Description

Thesis Summary

â–  MARS is a slowly growing company trading at 10x current levered cash flow and <9x next year’s cash flow

â–  The business is reasonably high quality and highly stable over a cycle

â–  Fair value is approximately 45% - 65% above current levels with downside supported by a 7.1% dividend yield and the value of the company’s real estate

Business Overview

Marston’s is an owner, operator and lessor of pubs and lodges in England and Scotland with 1565 pubs and 1050 hotel rooms. The company is best thought of as 3 different segments:

Destination and Premium (46% of sales, 45% of profits) – Marston’s 377 owned and operated higher-end food-driven pubs. Average sales per unit are approximately £1.1mm and operating margins are over 20%. Key brands include Pitcher & Piano, Revere and Generous George. This segment also contains the company’s lodging activities.

Taverns and Franchised (28% of sales, 39% of profits) – This segment consists of Marston’s 1188 lower-volume, beverage-driven pubs. Approximately 550 of these are “franchised” locations where operations are handled entirely by local managers in exchange for 20% of sales. About 465 pubs in this segment are leased to third-party operators where Marston’s receives payments for rent and beer sales.

Brewing (27% of sales, 15% of profits) –Marston’s is the number 1 producer of premium bottled ale and cask ale in the UK with a 16% market share. Major brands include Pedigree, Hobgoblin and Bombardier. The company operates 6 breweries throughout England.

MARS is a Reasonably High-Quality and Stable Business

Marston’s return on capital consistently averages in the low double digits. While the company is generally thought of as “pub operator”, in reality over one-third of profits derive from brewing, real estate ownership and lodging which are generally considered higher-quality businesses.

Figure 1: 2018E Profit Breakdown by Segment

Martson’s is also a highly stable business. As shown in figure 2 below, even in the severe recession of 2008/2009 comp store sales only fell by less-than 1% and outside of recessionary periods same-store sales have been consistently positive.

Figure 2: Comp Store Sales

MARS is a Slowly Growing Company Trading at 10x Levered Cash Flow

MARS is a slowly growing business. Organically, same-store sales consistently grow in the 1%-3% range. About 30% of this organic growth is due to increased traffic and 70% is from pricing.  In addition, MARS invests about £75mm per year on value-creating growth projects. 2017’s asset growth will consist of approximately 350 hotel rooms and 20 new pubs. This modest level of growth should be achievable for many years in the future.

Despite this consistent (if slow) growth, MARS trades at only 10.2x this year’s cash flow and 8.7x next year’s.  Next year’s numbers assume only 1.2% same store sales growth and no increase in growth capex and thus appear highly achievable.

Figure 3: Price to Cash Flow Calculations

Fair Value is Approximately 45% - 65% Above the Current Price

To value MARS we first look at the value of the business today. To do this we conservatively assume 1% long-term organic profit growth which is much lower than historical growth. At a 10% cost of capital this implies the current business is worth about £767mm (69/(.1-.01) = 767).  Next we assume MARS is able to investment £70mm per year for the next 12 years at a 11% return and fund this investment with debt / leases costing 5.5%. The cash flow from these investments discounted back at 10% is worth approximately £344mm. Together this suggests a total value of approximately £1.81/share or 66% above the current price. Details are shown in the Appendix.

Another way to value MARS is a simple dividend growth model.  This method is appropriate for stocks like MARS that pay a dividend and where ROE can be reasonably estimated. The formula for this model is Value = dividend *(1+g) / (r – g), where g = retention ration * ROE. As shown in Figure 4 below, this formula yields a fair value of £1.49 or 44% above the current price.

Figure 4: Dividend Growth Model Valuation

Valuation is Supported by a High Dividend Yield and Significant Real Estate Value

Marston’s has consistently paid a dividend near the current level for over 15 years. This dividend provides a return to shareholders regardless of market fluctuations. The dividend is well covered and does not appear likely to be reduced materially.

Marston’s owns 99% of their real estate.  In the UK real estate is held on the balance sheet at market value. As such, tangible book value should be a decent proxy for liquidation value. Tangible book value here is £0.95/share implying only 9% downside in a liquidation. While of course this could be much lower in a true distressed liquidation, there is clearly some hard asset value to support a possible downside scenario.

Other Key Risks

Change in Consumer Tastes – Marston’s customers appear to visit the company’s pubs regardless of the economic situation. This is largely due to a ‘pub culture’ that is unique to the UK. If however, consumer were to instead want to eat fast food or casual dining (as is the case in the North America) this could hurt Marston’s sales and profits.

Leverage – Marston’s net debt to EBITDA is about 5.8x. While this is indeed high, it seems appropriate given the stability of the business and the high real estate ownership.  Interest rates are <5% so interest coverage is >3x and the covenants in the credit agreement are generous. Furthermore, only 1/3rd of this debt comes due within the next 5 years. If you were to adjust for MARS’ high real estate ownership by capitalizing the lease payments of peer companies and including this as debt then Marston’s leverage ratio would appear more in-line with peers.

Appendix: Valuation

Catalyst

Dividends. Slow profit growth