Description

Mitchells & Butlers PLC (MAB.LN-227.75p, or MLB-$3.92) is the UK's largest operator of managed pubs. With the early signs of a sales recovery underway, a recapitalization plan recently announced, and the impending sale of its most comparable competitor highlighting the value of MAB's estate, we feel an investment in MAB shares is both timely and compelling. The company's plan to return GBP 500mm to shareholders (68p per share) followed by a share consolidation -- effectively a large buyback -- better leverages EPS to an eventual recovery and is the most immediate catalyst to driving the shares upward. However, having been the subject of takeover interest several months back and with numerous private equity groups having recently bid for Scottish & Newcastle's pubs, MAB may draw renewed takeover interest prior to the actual recap (less likely afterwards). Pro forma for the return of capital and subsequent share consolidation, MAB shares are trading at about 10x 2004e EPS, a large and unwarranted discount to other UK managed pub groups with lesser assets. Valuing MAB at only 13x 2004e EPS (PF) would put the stock in the range of 300p, or 32% upside from current levels. We believe downside is fairly limited given the likely takeover interest, the fact that MAB had already received (but rejected) a lowball bid several months ago (at 205p), a valuation comparable to Scottish & Newcastle's takeout price would likely equate to north of 300p for MAB and, operationally, the company should begin to feel the wind at its back as 2004 progresses.

History. Mitchells & Butlers became a standalone entity in April, when Six Continents ("6C") separated its Pubs business from its Hotels unit (now InterContinental Hotels Group, IHG.LN). Six Continents itself had undergone significant changes in recent years, the most pertinent one to this story being that it had pruned its Pubs estate down from nearly 5,000 in 1992 to a current base of 2,100, retaining the highest quality and most profitable properties which now comprise Mitchells & Butlers. Six Continents had changed its name from Bass in 2001, a year after having sold its beer business to Interbrew, and shortly thereafter sold a chunk of its Pubs to Nomura. With a significant amount of cash in its coffers, 6C determined to either bulk up its Hotels and Pubs businesses through acquisitions or, failing that, return the cash to shareholders. It opted for the latter and, at the time of the last spring's demerger, the company returned GBP 700mm of its capital in the form of a special dividend.

Just prior to the demerger, Six Continents had received two credible offers from parties interested in its Pubs unit. The first was from Hugh Osmond, the founder of Punch Taverns, who bid GBP 7bb for all of Six Continents (including the Hotels unit); Osmond's intent was to sell off Hotels and retain Pubs. Management rejected the offer, in part because Osmond would finance the deal mostly through issuing stock from one of his closely held entities. Osmond then maintained that he would reconsider an offer for Pubs once it traded separately. The second came from BC Partners (UK private equity shop), which offered to buy the unit for GBP 2.8bb including debt (equating to 205p on the current equity base). This was also rejected by management as too low, which at the time maintained that the business was worth at least GBP 3.5bb (300p). BC initially indicated it remained interested in MAB but in May reversed course citing a lack of cooperation by management, who by this time was determined to create value by running the business and better optimizing the balance sheet.

In the midst of the two bids for MAB and rumors of other interested parties, Scottish & Newcastle ("S&N"), the UK's second largest operator of managed pubs, announced its intent to sell its Pubs unit, effectively starting the bidding at GBP 2.3bb by saying it expected at a minimum the division's book value. Once the auction began, MAB management made clear that, while there could be significant synergies between the two very comparable groups, it would only pursue a deal if one could be done at a very attractive valuation, unlikely given the amount of groups then looking at the S&N assets.

With the S&N auction on the back burner, in late May MAB management announced its preferred and intended plan of action: following in the footsteps of its former parent, the company would return "at least GBP 400mm" to shareholders, although specifics of the plan were at that time limited. MAB had been demerged with GBP 1.3bb of net debt, or 3.5x 2002's EBITDA, fairly typical leverage for the UK managed pub industry. Management had felt, though, that given the pretty steady nature of the business as well as MAB's scale, it can withstand at least another multiple point of leverage while retaining an investment grade rating.

