Mitchells & Butlers (Bloomberg: MAB LN) is the UK’s leading managed pub and pub restaurant operator. It operates a high quality estate, focused on long term growth in the informal, value for money, eating and drinking out market. It is highly cash generative, property backed (90% of pubs are freehold, 75% are in residential areas), and operated by one of the strongest and most experienced management teams in the sector. Its fundamentals are very strong; indeed, MAB will report numbers on September 27, 2007, where the board has guided to hitting the upper end of expectations despite challenging comparables, a smoking ban and particularly poor weather in the U.K. The opportunity, however, lies in the free option value of a very highly probable set of events.

On May 4, 2006, MAB rejected an offer of 550p/share for the company from property magnate Robert Tchenguiz. Since that time, Tchenguiz has built a 19% stake in the company. On May 21, 2007, MAB and Tchenguiz announced they are exploring a 50:50 JV covering the majority of the MAB property assets (more on this below). On August 2, 2007, the company announced that in view of the prevailing conditions in the debt markets, the board of MAB has concluded that the JV is unlikely to be achieved until debt markets have improved – however, that both management and Tchenguiz remain as committed as before to getting a transaction consummated. Throughout this time, MAB’s stock price climbed from 550p at the time of the Tchenguiz bid in 2006 to 900p by the end of June as it was substantially pricing in the property transaction. Since that time, the stock price has come back down to 608p as of writing (September 19^th).

Our investment thesis is that MAB is fairly valued both in absolute terms and relative to its peer group of companies, under the status quo. However, assuming consummation of the property transaction with Tchenguiz, on a pro forma basis, it is trading on a 15-16% unlevered free cash flow yield, 2.5x EBITDA and 5.2x EBIT. We view this as an incorrect valuation for the pro forma asset and see well over 30% upside to a very conservatively calculated fair value. Additionally, we see a savvy property investor and major shareholder committed to getting the transaction completed, and a management team that is fully on board and equally committed to getting this done. Indeed, interest rate and inflation hedges for 30 years were already in place for the financing of the JV and it was only days from being consummated when the debt crisis hit the banks. Therefore, we view the pro forma structure as a matter of “when”, not “if”: i.e., today we are buying a fairly valued asset with free optionality on a likely and highly value creative event. Additionally, with the Tchenguiz bid at 550p in 2006, and today’s price at 608p, we see the downside as limited and find the present risk: reward quite attractive.

Our math is as follows on 2008 numbers (FYE September). MAB had agreed with Tchenguiz to do a sale & leaseback transaction to a 50:50 owned JV of the vast majority of its freehold property of £5.5bn. The math is that it would sell £4.5bn of its property to the JV and lease it back at a yield of 5.3% or £240mm p.a. Moreover, it would lever up the property JV to a loan-to-value of 85%, so the £4.5bn in assets would be offset by £3.825bn of debt, leaving an equity account of £675mm. This would be a 50:50 JV, so half of the equity would be funded by Tchenguiz, and half would be funded by MAB – so MAB would face a cash outflow £340mm. Therefore, from this whole sale & leaseback transaction, MAB would collect £4.2bn cash upfront (i.e., £4.5bn from selling all its assets, less the £340mm of funding of the equity portion).

On consensus numbers, MAB has an EBITDAR of £540mm. Pro forma for the sale and leaseback detailed above, it would be hit with an additional £240mm p.a. of rents, and additionally, it has an existing rent charge of £47mm, so its pro forma EBITDA would be £255mm. Now, management has said that they would like to run the company with a pro forma fixed charge cover (defined as EBITDAR / (net interest + rents)) of slightly under 2.0x. In order to get to this fixed charge cover ratio, based on the new level of rents on the company’s books, the pro forma MAB would have to have £310mm net cash on its books earning interest at about 5% p.a. (i.e., 540 / (-310x.05 + 240 + 40) =2).

So, we take EBITDA of £255mm calculated above, - £130mm D&A, +£16mm interest income as calculated above, gives us a PBT of £140mm, -£39mm taxes at 28% marginal cash tax rate, gets us a net income of £101mm. To this, we add back £130mm of D&A, subtract -£120mm of maintenance capex based on management discussion and in their interim presentations, and finally subtract out -£11mm of the after-tax interest income to get to an unlevered free cash flow of £100mm; we set this number aside for now. (note: D&A may infact be a lower, but not materially, as some fixtures and fittings, etc. will be transferred to the propco in the sale & leaseback transaction – so depreciation and maintenance capex are roughly in line).

MAB is currently trading on 608p per share and has 402.5mm shares outstanding giving us an equity value of £2.45bn. Additionally, the company will have roughly £2.45bn net debt by the end of the year. However, we recall from above that the sale & leaseback transaction will result in a net cash inflow of £4.2bn. Of this inflow, £2.45bn will go towards paying down the net debt just discussed, an additional £310mm will go to fund that amount of cash on the balance sheet earning interest at 5% (and hence bringing the company’s fixed charge cover in line with management’s stated targets), and finally we charge the company with £250mm for securitization break costs and other transaction expenses. Out of the £4.2bn it got from the sale and leaseback, this leaves us with a free £1.1bn of cash which management will dividend out to shareholders. So, going back to the pro forma enterprise value calculation, we have an equity value of £2.45bn calculated above, we no longer have net debt as it was paid off, we have net cash of £310mm, we have a stake in a 50:50 property JV calculated as 50% of the JV’s net asset value of £338mm, and finally we have a one-time special dividend per guidance and our calcs of about £1.1bn (i.e., the amount we are left with from the cash of the sale & leaseback, after net debt has been paid, the opco has been capitalized with cash, and transaction fees and expenses have been paid). This gives us an enterprise value of roughly £650mm.

We know the unlevered free cash flows are £100, we have the enterprise value of £650mm, so on a pro forma basis, we get a ~15-16% unlevered free cash flow yield, and 2.5x EV/EBITDA, which really would make this a fundamentally deep value asset: so, MAB today gets you a free option on a very cheap pro forma company, with the added note that there is a very high probability that this option is going to get exercised. The key risk is that the terms of the deal change substantially – that is not the indication we have received to date and our base case is run with a slight haircut, but this should nonetheless be flagged as a risk factor. Regardless, we view the risk:reward as compelling.