Spirit's

stumble

The UK's largest managed operator, Spirit, which has just in excess of 2,000 pubs, has reported a decline in profits in half its estate. The PMA Team looks at its prospects

Some observers believe the chances of Spirit Group being around in its current form in a year's time have taken a significant drop in the past fortnight. Dispirited is the word used by one analyst to describe the company ­ which doubled in size after buying S&N Retail in October 2003 ­ in the wake of a lacklustre performance in the half the estate whose results are now in the public domain.

The company has moved to review options at the 220 high-street pubs in its City Night and Day estate (reviews like this tend to lead to a sale). But Spirit insists that a 6% increase in volumes in the S&N Retail estate, thanks to lower prices, is an upward curve that will continue ­ and will deliver improved margins.

However, many think Spirit's private-equity backers could be tempted to sell the rest of the business in pieces with handsome multiples currently being paid for freehold assets.

"It will be broken up," is the verdict of a second City analyst. "Spirit's owners are unlikely to want to sit on a business going backwards."

Last November, 1,080 Spirit pubs were securitised to raise £1.2bn. The move means Spirit is legally two separate entities ­ its "borrower" securitised estate that took part in the bond issue and the rest.

The company is now obliged to report to the bond market on sales performance in its securitised estate. And its figures were far from impressive, although reflective of the fundamental issues facing thousands of licensees in the trade.

Costs have spiralled rapidly. Utility costs have increased by 20%, the cost of the basic Sky Sports package increased by 18% and the National Minimum Wage increase in October 2004 had added £lm to wage costs in a single quarter (one analyst believes this could add £6m to the labour bill for the full year).

The issues are market led

Sales were completely flat in 92% of the "borrower" estate; its uninvested portion ­ a mixture of S&NR and Spirit pubs ­ where there has been no capital expenditure for the past two years. The net result is that Spirit is likely to be 6.5% or £14m short of profit expectations in the borrower estate for its full year as margins are squeezed by the double whammy of fairly static sales and increased costs.

Spirit's finance director Benedict Smith and commercial director Andrew Knight hosted a conference call for worried investors last week. Smith insisted that the cost increases had been predicted but the market was now considerably tougher. "The issues are market led," said Smith.

"The costs are not growing faster than expected but market conditions are tougher," claimed Smith, who said that eating-out market growth had slowed in January to 1% from 2% in October last year. Spirit was, he insisted, growing its share of the eating out market with a 6.1% increase in food sales and a 0.4% increase in drinks sales thanks to investment in 8% of the borrower estate.

Volumes in the former Scottish & Newcastle Retail pubs had increased but lower prices had resulted in flat sales.

"The inherited volume decline has [been] arrested at S&N Retail pubs," he said. Generally, Spirit had moved prices down in the S&NR estate to be in line or just below competitor levels. Recent brewer price rises meant prices were now moving up slightly. Increased volumes had ensued and created contract volume headroom to allow the introduction of Stella Artois, Carling Extra Cold and Kronenbourg Blanc, as well as Foster's in Spirit pubs.

Spirit was also planning to introduce a new premiere own label wine and adult soft drinks range. "We are increasing our drink range and investing in better quality food to drive sales growth," Smith told fund managers.

Fellow director Knight reported that Spirit was reviewing its labour costs at every single pub and was also reducing the complexity of certain menus.

Analysts have not been impressed by claims that eating-out-market growth is slowing down. Michael Cox, of Royal Bank of Scotland, noted that Mitchells & Butlers, Spirit's nearest comparable, boosted food sales by 10% and drink sales by 2% in the 16 weeks to 15 January. "All the growth came from volumes as prices were held constant," he said.

Likely to outperform the market

One fund manager asked Benedict and Knight for a solution to Spirit's profit slide. How did they plan to get Spirit's profit moving in the right direction? "We are growing our market share," said Smith. "We have strong, centrally led commercial teams. We can roll offers across a large number of pubs [backed by] marketing spend. We are likely to outperform the market."

Spirit is planning to spend between £35m and £45m this year in its three drive brands ­ Chef & Brewer, Two for One and John Barras. Its total capital expenditure programme will see £110m invested with a further £25m going on repairs and charged to the profit and loss account. At any given moment, though, between 80% and 90% of the estate will remain uninvested.

Spirit rivals have accused the company of adopting a "one price fits all" approach. Knight insists that pricing is set pub by pub, with as many as 100 variants on its pricing model nationally. New offers had been introduced at 1,500 pubs in the past nine months and volume gains at S&NR pubs would continue.

Feeling impact of rising costs

The first 15 S&N Retail pubs that had seen lower prices, for example, were enjoying a 33% increase in volumes. As volumes continued to grow, so margins would be restored. Knight pointed to the example of John Barras where sales growth was approaching double digits thanks to better value food and reduced prices.

One rival operator, though, believes that many of the pubs in the original Spirit estate should have been tenanted under the aegis of Punch. He said: "Some of its pubs are still too small to be run as managed pubs. It's these pubs that feel the impact of rising costs greatest."

At least one fund manager who listened to the Spirit briefing thought the prospects of the company achieving profit growth were doubtful and suggested a merger ­ a euphemism for trade sale ­ might be the solution. "Time will tell," said Smith. "It's not something we're looking at ­ it's not on our agenda." There's no doubt, though, that Spirit's private-equity backers will be giving it some thought. Trade buyers and private-equity firms would be lining up around the block to buy each and every part of Spirit.

But Smith told the Morning Advertiser this week: "For half of our shareholders, Spirit is still a fairly new investment. Shareholders have already had some of their investment back ­ they've already taken some of their money off the table - and there isn't any rush. We are outperforming the market."

The analyst's view of the borrower estate

We think the full year result is likely to benefit from a small gain through seasonality and a further gain from purchasing synergies not fully reflected in the quarter to November. However, it is clear that sales are flat and margins have fallen, and therefore the full year is likely to undershoot expectations.

If we had to guess, we would estimate an Ebitda of around £200m is likely, some £14m or 6.5% short of expectations.

Michael Cox, Royal Bank of Scotland

Spirit Group's financial success

by Mark Stretton, editor of M&C Report

Spirit Group, in financial terms, has been a resounding success. Following the acquisition of the S&N Retail business, arguably the finest large grouping of managed pubs in the industry, for £2.51bn, its private-equity owners have released £2.755bn from the business.

It sold 364 lower quality pubs to R20 for £345m, issued bonds against half the estate raising £1.2bn, sold Premier Lodge to Whitbread for £536.2m, and secured two sale-and-leaseback deals,