When the first round of bids were taken for the S&N assets, MAB put in a relatively conservative one -- no doubt high enough to help reaffirm the value of its own estate but not high enough to actually win. Not surprisingly, MAB didn't make it through to the second round and last week S&N announced it had agreed to sell the unit for GBP 2.51bb to a consortium led by privately-owned Spirit Group, the UK's third largest managed pub operator. The price tag equates to 1.1x S&N's book value, 2.4x 2003 sales, 8.4x 2003 EBITDA, and values each unit at about GBP 1.7mm. Valued on comparable multiples of book, sales, and per unit, MAB's price tag would be 324p, 314p, and 296p, respectively (average of 311p). Valuing the estate at a similar EBITDA multiple would yield a much lower 260p. However, we would point out that, having committed significant capital in recent years to upgrade its units -- the benefits of which are not fully in its historical numbers -- MAB has more inherent upside to its profitability, for which we believe it would be at least partly compensated in a takeout.

In any event, we believe that while it remains possible some former interested parties revisit and bid for MAB prior to its effecting the recap plan, more likely the dividend and share consolidation will occur and investors will be equally well served over the intermediate term.

Current Events. Having originally indicated in May it would return at least GBP 400mm of capital to shareholders, last week the company formalized its plans by announcing it will dividend out GBP 500mm, or 68p/share. As with the Six Continents return, the dividend will be subsequently followed by a share consolidation of a commensurate amount of capital and (if 6C is the model) likely at the stock price on the day of the dividend. For those unfamiliar with this process, it's fairly simple and is effectively a large stock buyback: there are 734mm MAB shares outstanding, each of which will first receive a special dividend of about 68p, totaling GBP 500mm of capital; then GBP 500mm worth of stock is consolidated, or retired, using the current stock price. For illustrative purposes we'll assume today's closing price of 227.75p is used (obviously that's 2.2775 in Pounds), which would result in 219.5mm shares being consolidated (GBP 500mm divided by GBP 2.2775 = 219.5mm shares), or approximately 30% of the current shares outstanding. Pro Forma, then, MAB would have 514.5mm shares outstanding.

Mitchells & Butlers further announced that as part of its plan to recapitalize the balance sheet, it will securitize the vast majority of its estate (all but about 150 of its Pubs) through the issuance of GBP 1.9bb of bonds, which it will begin to market in the next few weeks and issue in November. In raising GBP 1.9bb, the company will pay off all of its GBP 1.3bb of existing debt, dividend out the GBP 500mm, and will have GBP 100mm left over for working capital as well as to fund future pension payments. S&P and Fitch have already indicated investment grade ratings, ranging from AAA to BBB+ (depending on the issue), for the forthcoming Notes.

In our opinion, MAB's recap plan more efficiently utilizes the balance sheet by using more leverage to lower its weighted average cost of capital and effectively buy back 30% of its stock on the cheap, which is significantly accretive to 2004e EPS (about 14% by our calculation). Leverage goes from 3.3x to 4.8x (net debt rising from GBP 1.3bb to 1.9bb on 2004e EBITDA of GBP 393mm). Assuming the bonds are placed at an average interest rate of 6.5% (current rates on similar issues are closer to 6%), interest coverage drops from 4.9x to a still healthy 3.2x (about 2.6x after maintenance CapX).

