What would free-of-tie pub life look like?

By Mark Stretton, M&C Report

- Last updated on GMT

Related tags Pub companies Real estate investment trust Geof collyer

What would life be like if Fair Pint got its way?
What would life be like if Fair Pint got its way?
While the leased pub industry is focused on resolving its issues through mediation, perhaps it is time to at least consider the possible scenario of life without the tie, writes Mark Stretton.

Ponder it quietly, but what does a free-of-tie future look like?

So far the industry's calculations and thoughts on a post beer-tie world could probably be captured on the back of an envelope. But, no matter how unlikely, it is a reality that operators of tied pub estates must start to consider in these uncertain times.

What is certain is that tie-banning legislation would have far-reaching consequences, dramatically altering the structure of the pub sector. Many argue it would devastate the industry. Some of the City's leisure analysts have looked at the thorny issue in a bit more detail. While one leading analyst says that scrapping the tie would herald the "creeping death of the industry", it would not necessarily devastate the larger pub companies, he argues.

Deutsche Bank's Geof Collyer, the highly-regarded analyst who has tracked the pub sector for more than 20 years, believes companies such as Enterprise Inns and Punch Taverns could — after some significant surgery — match or even enhance their cash flows in a new free-of-tie era.

This notion speaks against the widely held belief that the current system optimises the profit that can be extracted from a leased estate.

Higher cashflows for big pubcos?

The sweet spot for a pub lease agreement is that more than half the rent, the so-called "wet rent", is linked to cash flow through the tie. It allows pub companies to take 50% of pub profits. The accepted view is that pubcos could not hope to replicate the amount of income they extract from a pub via a dry-wet rent, purely through a dry rent model. Licensees just would not be prepared to commit to such a high fixed cost.

At the same time, the pub companies would no longer be able to wield such buying power from the brewers and reap such massive margins supplying their licensees. At the height of its powers, the leased model produced profit margins of 40% to 50% on tied products. The wholesale profit per barrel earned from the brewers over and above that which could be achieved by freehouse or free-of-tie licensees could be worth about £65m a year for Enterprise.

Brewers and suppliers would see a ban on the tie as a massive opportunity to rebuild profit margins in the on-trade drinks channel. They would no longer need, or want, to deal with the pubcos.

But, as counter-intuitive as it may seem, Collyer reaches his conclusion by logically working through a number of the strategic steps that the pub companies would likely pursue.

Firstly, a massive rationalisation of head office cost. Because leased estate operators would no longer have a vested interest in driving beer volumes — in fact they would not have a vested interest in driving any part of the pub's performance — they would no longer have the need for such complex head office structures.

They would morph into fully-fledged property groups. Out would go all the discretionary licensee support. Collyer believes such a move would save a company such as Punch up to £50m a year.

Secondly, again for the reason of not having a financial interest in the trading performance of any given pub, the pub companies would stop investing in their estates. In keeping with other types of landlord, the approach would be more akin to "this is the rent, here are the keys, and good luck". For a company like Punch, which has historically deployed relatively high levels of capital expenditure in its estate (effectively reinvesting the wholesale beer profit from the suppliers back into helping to drive the pubcos' licensees' profitability), this would save up to another £60m per year.

Thirdly, many of these pub property companies would be eligible for Real Estate Investment Trust (REIT) status, saving millions annually in corporation tax. A concept that was born in the US and designed to encourage investment in the property sector, REITs do not pay any corporation tax. Conversion to REIT involves a one-off levy equivalent to 2% of the asset value, which, in the case of Enterprise and Punch, would broadly mean a one-off tax hit of £120m (payable over four years) against an asset base worth some £6bn, but would save it about £50m every year in tax.

These three factors, combined with the fact that rents could go up by about a third in the absence of the tie, according to Collyer, would not only make up any shortfall in cash flows as a result of an abolishment of the tie, but actually make the likes of Enterprise and Punch more money.

It is also worth noting that — clearly — the pub companies would no longer be wedded to the pub industry in any way, other than by virtue of owning several thousand pubs. Without the carrot of income connected to beer and other tied products, the parameters upon which they assess the benefit of owning a property that operates as a pub versus something else would change. It would all be about what the asset could produce on a dry-rent basis.

In many cases there would be less benefit in owning a pub, versus owning a property that was once a pub but was now more appropriate as a car park, a launderette, a convenience store, restaurant, coffee bar, sandwich shop or fast-food outlet.

The free-of-tie losers

"Just because the big pub companies would be able to transition through such a huge change," says Collyer, "it does not mean that a scrapping of the beer tie would not be an unmitigated disaster — it would. The biggest losers would be consumers and more pubs would close."

On the issue of consumers, many believe that a scrapping of the tie would lead to less choice in terms of drinks brands. The reason for this is twofold. Firstly, many local beer brands that survive by dint of being supplied to tied pubs would disappear in a free market. "You sometimes have to protect consumers from themselves," says Collyer. "They will buy whatever the big boys' marketing millions throw their way."

Secondly, without the tie, individual traders would seek out the best buying terms in the free market. Clearly, they will not realise the best deal through buying 25 different products from 25 different suppliers. It will be through sourcing their entire drinks range from one or two brewers and it is likely the "big boys" would again triumph.

This would be very different from the current number of products available to tied pubs of the big pubcos — Enterprise offers about 800 different products, while Punch has about 250.

In Europe, where pub ties do not exist, it is often the case that two or three brewers, such as Carlsberg and Heineken, dominate the bar at the expense of all other brands, and the price per "demi-litre" is extortionate in comparison with the price from a supermarket.

Collyer believes that the number of pubs leaving the industry would accelerate, because of the reduced levels of investment.

In the four years between 2005 and 2008, Enterprise, Greene King, Marston's and Punch between them invested £700m in their leased pub estates. As a benchmark they normally pay 75% of the cost of a capital expenditure (capex) project, with the individual licensee picking up the remaining 25% of the bill. So in those four years, it can be assumed that a total sum of about £900m was invested in the leased estates of these four companies.

In the free-of-tie world, lessees will not entirely fill the capex void left by pub companies and therefore, in the face of diminished levels of investment, trading levels will inevitably decline across large swathes of previously tied pub estates. It will heap further pressure on pub viability.

While, as discussed earlier in the article, the larger pubcos would readily let defunct pubs as shops or takeaway outlets, not every property will have a viable commercial alternative. The only remaining option would, of course, be to sell unviable commercial properties for houses or flats, although this may not be a bad thing for Enterprise and Punch shareholders. Given that both Gordon Brown and David Cameron are ­calling for three million new homes in Britain, there will always be plenty of dem

Related topics Legislation Other operators

Property of the week

Follow us

Pub Trade Guides

View more