A Look At Pub Operator Marston's Plc

| About: Marston's plc. (MARZF)

Summary

Marston's Plc has a decent upside potential.

Although the pub industry is shrinking, Marston's strategic investments should offer benefits.

A Target Valuation based on P/E and DCF Valuations is above 140 pence/share.

Executive Summary

Marston’s Plc (Mars) is in the business of Pub and Brewery operating 1559 pubs and five breweries across the UK. Mars is a relatively small player in the market however it has been able to grow at a higher rate than industry. Pub industry in the UK is on decline and number of pubs in the UK are getting lower. There is fierce competition from Greene King Plc, JD Wetherspoon Plc, Punch Taverns Plc and EI Group Plc. Although the company is profitable and growing, it suffers from higher leverage and higher interest costs. As of today, June 28, 2017, Stock is trading at 122.4 pence per share on London Stock Exchange. A discounted cash flow analysis and pricing using forward P/E multiple suggests a fundamental valuation of 143 pence per share. I recommend Marston's Plc as a Buy.

Company Background and Business Analysis

Marston’s Plc (Mars) is one of the oldest 'pub operator' publicly listed company in the UK, employing 14000 people and having revenue of £906m in 2016. It operates around 1600 Pubs and 5 Breweries and generates revenue by selling drinks and food through their three categories of Pubs – Destination & Premium, Taverns, and Leased. Mars is also the largest brewer of cask ale (a type of beer) and holds a 20% share in premium cask ale market, and a 25% share in premium bottled ale market. About 90% of the beer produced is sold to third parties. Around 80% of the revenue comes from pub business and 20% from Brewery, although the latter is expected to increase to 22% as a result of growth in bottled ale business. Mars also has 953 rooms across their pubs for guest stays.

Mars operates in a very competitive and shrinking business environment. The Pub industry in the UK is in decline, and the number of Pubs has been reduced to around 47,548 in 2016 from 49,000 in 2012 and 60,000 in 2000. A few other issues which the pub business is facing are declining alcohol consumption, rising beer duty and competition from supermarkets as people are increasingly buying alcohol from the supermarkets than in Pub. However, Mars has responded by changing their focus from low revenue wet-led pubs to higher revenue food-focused pubs, and as a result, they have been selling-off Taverns pubs (Revenue/Pub - £270,000 in 2016) and investing in destination & premium pubs (Revenue/Pub - £1.060m). They are planning to open 23 pubs every year for next five years. Mars also invested in the brewery business to capture the growth in bottled ale market. They have introduced 42 new beers in 2016, and invested additional funds in Burton Brewery, including £5m in the canning line. Another step Mars is taking to increase revenue and profitability is to introduce franchise-style agreements to all of their Taverns Pubs. Currently, 500 are under a franchise-style, and this is expected to increase to all Taverns pubs, resulting in higher and stable revenue and profits. There is also focus on providing healthier meals, and hence 500/600 calorie food options are offered in pubs.

Mars' revenue has been increasing at compounded annual growth rate of 5.92% in past five years as a result of the change in strategy, and they are expected to grow somewhat slower pace than 5.92% over the foreseeable future. Reasons for slow growth in future include the further shrinkage of pub market (45,000 pubs by 2020) (Pub Market Report: Optimism for on-trade growth), an uncertain economic environment resulting in higher costs (Brexit), tough competition, and limited capacity of Mars to take on further debt. Mars could show a decent growth when compared to the competitors because of investment in rooms and food-focused pubs, and due to the fact that Mars is a category leader in premium and bottled ale market. Main competitors for Mars are JD Wetherspoon Plc operating 956 pubs, Greene King Plc (GKP) operating 3100 pubs, restaurants, and hotels, Punch Taverns Plc operating 3500 leased and tenanted pubs, and Enterprise Inn operating 273 pubs and 4440 leased properties run as pubs. Only Mars and GKP has the brewery arm which provides the benefit of diversification and supports pub revenue stream during difficult times. However, JD Weatherspoon is expected to grow more than any other competitor.