Running through the P&L numbers (all of which are in GBP), our pre-recapitalization estimates for 2004e (Sept. FY) call for Revenues of 1.54bb, a modest 2% increase from 2003e's 1.51bb (which itself is up 1.7% on 2002); operating income of 296mm (19.3% margin) vs. 283mm in 2003e (18.8% margin); 80mm of interest expense (vs. 82mm) leading to Pre-tax Income of 216mm (vs. 201mm); and after a tax rate of 32%, Net Income is estimated at 147mm, which on current shares outstanding of 734mm equates to EPS of about 20p per share. Now, assuming the bonds are placed at 6.5% and the share consolidation is effected at today's price of 227.75p (resulting in 219.5mm fewer shares, or 514.5mm PF), EPS rises about 14% to 22.8p: Operating Income is still 296mm, but with the higher debt balance (at 6.5%) interest expense rises to 124mm, resulting in Pre-tax Income of 172mm; after the 32% in taxes, Net Income would be 117mm, which on the PF shares of 514.5mm would lead to EPS of 22.8p, a 13.9% bump. The EPS sensitivity to a higher estimated consolidation price is not as great as one might think: still using an estimated 6.5% cost of debt, the 500mm dividend/consolidation doesn't become EPS neutral until about 338p, or 110p higher. Assuming the stock were to rally to 260p and this price were used, the recap would still be 8% EPS accretive (21.6p). The EPS sensitivity seems greater to changes in the estimated interest rate on the bonds: using today's 227.75p price for the consolidation, a 6% interest rate would yield EPS of 24p (20% additive), while a 7% coupon would make the transactions only additive by 7.6%; the recap would be EPS neutral at an interest rate of 7.6%.

Business. At this point, before running through the valuation, it pays to detail the business. As stated above, Mitchells & Butlers is now the UK's largest operator of managed pubs, with 2,095 units; Spirit Group, upon acquiring Scottish & Newcastle's pubs, will eclipse MAB with about 2,500 units. There are currently about 60,000 pubs in the UK and they are generally broken down amongst three different business models: "managed" pubs, which MAB operates; "tenanted" pubs; and independently owned pubs. Managed pubs, which account for about 20% of the 60k in the UK, are typically owned and operated by a company, which hires a salaried manager and staff to run the place. The managed pub's revenues are primarily derived from selling drinks and food (2/3 vs. 1/3) and its costs are largely the cost of these goods plus staffing expenses, maintenance and repair. There's generally a decent amount of operational leverage with managed pubs, given the relatively fixed costs of the staff. (Other publicly owned UK managed pub companies include J.D. Wetherspoon (JDW.LN), Wolverhampton & Dudley (WOLV.LN) and Greene King (GNK.LN), although the latter two also have tenanted pubs as well.) Under the tenanted model (50% of the UK's pubs), the pub owner rents out the site to the lessee, collects rent from him and often contracts to sells beer to him as well. The tenanted model is considered a "safer" one (requiring only rent collection and delivery of beer) and there is less operating leverage. The two large public companies in this space are Enterprise Inns (ETI.LN) and Punch Taverns (PUB.LN).

MAB sold most of its tenanted pubs to Punch in 1997. In 1999, the company cherry-picked 550 prime managed sites from Allied Domecq which, though they haven't quite yielded their originally expected returns, are still considered profitable, high-traffic pubs. MAB's current base of 2,095 units are well diversified, both in terms of geography and revenue mix: geographically, about 70% of the units are in residential areas, where it is more difficult to receive operating licenses, affording some protection from new competition; in terms of asset mix, 30% of the units are actually "Pub Restaurants" or outright restaurants which are obviously food-driven, somewhat balancing the drinks-led Pubs. The company has spent a healthy amount of capital in the past few years to upgrade its Pubs and Restaurants, creating successful brand names with higher average weekly revenues. In the past three years, total CapX has run at about 15% of sales on average vs. depreciation at 6%. The results are evident, using this year's first half as a guide: branded restaurants generated average weekly revenues of GBP 19.3k vs. unbranded at GBP 14.2k (86% of restaurants have already been branded), while the branded pubs estate generated GBP 14.5k on average vs. the unbranded pubs at GBP 10.7k (45% of Pubs are now branded). Incremental ROI tends to be in the 13-15% range. It is clear that, with only 3% of the UK's 60k Pubs but about 8-9% of the industry's GBP 18bb in revenues, MAB has captured a significant market share (even adjusting for the larger size of its units).

