Punch - Conversion

All,

Please find our updated analysis here.

Upon some further analysis of the latest financials and pub economics at large, we are becoming more constructive on the name and may end up taking a position on it, pending further discussions among the team. Absent a compelling rationale for converting more pubs into food-centred PMs and being forced to change tack towards rolling out more wet-led pubs instead, management are frugal and cashflows have remained relatively clean of the usually permanent one-off charges. So while we are a bit disappointed that Punch have not found a single pub (among 1,267) worth converting in the last quarter, we note that cash conversion is better than we thought. What’s more, Beer inflation in the UK continues at 6% p.a. and is rising. With gross margins on beer continuing near 60% and no change in WC suggesting trouble is brewing at the publicans, Punch are demonstrating they can more than pass through the expense inflation.

Investment Considerations:

- 12% yield are not the world, but downside from here seems limited too. EBITDA margins are down at a new low, but the end of VAT holidays should annualise in Q3 (to May) and the company looks to have achieved cost pass-through while generating approx. 1.4x interest coverage on a pre-IFRS 16 basis. Coupled with the strong asset backing we feel comfortable in these bonds. 

- The original thesis of converting wet-led L&T pubs into food-centred MPs has broken down. Conversion costs have become too high and food is not growing as fast as drink. But the general inflationary environment - while dropping percentage margins - is lifting absolute earnings on the majority of the estate, the hitherto ugly duckling: L&T. Fortress are lucky.

- The considerable runway until 2026 allows the company to raise its margins with a different type of conversions - into wet-led MPs. Not requiring a crewed kitchen, conversions take far less CapEx intensive and costs are contained going forward.

- The 20%+ IRRs management are seeking on CapEx spend suggest a 4-year+ pay-back - only after it is time to talk about refinancing. But Punch, deservedly trading on a high EBITDA multiple due to strong asset coverage and excellent cash conversion, would see value accretion after only the first of post conversion trading. 

Conversions:

- The company has abandoned its strategy of converting more L&T pubs into food-centred MPs. The economics are not feasible in this environment.

- Management are identifying a new set of pubs to convert into MPs, but into wet-led concepts instead. Until then we will probably see another six months without conversions.

- On our math the conversions are not required to return bondholders to par in year to 18 months.

- We are less focussed on conversions from here. Apparently we have been converted instead.

Inflation and Margins:

- Inflation is good. Bonds are fixed and the 6% and rising topline inflation has already been enough to offset Punch’s cost. Due to its scale, we expect the company to be able to control COGS relatively well and labour and energy costs are minimal on the dominant L&T estate.

- Margins have reached a new low in Q223, but that is in part still due to the end of the VAT holiday at the end of the comparable quarter last year. Going forward, these (revenue) headwinds should annualise.

- Energy and Gas contracts are now set for the majority of the estate - except for the Laine pubs (2% of the estate). 

Happy to discuss,

Wolfgang

E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk