017, see Exhibit 30 ), and for future dividend growth to be limited to inflation or EPS growth. However, there is ample FCF to fund a dividend on our 2017 forecasts even post amortisation, and enough in 2016 to fund a decent 10p start. We also think the company could reprofile its securitised bonds, just as Spirit did, whereby lengthening the bonds’ duration (at the current attractive high coupon) reduces the annual amortisation charge. This could lead to a material increase in FCF. We forecast a 10p (£41m) dividend commencing in 2016, but think the company could realistically pay 20p if it moves to a 100% cash payout on 2017e FCF post bond amortisation (equivalent to a 50% payout pre amortisation). Bond repayments bring with them an interest saving so arguably should be ignored from this calculation anyway, and anyway the annual repayment could reduce sharply if the debt is reprofiled. The shares are trading on a 3.0% yield on our 10p base case forecast but 5.8% on our bull case 20p payout.

4. Monetise the real estate: M&B owns over 90% of its pubs either freehold or long leasehold and is widely considered to have the highest quality pub real estate in the industry, having churned it aggressively for years. It had £4.3bn of property, plant and equipment on its March 2015 balance sheet, and we forecast a Sept-15e NAV per share of 405p net of all liabilities. The pubs are revalued annually. The shares are trading below this, but they have before for an extended period, and property support appears somewhat theoretical at the moment. However, given more liberal credit conditions, the company could conceivably consider an ‘opco/propco’ with potential REIT conversion. This failed in 2007 due to the credit crunch, but because M&B has fairly high margins and a high quality estate, and if its main shareholders pushed for it, we think it could structure an interesting vehicle. If we assume the opco could run at 2.0x Ebitdar rental cover (c. £200m of new rent) and debt-free, 1x basic NAV for the propco (515p, equivalent to a 4.8% rental yield, based on a simple gross asset value less net debt less post-tax pension deficit), and say 4x Ebitda for the opco (200p, with rent partly linked to sales with an inflation-linked minimum, equivalent to 11x P/E), this gets to 710p, over double the current share price.

5. Take part in industry consolidation: Finally, M&B could participate in M&A. The managed pub sector is very fragmented, there is a plethora of brands and concepts (most of which are relatively weak in the eyes of the consumer and lack scale), and there is a lot of cost saving potential given shared overhead and purchasing. For example, Greene King targets at least £30m of synergies from its acquisition of Spirit, equivalent to a one-third uplift to Spirit’s 2014 Ebit. If M&A were to occur and dilute the stake of M&B’s major private shareholders, this might be taken positively by the market as we think investor concerns relating to these stakes could be contributing to a valuation discount.

Of these options, we think defensive retrenchment to fund a high dividend could lead to a major reassessment of M&B: This would certainly look like a low risk option, and might offer outsized rewards. A secure income stream sharing some of the characteristics of property companies could be taken positively by investors. Even on our lower forecasts it is trading on just 7x Ebitda (8x including the pension deficit), 9x P/E, and with a 3% dividend yield (on 2016e and 2017e). We admittedly see few near-term catalysts, but the deep value in the company means we remain Overweight.”