Capital Pubs:
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Targeting freehold pubs allows the company to obtain debt financing underwritten by the company’s strong net asset backing and revenue generation capacity – a business model based on a virtuous circle of growth with minimal risks of shareholder dilution.
Market: AIM A fair few headline grabbing merger and acquisition deals have come out of the pub trade in the past decade. There are over 70,000 pubs in the UK, with combined sales of £25 billion, making this a big sector, but growth in this sector has long been flat. Pub ownership used to be fragmented, but today there are vast estates of pubs run by a handful of companies, and the few remaining players are still relentlessly attempting to pull off the last few mega-deals.
While all this merger and acquisitions, and sale and leaseback activity has been going on, pub groups have sifted through their portfolios of pubs and sold off, piecemeal, the pubs that don’t fit their specific parameters. Some of these pubs are then converted into residential, or commercial, properties but many of them are snapped up by smaller players who can generate profits from operating standalone pubs. The Capital Pub Company, formed in 2000, by David Bruce (CEO) and Clive Watson (Managing Director) took advantage of the Enterprise Investment Scheme (EIS) and raised £8 million to invest in freehold pubs. The company acquired five pubs in the first year (four were subsequently sold) and an additional nine pubs in 2002, after raising a further £6.4 million. The deals kept flowing; in January 2006 the group secured bank financing and raised a further £3.9 million to purchase ten pubs from Spirit for £31 million. By September, it had agreed to acquire four pubs from Mitchell’s & Butler for £7.3 million, and then in January 2007, another four pubs for £9.2 million. The end result was a company with 23 pubs that are ’free of tie’ (i.e. ’free houses’ that are not contracted to a brewer) and 20 of these are owned freehold.
Targeting freehold pubs allows the company to obtain debt financing underwritten by the company’s strong net asset backing and revenue generation capacity – a business model based on a virtuous circle of growth with minimal risks of shareholder dilution. At present, all of the company’s pubs are in Greater London, and David Bruce and the rest of his executive team are on the lookout for more deals. Their criteria for acquisition includes unbranded, freehold, already profitable free-of-tie pubs in Greater London, with 80% of existing revenue from drinks and 20% from food, that require only limited refurbishment. Having met these criteria, it only remains to convince David and Clive that the proposed acquisition can achieve a 12% EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) return on capital invested (excluding head office overheads). With this strict acquisitions policy, it will come as no surprise to readers that full year results for the year ended 31st March 2007 showed turnover up 47% to £14.22 million, pre-tax profits up 41% to £1.64 million and earnings per share up 23% to £7.14. What is more interesting is that, in 2006, gross margins increased from 68.6% to 69.9% and operating margins increased from 19.3% to 21.8%, vindicating the company’s convictions that it can improve operational performance of the pubs it acquires.
England and Wales recently introduced new smoking bans, which the doomsayers claimed would hit businesses like pubs hard. To date, the effect has been neutral for most pubs. In the meantime, we strongly encourage interested readers to visit one of the company’s pubs and carry out some ’practical due diligence investigations’. However, if you can’t be this thorough, with strong cash flow, dividends, great net asset backing and experienced management, it would take a high degree of stony-faced pessimism about the consumer economy and property values not see this well-managed company as a worthy addition to any small cap investment portfolio.
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There are a number of business models in the pub industry, but the key driver of recent years has been shareholder pressure to unlock the vast amount of property value locked-up in portfolios of` pubs. In response to this pressure, pub companies have focused on building ’managed estates’, whereby the pub group manages the pub operations, and unlocks the value of the property portfolio through a sale and leaseback model – has been hugely rewarding for shareholders. So the large players in the market have been predominately driven by economies of scale in their trading and also unlocking the value of their property portfolios.
Buying pubs freehold is a capital intensive operation, but David and Clive have considerable experience in working with big brands and their inherent economies of scale, and felt there was an opportunity to generate substantially more revenues from local pubs which already had high beer and food volumes, by improving the way they were managed.
House broker, Fairfax, issued a brief research note following the posting of full year results: this stated that The Capital Pub Company’s turnover came in 5% ahead of expectations, adjusted profit before tax 17% ahead, and basic earnings per share (EPS) “smashed“ its in house estimate, coming in at 7.7 pence due, in part, to a lower than expected tax charge. Net asset value for the company, calculated at the time of listing, was 182 pence at a 13% premium to the share price. Fairfax are forecasting 2009 full year revenues, based on the current number of pubs, of £17 million, with an operating margin of 23.5% and tax rate of 28%, producing earnings per share of 8 pence and dividend yield of 2.4%, which also implies a forward profit to earnings ratio of 19.8. It is extremely likely that these numbers will be revised many times between now and 2009, as pubs are bought and sold to suit the management’s business model.