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Sun 5th Jul 2015 - Analyst – Greene King’s Spirit acquisition opens up host of options
Analyst – Greene King’s Spirit acquisition opens up host of options: Deutsche Bank Geof Collyer has issued a ‘Buy’ note on Greene King and set a share price target of 1,175p after the completion of its Spirit Pub Company acquisition. Collyer noted that the deal underpins medium-term Greene King growth, allows learning opportunities for Greene King but also sets up Greene King for other opportunistic acquisitions – and a possible spin-out of a high quality leased and tenanted estate. He said: “Spirit is the third acquisition that Greene King has made that will have expanded its profits by more than 50%. It will transform Greene King into the sector‘s largest pub group by Ebitda, contributing 37% of the enlarged group Ebita (on a proforma basis), and increasing FY16E profit before tax by 41%. We see Spirit as underpinning growth for the group over the medium term, with no need to get involved in a space race with the peer group for new sites. Greene King also now becomes the fifth biggest UK Leisure stock (by Ebitda), and so will appear on many more investors’ radar screens, helped by a near 4% dividend yield. There is around 35% upside to our target price with upside risk to forecasts. Greene King has been the best performing pub stock over the past 5 years with 168% TSR versus. FTA-AllShare +73%), and operationally, has improved the quality of its businesses more than any of its peers. Whilst Spirit expands the group’s geographic footprint, it also consolidates Greene King’s strong position in London & South East (we estimate profits to be more than 35% of group from this region), where spend on eating and drinking out is 20% higher than the rest of Great Britain. Spirit is not without its challenges, but a key opportunity is to invest properly in the group’s high quality assets – something which the previous management has not been able to because of capital constraints. We have adjusted our forecasts for the post merger structure. Spirit is in for 85% of FY16E and we have split the £30m of merger synergies 30/50/20 over the next three years. We value Greene King on 13.5x EV / Ebita basis (in line with the Travel & Leisure sector average), and are using FY17E as the base year, to capture 80% of the synergies and a full contribution from Spirit. We have been conservative in the outer years of our 5-yr forecasts, and estimate that we have a £54m cushion in our profit before tax (equivalent to a 15% upgrade to FY20E). The principal downside risks (i) Operational, notably a failure to deliver on the implied profit uplifts from the Spirit acquisition and attendant £30m of synergies. (ii) A return to input cost inflation. We estimate that a 1% move in Retail COGS would impact PBT by 2%.”

What can Greene King learn from Spirit? Collyer said: “The acquisition is not without its challenges, including its higher leverage from 33% of the acquired estate being leasehold, including an onerous lease provision that we expect to be revised to a more conservative position. This latter point may be a problem for others; we have never included it in our forecasts or valuation metrics. We also expect some minor accounting changes that could nudge down the historic Spirit numbers, mainly due to depreciation rates in the tenanted & leased business. Spirit management has invested significantly in its people and its business systems, and has been smarter than many in terms of cleverer ways of working and business systems, and is some way ahead of its peers, including in some areas, Greene King. Harnessing this investment and aligning it to get the most out of the best of both cultures will be a key challenge for the integration programme. Spirit’s investment per pub on major outlet repositioning has to date been around half that of its peers. This is a key revenue synergy opportunity for Greene King, to invest properly in the group’s high quality assets – something which the previous management has not been able to because of capital and cash flow constraints. Spirit has always seemed to us to be more advanced in terms of its attitudes to CRM, people training (its retention rates have improved radically over the years), uses of social media for marketing, and generally appeared further up the curve in terms of IT analytics. Spirit genuinely seemed to us to have been ahead of the game. This is maybe not surprising, given the lack of capital to invest, so why not concentrate on investing in your people? It was the people story that Orchid also played up, for much the same reasons. But in both cases, the investment in people should have been a priority over the hard core capex. No point spending all that money if you don’t know how to actually run your businesses. That was a lesson that the newly arrived chief operating officer at M&B tried to teach Whitbread some years ago in a previous life, and found himself working elsewhere pretty quickly. There are many examples of companies copying each other’s successful trading formats, but it is the operational execution that actually delivers the bottom line result, and failure here can nullify the benefit of the investment. The recession and lack of sales from the reversionary leases will have had a major impact on the sales line To deliberately misquote that old cliché – ‘There are two eyes in Spirit, and both have been focused on the team’.”

Longer term opportunities for Greene King: Collyer argued that Greene King ‘should be in the right place for any sell-off of Whitbread’s restaurants if there was to be any change of direction under the new chief executive, as Greene King will now own over >100 pub restaurant sites that have a Premier Inn next to them, and may be keener to determine a more profit-based arrangement regarding providing food and beverage for Whitbread’s hotel guests’. He said: “We don’t see any pressure to do this, but there could be scope further down the line to demerge a stronger, more profitable, higher quality tenanted and leased Pub Partners division. There could be an opportunity to buy in some of the (spirit) freeholds from either British Land or Cerberus, or, given the latter group’s relatively recent entry into the UK pub property market, maybe sell them some more tenanted pubs. Over the past decade Greene King has consistently used its mergers and acquisitions programme, not just to add higher quality sites at the top end of its portfolio, but also used these transactions as an opportunity to be more aggressive about bottom end managed estate churn – selling 200 managed pubs and transferring 214 to tenancy. The Spirit deal provides more opportunity to for this as well as the potential to reverse transfer some of Spirit’s tenanted & leased pubs back into management. (The entire estate was converted from managed to tenancy following Spirit’s acquisition by Punch Taverns back in 2005/6). Entry into FTSE 100 (is) not an opportunity, but an eventual possibility, given the momentum that should return to the stock after its ‘annus horribilis’ in FY15. Notwithstanding the different business models, post Spirit, Greene King will be the fifth most profitable UK stock under our Travel & Leisure coverage (by Ebitda), more profitable than Merlin Entertainments, IHG & William Hill, each of which has a greater market capitalisation, and two of which are in the FTSE 100.” 

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