Financial Performance Analysis

Revenue per Pub – Revenue/Number of Pubs

Revenue per pub is one of the primary driver and key performance indicators for pub business. As discussed above, the company operates in 4 segments, and all of them have different revenue profile. This table helps to understand where the most value is created and also helps in forecasting. Revenue/pub have been increasing in all the segments except in Leased Pubs, which are stable.

Revenue/Pub (£m)

2013

2014

2015

2016

- Destination & Premium

1.0006

1.0587

1.0280

1.0596

- Taverns

0.1906

0.2088

0.2499

0.2722

- Leased

0.1444

0.1557

0.1572

0.1532

- Brewing

25.4600

26.5000

33.8200

38.6600

Operating Margin (EBIT) – Operating Profit/Sales

Mars' operating margin is on decline marginally from 21.50% in 2013 to 19.07% in 2016 as a result of higher operating expenses across all the segments, especially the central services cost. These costs are expected to show the same trend and increase very slightly, except in the Taverns category where operating expenses are projected to decrease slightly because of change in model to franchise-style.

Operating Profit/Sales

2013

2014

2015

2016

Destination & Premium

20.13%

20.16%

20.49%

20.46%

Taverns

27.71%

24.74%

26.04%

25.34%

Leased

46.76%

44.26%

44.40%

47.73%

Brewery

13.28%

13.13%

12.24%

12.00%

Central Costs

-1.84%

-2.09%

-2.20%

-2.31%

Underlying Operating Margins

21.50%

19.82%

19.56%

19.07%

Underlying Net Profit Margins – Net Profit/Sales

Although underlying operating margins are decreasing slightly, underlying net profit margins have seen slight increases because interest costs have not risen as much as revenue. The net profit margins increased a little bit from 8.74% in 2013 to 8.88% in 2016. This is healthy net profit margin, but lower than Greene King Plc's average of 9% in last five years.

Interest Coverage Ratio – Finance Costs/EBIT

This ratio has been increasing in last two years as a result of higher operating profit. Interest costs rose marginally, but operating profit has grown at a higher rate than interest costs. Currently, this ratio is 1.97, which in itself is not very healthy. Lower interest coverage means higher risks; however, Mars revenues are stable and increasing. Moreover, the nature of the business is such that revenues will not vary significantly. Again, Greene King Plc has higher interest coverage of around two over last five years.

ROE – Return on Equity – Profit/Total Equity

In the most recent year, Mars has an underlying return on equity of 10.69%. This is higher than the 5-year average of 9.25%.

Return on Equity = Net Profit/Sales X Sales/Total Asset X Total Asset/Total Equity

Net Profit Margin

Total Asset Turnover

Leverage

ROE

2016

8.88%

0.32

3.72

10.69%

2015

8.73%

0.31

3.50

9.43%

2014

8.47%

0.30

3.46

8.79%

2013

8.72%

0.30

3.12

8.11%

ROE is increasing as a result of an increase in leverage as the company is taking on more debt. This is not sustainable as Mars is already highly leveraged and have limited capacity to take on further debt. Mars is also employing their total asset more efficiently now generating £0.32 revenue in 2016 as compared to £0.31 in 2015 and £0.30 in 2014.

Price-Earnings Ratio – Market Price per share/Earnings per share

A price earnings ratio tells about the growth prospects and future expectations of the company. Mars underlying P/E Ratio has been very stable around 10. Underlying P/E in 2016 is 10.12 which is lower than last five-year average of 10.52. This is also lower than the industry's average of 12.14. Lower P/E means that investors are not expecting higher future growth. It could be assumed that investors are now expecting a lower dividend, lower growth in the dividend, and higher risk.

Forecasting Income Statement & Free Cash Flow

Revenues

As discussed in the latest annual report, Mars is planning to open 20-23 new premium pubs for next five years. Additionally, as per the same report, they are planning to reduce Taverns pubs for next few years, and the target is to sell-off 75 Taverns pubs in next five years. Revenue from Leased pubs is seen increasing at 3% in 2017 and 2% after that, while from Brewery it is rising at 7% in 2017, 5% in 2018, 4% in 2019 and then 2% in 2020. This is because of higher growth rate in cask and bottled ale market. A terminal growth rate is assumed at 1.5% which is in line with forecasted increase in GDP.

Number of Pubs

2013

2014

2015

2016

2017

2018

2019

2020

- Destination & Premium

349

356

397

416

436

456

473

483

- Taverns

1316

1078

859

812

779

759

746

740

- Leased

385

341

341

331

330

328

326

325

- Brewing

5

5

5

5

5

5

5

5

Operating Expenses

These expenses have been very constant in across all the segments in last four years. It is assumed that these costs will tay consistent, except central costs. Central costs have been rising, and they are presumed to be increasing at the rate of the growth of revenue. These are increasing because of company growth. As per company annual report, operating expenses are not expected to increase significantly as they have the forward lease agreement in place until 2019.

OPEX

2013A

2014A

2015A

2016A

2017E

2018E

2019E

2020E

Destination & Premium

79.87%

79.84%

79.51%

79.54%

79.69%

79.69%

79.65%

79.62%

Taverns

72.29%

75.26%

73.96%

74.66%

74.04%

74.04%

74.39%

74.22%

Leased

53.24%

55.74%

55.60%

52.27%

53.21%

54.01%

54.17%

53.85%

Brewery

86.72%

86.87%

87.76%

88.00%

87.34%

87.34%

87.46%

87.58%

Central Costs

1.84%

2.09%

2.20%

2.31%

2.42%

2.50%

2.57%

2.62%

Total Expenses

78.50%

80.18%

80.44%

80.93%

80.98%

81.18%

81.42%

81.42%

Interest Costs and Tax

Interest expense for 2017 has been calculated by taking different kinds of debt and interest paid on them. After 2017, interest costs are expected to increase as the company assumes more debt, although not significantly. Interest rate payable won't shift very much because Mars has fixed interest rate swap agreement.

The UK Corporate Tax rate is 20% for this Business; however, the company has been deferring tax and claiming some tax credits and hence effectively paying 17-18% tax expenses on underlying profit before tax. It is assumed that Mars will continue to account 18% tax expenses.

Interest Cost Forecast

Debt at End of 2014

Interest

Effective Rate

Debt at End of 2015

Interest

Effective Rate

Debt at End of 2016

Interest

Effective Rate

Finance Income

(0.50)

