Description

Summary

JD Wetherspoons is a good business operated by a great owner operator who has over four decades compounded shareholder value at great returns, despite several headwinds during his tenure. Due to the combination of COVID, inflation, UK macro issues, Brexit, changes in tax codes, we can now invest in this business at 6x normalized earnings. The timing might not seem brilliant given the state of the UK consumer, but we believe that the company with the best team, best place to work and lowest cost position will come out stronger after this downturn. One thing I am willing to bet my money on is that the UK consumer will return to the pub.

Company background

JD Wetherspoons opened its first pub back in 1979 and has since grown to be one of the largest pub operators in the UK with ~900 pubs/restaurants. It is led by the famous CEO and Chairman Tim Martins who has continuously focused on doing things his own way to compound capital for shareholders instead of following what is expected from him. His letters to shareholders are entertaining to say the least and includes the obligatory rant about how much taxes his pubs are contributing to the government. As an example, he gladly breaks UK corporate governance code by letting people with significant industry knowledge stay on the board for longer than the recommended 9 years. Further, you must look at free cash flow per share because he does not care about the reported earnings or growing an empire measured by the share size of the company. He is a true fanatic you want to partner with who still owns 22% of the outstanding shares.

EPS vs FCF per share

The track record above is stellar when you realize that JD Wetherspoons has been operating in a shrinking market during its entire lifetime with the number of pubs in the UK declining from 70,000 when it started four decades ago to ~50,000 today. This is one of the reasons why we are not afraid to invest into this business even though the future seems a bit cloudy and uncertain at the current moment.

What makes this a great business?

Intelligent fanatic: Every week Tim with his management teams travel to meet the management of its pubs to learn what they are doing to optimize free cash flow. The team takes down the incremental learnings from each pub owner and transfers this knowledge to other pubs who might face the same issues. It is important to note that the average pub manager has been with the company for 14 years (up from 9 years in 2009) and the average kitchen manager has been with the company > 10 years (up from 6 years in 2009). This shows the true culture Tim has been able to build.

Focus on cash earnings, lowest possible tax bill: Focus on taxes is a criterion in Will Thorndike’s book “The Outsiders” and Tim Martins is for sure a candidate for the second version of the book if it will include international CEOs. As an example, he books cutlery to have an expected lifetime of less than 1 year so he can expense the whole investment rather than capitalizing the investment. Further, when you walk around a pub you can always see that the floor is a combination of many different types of flooring. This is to ensure that he can replace only parts of the floor within one year, which again means he can expense the investment rather than capitalizing it. True fanatic.

Return on capital: Initially the pubs primarily served drinks. Tim realized that the assets are underutilized and expanded this to include dining, now many of his pubs also are transformed into hotels to increase revenue / capex. Another interesting observation was that JD Wetherspoons was one of the first restaurants to develop its own ordering app. This came from an internal project where the waiters realized customers spent a lot of time waiting in ques to drink beer. This was valuable time the customer could be sitting at the table drinking. In sum this investment reduces the required number of waiters and increases revenue/table/hour. Brilliant. The graph below shows the impressive increase in sales per pub.

Lowest cost: The goal of JD Wetherspoons is to be the lowest cost provider in a tough industry, that is a position we always like. If you go to one of their pubs it is impressive how cheap you can get a pint. It uses its share size to negotiate great procurement deals with obscure breweries who do not have much power, but appreciate the volumes and stable customer. Another key reason JD Wetherspoons is able to be the lowest cost player is that it owns its own real estate. This is a key point in today's raising rates and inflationary environment that we do not think the market is giving enough credit. Back many years ago its competitors were driven by greedy shareholders to do sale leaseback of its properties, something Tim was always against as it views its agility in closing/remodeling/repurposing its real estate as one of its competitive advantages. Not only does it help the operational agility of the company, but it also serves as an inflationary hedge for current shareholders its competitors do not possess.

It is also worth mentioning that the company has fixed a majority of its interest rates until 2031 which based on today's market rates have tremendous value, and again enhance its competitive position.

Valuation

At a share price of 5 GBP the current market cap is 600m GBP and with net debt of 900m GBP the total enterprise value is 1.6bn GBP. I see no reason why the earnings of JD Wetherspoons should be permanently impaired and from 2014 to 2019 it made an average FCF of 100k GBP.  The shares are down from a high of 16 GBP and we now believe the time is right, although looking out the window at the UK consumer it does feel like it. The biggest risk on the valuation is its debt burden and share issuance risk, but we like our odds being in the same boat as Tim Martins.

Catalyst

- UK consumer goes back to the pub

- Slowing inflation / stabilization of interest rates in UK