J.D. Wetherspoon (Bloomberg: JDW LN) is a managed pub operator which own and runs ~700 mainly high-street and food-led pubs in the U.K. It has an equity value of £3.1/share, net debt of £3.9/share and an enterprise value of £7/share. On our numbers, which have scope to be cut back further (discussed below), JDW is expected to generate an EPS £0.20/share and unlevered free cash flows (MCX) of £0.5/share – i.e., it is trading on 15x P/E and 7.5% FCFF yield. In itself, this is not a particularly cheap asset – our thesis is that JDW is more of a restaurant than it is a pub, that the U.K. consumer will be hit much harder in 2009 than it has been in 2008 (i.e., JDW is positioned as value for money; but it is still subject to the discretionary spend of a restaurant), and that the business’ cyclicality, operational and financial gearing are not fully reflected in consensus figures. Consequently, the stock is not cheap and there is no reason for it to re-rate while there is a high porbability of reduced like for likes, further cuts to profitability and a stock price that follows earnings downgrades.

 

JDW is a managed pub operator; i.e., it either owns or leases the underlying real estate of its pubs, and staffs the pubs with a hierarchical management structure and employees. Its cost bar breaks down as follows: ~ 35% COGS (variable), 27% staff (fixed), 4% repairs (fixed), 6% rent (fixed), 4% head office (fixed), 5% depreciation (fixed, non-cash), 11% other (energy, rates, fixed). On this basis, a 1% change in LFL sales impacts EBIT by 8% and EPS by 15%; the business has material operational gearing. In this regard, we should distinguish JDW from its better known peers Punch Taverns and Enterprise Inns, which are effectively property companies that own their underlying real estate but then lease it out to lessees in exchange for a combination of “dry” and “wet” rent. For example, the P&L of a typical tentanted pubco will have gross profits comprised of ~50% rental income and ~50% beer income (i.e., the pubco purchases beer at a wholesale discount and re-sells it to its legally tied estate) and will have EBIT margins closer to 55% rather than JDW’s 8-9%.  Therefore, tenanted pubcos are viewed as more resilient in a downturn in that at the end of the day they are due rental income (i.e., combination of dry and wet rent) from their lessees who are ultimately legally required to pay up. However, the lessee’s themselves have economics similar to JDW in that they have high operational and financial gearing – and this is what we see now in the rising number of pubco lessees who are facing issues. Nonetheless, the point is that the business models are fundamentally different – JDW has the business and P&L dynamics of a restaurant with a significant embedded element of operational and financial gearing.

 

Additionally, we would point out that JDW’s real-estate is comprised of large, high-street pubs with an average weekly turnover of £24k. In 2008, food accounted for 27% of sales – with two thirds of total sales including drinks with meals – whereas food only accounted for 5% in 1992, at the time of JDW’s IPO. In many respects, JDW is a pub in name but a restaurant in fact; its dynamics are different from the theoretical pub model, typically rural, which is far more resilient in the face of a downturn in that it serves as a community social hub, plays a key role in community life, and more often than not is principally drinks led rather than including (discretionary) food within its mix. JDW’s pubs, on the other hand, are located on high-streets, are often viewed as after-work drinks locations, to an extent benefit or suffer from high street footfall patterns, and are increasingly positioned as restaurants. The macroeconomic reasons for our pessimism on the U.K. consumer are well flagged; we would only add here that the further likely cutbacks in discretionary spending will inevitably include reduced eating out, as the experience of listed restaurant groups has consistently demonstrated and is indeed continuing to show. JDW has positioned itself as a value destination, with cheaper beer and lower priced food, but we would argue that it is not immune from a cut in discretionary spend and that its LFL’s will inevitably fall.  Our variant perception is that consensus is not fully taking into consideration the magnitude of the potential profitability collapse.  We find the "trading down" argument as relevant but ultimately ineffective in the face of a broadery discretionary spend collapse; the dynamics are different for a beer that costs £2.20/pint and is a broader group/social experience vs. a meal that ranges from £5-12.

 

There are additional headwinds, including cost pressures from higher National Minimum Wage and statutory holiday pay changes and energy prices, which according to management would require a 3% LFL increase (!) just to maintain last year’s level of profitability. Moreover, the group has to refinance an £87mm private placement in 2009 and its £415mm banking facility is maturing in December 2010; these should not prove to be onerous, as the company does generate cash and can cut back capex growth plans, but well worth monitoring as the year progresses and profitability collapses -- in light of current 5x lease-adjusted net debt to EBITDA.

 

Modeling a potential EBITA decline vs consesnsus we could see JDW trading at £2.25/share in 2009 and presenting more than 25% downside from current levels; we would also highlight its relative out-performance versus its broader peer group (e.g., YTD JDW -16% vs MAB -61%) and the realization that potentially it is not as immune as consensus anticipates.  We view the upside risks as minimal compared to the downside potential.