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Fri 30th Jun 2017 - Update: Jamie Rollo on Greene King, Starbucks tax bill
Jamie Rollo – Greene King running hard to stand still, ten questions: Morgan Stanley leisure analyst Jamie Rollo has said Greene King is running hard to stand still following its full-year results and included ten question he thinks investors might have. He said: “Greene King’s FY17 results make us incrementally more cautious on the shares, and we nudge down our earnings per share forecasts 2% and our price target from 700p to 670p. The headline results were flattered by the annualisation of the Spirit acquisition, excluding which we estimate Ebit was flat (and declined 4.6% after stripping out synergies). A more comparable second half performance (with Spirit in both periods) shows Ebit fell 2.0% or 5.4% excluding synergies, and managed pub margins fell circa 110 basis points (versus first half -50 basis points), despite stronger like-for-like sales in the second half. Synergies were accelerated yet FY17 Ebit came in slightly below our forecast, and there are no more quantified synergies to drive FY18E. Looking forwards, we see flat to declining profits over the coming years as cost pressures bite, and like-for-likes remain subdued (though Fayre & Square was a 50 basis points drag on managed like-for-likes of 1.5%, implying -8% like-for-likes here, so we assume a reasonable 1.5% in FY18 as this brand is converted). Core estate capex looks set to remain well above depreciation and amortisation, so free cash flow conversion is weak, and we see little de-leverage, with debt remaining at about four times. We also worry about earnings per share dilution from potential asset sales as pressure builds on the weaker pub ‘tail’, and note the impairment charge at year-end. In its favour Greene King has a good quality asset base, seems well run, and the shares look good value for a largely freehold operator. Yet Mitchells & Butlers (M&B) shares similar characteristics but trades on a significant discount (calculated 2017E price-to-earnings ratio 6.4 times M&B versus 9.9 times Greene King), suggesting valuation offers little support. We include some questions we think investors could have for management after the results:

1. What was the company’s underlying FY17 performance if we exclude the incremental contribution from Spirit? Spirit only contributed for 45 weeks in FY16, and we estimate its extra seven-week contribution added £20m Ebit to FY17, implying underlying Ebit was flat (and -2% in the second half when Spirit was annualised). Further, what was the underlying FY17 performance excluding the Spirit synergies? These were £35m in FY17, an incremental £18m, suggesting underlying Ebit fell 4.6%.

2. Why did the drop in Pub Company operating margins accelerate through the year? Ebit margins fell circa 80 basis points for the managed pub division, implying a drop of circa 110 basis points after circa 50 basis points in the first half, despite like-for-like sales being stronger in the second half than first half (1.8% versus 1.3%). Does this reflect accelerating cost inflation, and/or more reinvestment, and what is the implication for FY18? 

3. What can the company do to protect margins? The company expects net cost inflation of £15m to £20m in FY18, made up of gross cost inflation of about £60m and cost mitigation of £40 to £45m. Where is this cost mitigation coming from, and is it repeatable in future years when gross cost inflation is also high? What like-for-like sales growth does the company need to maintain flat margins?

4. What are management’s expectations for trading for the rest of year? Pub Company like-for-likes were 1.5% in FY17 but a good 2.7% in the fourth quarter, but this seems to have slowed sharply since year end given industry data (Coffer Peach -0.4% May) and the company’s comments about tough comparables. Does the company think the UK consumer squeeze is affecting demand, or is this slowdown temporary? What is a good working assumption for like-for-like sales? Can the company break down like-for-like sales growth between food/drink, London/ex-London, and for some of its main brands?

5. What impact does the company expect from the introduction of the Market Rent Only option? What measures is it taking to mitigate this? What might be the cost of reduced income from the tenants that take up the option and higher incentives to persuade other tenants to remain tied?

6. What return should we expect on the 300 brand conversions? Greene King is one year into a plan to convert circa 300 brands over the next four years at a £120 to £150m capex, targeting five core brands. Is this considered to be revenue generating or should it be viewed as a move to address underinvestment in the acquired Spirit estate? What was the return on the £30m spent on the 63 conversions in FY17, and what were group uninvested like-for-like sales in FY17 excluding the 30% sales uplifts on these?

7. Why did the company take a £78m gross impairment charge last year? What percentage write down on the affected pubs does this represent? Is there a risk of a writedown on the £450m of Spirit goodwill? Both Greene King and Spirit have churned their managed estate much less than peers, so is there a risk of a large tail of underperforming pubs that may need to be sold?

8. The company has identified five brands it will focus on going forward; what will happen to the other 15 brands and the unbranded pubs? Would it consider acquiring new concepts to roll-out, for example in the coffee or grab and go segment? Why was the Metropolitan brand dropped from the growth brands?

9. Why is free cash flow set to weaken, and is cash dividend cover sufficient? The company generated £120m of free cash flow in FY17 (defined as free cash flow post core capex, interest, tax and dividends), but expects this to normalise to £60 to £80m going forward, as working capital, tax and capex normalise. With £100m of dividends, this implies cash cover of 1.7 times, or 1.3 times to 1.4 times post brand conversion capex, is this enough headroom?

10. When will the company start to de-lever? Net debt rose slightly in FY17, and leverage rose 0.1 times to four times, which is the company’s target. With £60m to £80m of normalised free cash flow, a similar amount being invested in brand conversions and new pubs, and little Ebitda growth forecast, when will the company start to de-lever?”

Starbucks to pay $22m tax bill: Starbucks will pay nearly $22m in UK corporation tax after a sharp rise in its taxable profit and turnover last year. The company, criticised in the past for opaque structures that helped minimise tax payments, said its taxable profit in its European, Middle East and Africa (EMEA) division had jumped by 92% to more than $90m in the year to October 2. This has resulted in a 44% increase in its corporation tax paid to nearly $22m. Starbucks reported the tax payments in accounts for four UK-based subsidiaries created when the group moved its European headquarters to London. As the intellectual property of the brand in EMEA is based in the UK, royalties are subject to UK corporation tax. Turnover at the company’s 2,642 stores, many operated on a franchise basis, rose by 17% to $217m. The uplift came after Starbucks expanded into new markets, including South Africa and Turkey, and grew like-for-like sales. Operating profit jumped by 183% to $56m, reports The Times.

Ten Entertainment Group acquires Rochdale bowling alley: Ten Entertainment Group, the UK’s second-largest ten-pin bowling operator, has acquired Strike 10 Bowl in Rochdale, Greater Manchester. It marks the company’s first acquisition since listing on the main market of the London Stock Exchange in April and its third acquisition of the year. The acquisition follows the company’s purchase of The Lanes in Eastbourne in February and Bowlplex in Blackburn in January, both of which are undergoing a redevelopment and enhancement programme and are now operating under the Tenpin brand. Ten Entertainment Group has said it aimed to acquire two to four new sites each year. Chief executive Alan Hand: “The completion of our third site acquisition this year is an exciting development and will grow the group’s portfolio. That we have acquired three new sites so far this year is testament to the exceptional team we have at Ten Entertainment Group, especially following our successful listing on the London Stock Exchange’s main market in April. Our two new sites at Blackburn and Eastbourne are undergoing our ‘Tenpinisation’ transformation process, which is proceeding in line with expectations. We now look forward to beginning the exciting process at Rochdale.”

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