Unsecured Bank Borrowing

219.60

11.70

5.33%

258.70

12.20

4.72%

263.00

12.89

4.90%

Securitized Debt

891.60

49.20

5.52%

866.20

47.80

5.52%

839.50

46.34

5.52%

Finance Leases

20.80

1.10

5.29%

20.70

1.10

5.31%

20.60

1.09

5.30%

Other Lease Related Borrowings

148.10

10.70

7.22%

195.10

12.60

6.46%

235.80

15.33

6.50%

Other Borrowings

120.00

1.80

1.50%

120.00

1.50

1.25%

120.00

1.56

1.30%

Total

1,400.10

74.50

5.32%

1,460.70

75.20

5.15%

1,478.90

76.71

5.19%

Forecasted Income Statement

2013A

2014A

2015A

2016A

2017E

2018E

2019E

2020E

Underlying Revenue

- Destination & Premium

349.2

376.9

408.1

440.8

457.8

474.2

491.9

501.8

- Taverns

250.8

225.1

214.7

221.0

224.7

227.7

229.4

234.0

- Leased

55.6

53.1

53.6

50.7

52.1

52.8

53.5

54.6

- Brewing

127.3

132.5

169.1

193.3

206.8

217.2

225.9

230.4

Total Underlying Revenue

782.9

787.6

845.5

905.8

941.4

971.9

1,000.7

1,020.7

- Growth

0.60%

7.35%

7.13%

3.93%

3.24%

2.96%

2.00%

Underlying Operating Expenses

- Destination & Premium

278.9

300.9

324.5

350.6

364.8

377.9

391.8

399.5

- Taverns

181.3

169.4

158.8

165.0

166.4

168.6

170.7

173.6

- Leased

29.6

29.6

29.8

26.5

27.7

28.5

29.0

29.4

- Brewing

110.4

115.1

148.4

170.1

180.6

189.7

197.5

201.8

- Services

14.4

16.5

18.6

20.9

22.8

24.3

25.7

26.8

Total Underlying Operating Expenses

614.6

631.5

680.1

733.1

762.4

789.0

814.7

831.1

Underlying Operating Profit

- Destination & Premium

70.3

76.0

83.6

90.2

93.0

96.3

100.1

102.3

- Taverns

69.5

55.7

55.9

56.0

58.3

59.1

58.7

60.3

- Leased

26.0

23.5

23.8

24.2

24.4

24.3

24.5

25.2

- Brewing

16.9

17.4

20.7

23.2

26.2

27.5

28.3

28.6

- Services (Costs)

(14.4)

(16.5)

(18.6)

(20.9)

(22.8)

(24.3)

(25.7)

(26.8)

Total Underlying Operating Profit

168.3

156.1

165.4

172.7

179.1

183.0

186.0

189.6

Net Finance Costs

82.1

73.1

73.9

74.7

76.7

77.4

77.9

78.4

Profit before Tax

86.2

83.0

91.5

98.0

102.4

105.6

108.1

111.2

Tax

17.8

16.3

17.7

17.6

18.4

19.0

19.5

20.0

Profit After Tax

68.4

66.7

73.8

80.4

83.9

86.6

88.6

91.2

- Growth

-2.49%

10.64%

8.94%

4.40%

3.13%

2.38%

2.94%

Basic Weighted Average Shares

569.4

571.0

572.2

574.6

576.3

578.1

579.8

581.5

Underlying Basic EPS

0.120

0.117

0.129

0.140

0.146

0.150

0.153

0.157

Free Cash Flow to the Firm (FCFF)

FCFF has been forecasted by taking operating profit from the income statement and adjusting for exceptional and miscellaneous items, depreciation, working capital, tax paid and capital expenditure.

Exceptional & miscellaneous items are by definition very unpredictable; hence the best estimate is taken by calculating them as a percentage of sales.

Depreciation will increase as a result of an increase in sales because to increase sales company has to replace the fixed assets and buy the new one. Depreciation is expected to increase at the rate of growth in revenue.

Tax paid as seen in cash flow statement has been relatively constant as a percentage of profit before tax. It is lower than actual tax expense because the company is deferring tax as evident from deferred tax liabilities in the balance sheet. However, these are only temporary differences and company is expected to pay these deferred taxes in future. Hence taxed paid are increasing and converging towards tax rate.

Growth in revenue is not possible without reinvestment. The company has to replace existing assets and invest in new assets to drive growth. Capital expenditures will increase as the company grows. As the company is planning to increase investment in premium pubs and new rooms, CapEx will grow at the rate of the growth of the company.

Forecasted FCFF

2013A

2014A

2015A

2016A

2017E

2018E

2019E

2020E

Underlying Revenue

782.90

787.60

845.50

905.80

941.43

971.92

1,000.71

1,020.74

Underlying Operating Expenses

(614.60)

(631.50)

(680.10)

(733.10)

(762.37)

(788.97)

(814.75)

(831.09)

Underlying EBIT

168.30

156.10

165.40

172.70

179.06

182.96

185.97

189.64

Exceptional & Misc Movement

(35.50)

(32.10)

(35.50)

(29.00)

(37.66)

(38.88)

(40.03)

(40.83)

EBIT

132.80

124.00

129.90

143.70

141.41

144.08

145.94

148.82

Depreciation

35.80

36.30

37.90

40.00

41.57

42.92

44.19

45.08

Working Capital Movement

8.90

(23.70)

10.70

8.90

6.59

5.83

5.00

4.08

Tax

(8.10)

(8.80)

(16.20)

(9.80)