In late September, the company gave its "trading update," a preliminary look at its second half (to Sept.), and results show some sequential improvement from prior periods and at the least a bottoming out in year-over-year sales comparisons ("LFLs," or Like-for-Like sales). Similar to most UK pub operators, the past year was a difficult one for MAB, as a weaker economy led to less traffic as well as a more competitive environment in and around central London. Looking at MAB's "uninvested" estate, or the pubs which have not had a meaningful amount of associated CapX, LFLs had been down in the range of 3.0%-4.5% in each of the eight-week periods ending last November, this January, March and May. (The "invested" estate, however, continues to show sales gains.) However, in the recent trading statement, the sore-spot uninvested pubs managed flat sales in the 19-week period ending in September, with sequential growth through the period, a marked improvement. Importantly, the uninvested sites in London, where it's most competitive, fell 2.7% during this period compared to a 6.5% drop in the prior 32 weeks; residential sites, which account for the majority of MAB's assets, were up 1.2% (3.3% including the invested pubs). Perhaps a bit early to call the sales recovery just yet, it would appear MAB's recapitalization plan should be relatively well timed, as ultimately accelerating revenues will have a magnified and meaningfully positive impact on EPS.

Valuation. We believe that Mitchells & Butlers shares offer significant upside from current levels, are inexpensive even before the recap/consolidation but are especially so on a pro forma basis. After participating in a broad summer rally among the Pub group's stocks, MAB has underperformed over the past two months. Our suspicion is that recent weakness may be related to some selling pressure from arbs who had hoped MAB would have received another approach by now and are exiting anticipating the company will go through with its current plans. Nonetheless, we view this weakness as an attractive entry point, at only 11.4x our 2004 EPS estimate before the recap and a paltry 10x on a pro forma basis. On a TEV/EBITDA basis, the stock is trading at 7.9x 2004e pre-recap and 8.2x PF (while the deal is very EPS enhancing, it actually raises the TEV/EBITDA ratio modestly, as MAB is taking down an additional GBP 100mm of debt not related to the dividend/consolidation).

While there are no truly pure comps to MAB given its size, superior assets, profitability and business mix, the three other UK public managed Pub companies do trade at a significant P/E premium (a recent phenomenon, with MAB's weakness and a rally in the group). J.D. Wetherspoon is now trading at about 14.5x CY04e EPS (it's on a July year); Greene King is at about 13x CY04e (April FY); and Wolverhampton is closer to 11.5x. We're assuming MAB, on a PF basis, can garner a 13x P/E multiple, which would put the stock at about 300p, 32% upside. A 12x multiple, fairly conservative, would equate to 275p or 20% upside. In addition to its attractive valuation, MAB management has indicated they intend to pursue a progressive dividend policy, with 2004's payout estimated at 9.5p, a 4.2% yield.

Miscellaneous. 1.) While there is plenty of liquidity in MAB shares on the LSE, ADRs trade on the NYSE under the symbol MLB. However, the ADRs are much less liquid, trading only about 30k shares/day. 2.) Given that the share consolidation will very likely take place in November or December and therefore MAB's market cap will decline by about 30%, it is possible the company will be dropped from the FTSE 100 when the reshuffling takes place at year-end. 3.) In terms of tax implications, our understanding is that, like the 6C dividend, MAB's will be considered a "return of capital" and therefore not subject to taxes or withholding.

Risks. We see the primary risks to the MAB story being: 1.) An inability to execute the securitization of the estate or interest rates moving up significantly during the next month (enough to make it uneconomic), unlikely in our view; 2.) A renewed economic downturn post the consolidation, when earnings will be more sensitive to changes in the top line. In addition, the potential for heightened competition in London leading to an erosion of pricing and margins. However, we do not believe there is unusual business risk in the Pub sector relative to other businesses, and we note MAB does generate FCF, earns incremental returns well in excess of its cost of capital, and offers a healthy dividend yield.

Catalyst

In November, MAB will securitize its estate and effectively buy back 30% of its outstanding stock via a GBP 500mm dividend and subsequent share consolidation. This recapitalization, greater optimizing the company's balance sheet, will heighten its leverage to an operating pickup, the early signs of which are beginning to appear. There is an outside chance, though not the basis for this recommendation, that renewed interest in the company as a takeout candidate will lead to MAB being acquired before the plan is effected; MAB's most comparable competitor, Scottish & Newcastle, recently agreed to sell its Pub assets for a valuation implying significantly more upside to Mitchells & Butlers' shares than currently afforded by the public markets.