(10.24)

(11.61)

(12.97)

(14.46)

Cashflow from Operations

169.40

127.80

162.30

182.80

179.33

181.22

182.17

183.51

Capital Expenditure

(104.10)

2.80

(98.40)

(95.40)

(99.15)

(102.36)

(105.40)

(107.51)

Free Cash Flow to the Firm (FCFF)

65.30

130.60

63.90

87.40

80.18

78.86

76.77

76.01

Present Value of Cash Flows

76.46

71.70

66.56

1862.50

Discounted Cash Flow Valuation & Pricing using P/E Ratio

DCF is used in the valuation of the firm operating assets instead of valuation of equity using dividend discount model. The reason for choosing DCF is because Mars is only paying 50-55% of their earnings as dividend and hence dividend will not capture the value of the full firm.

An adjusted forward P/E Ratio is used to price equity for 2017.

Risk-Free Rate –

The yield on 10-year Gilt in the UK is 1.18% which is taken as the Risk-Free Rate for Calculation of Cost of Equity and Cost of Debt.

Beta –

A proxy for the measure of market risk known as Beta is calculated by running the regression of the monthly return of Mars over past five years against the monthly return of FTSE 250. Beta for Mars is 0.7542

Equity Risk Premium –

ERP, expected excess return on equity over risk-free rate, is taken as 6.25% which is calculated by Prof. Aswath Damodaran from New York University, as published on his website.

Cost of Equity for Mars – 1.18% + (0.7542*6.25%) = 5.89%

Terminal Growth Rate – 1.5% in line with expected growth rate of UK GDP

Cost of Debt –

Based on Interest coverage ratio of 1.97 in 2016, the rating which is given to other companies having same interest coverage ratio is B- which represents a credit spread of 4.25%. Adding risk-free rate will give Cost of Debt as 5.43% and after-tax cost of debt as 4.34%

If interest coverage ratio is

greater than

≤ to

Rating is

Spread is

-100000

0.499999

D

10.00%

0.5

0.799999

C

7.50%

0.8

1.249999

CC

6.00%

1.25

1.499999

CCC

5.00%

1.5

1.999999

B-

4.25%

2

2.499999

B

3.25%

2.5

2.999999

B+

2.50%

3

3.499999

BB

2.00%

3.5

4.499999

BBB

1.50%

4.5

5.999999

A-

1.25%

6

7.499999

A

1.00%

7.5

9.499999

A+

0.80%

9.5

12.499999

AA

0.50%

12.5

100000

AAA

0.20%

Market Value of Equity - 771.27m, Fair Value (not book value) of debt as taken from annual report since debt is not publicly traded, 1485.4m

WACC = E/(D+E) *Cost of Equity + D/(D+E) *After-tax Cost of Debt = 4.87%

Forward Price Earnings Ratio – 9.8x

The average P/E ratio of the industry is 12.14, however, over the past five years, Mars' P/E has average 10.52. This is because of higher risk (leverage) and lower growth prospects in comparison to the industry. It currently stands at 10.12x and is expected to decrease as a result of the decline in growth opportunities. It is assumed that forward P/E could be 9.8 in 2017, reflecting higher leverage and lower growth prospect.

Company

PE Ratio

PUNCH TAVERNS

6.06

ENTERPRISE INNS

10.63

MARSTON'S PLC

10.65

GREENE KING

11.08

MITCHELLS & BUTLERS

11.56

WETHERSPOON(J.D.)

22.83

Average

12.14

Fundamental Value of Firm using DCF – £2077.21m. Reducing debt of £1845.4m and adding cash £185.6m will give equity value of £777.41m or 135 pence per share.

Pricing using forward P/E Multiple – Underlying 2017 EPS * 9.8 = 143 pence per share.

There is not a big difference between fundamental value and value derived from P/E. Reasons for the discrepancy is the expectation of the market regarding higher growth or slightly lower risk. Or it could be because of the forces of demand and supply.

Conclusion

I issue a recommendation of BUY,with a target price of 143 pence per share.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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