In general the pub industry is a pretty tough one to be in for long-term investors. Not only are many of the pub companies totally hobbled by the silly levels of debt they took on before the 2007 financial crisis, but the industry itself is facing secular headwinds as fewer people are drinking in pubs these days. All-in-all its a tough place to make money; both for the businesses themselves and for pub company shareholders.
That said discount pub operator JD Wetherspoon (LON:JDW) has traditionally represented one of the more attractive options for long term investors. When the shares first listed on the London Stock Exchange back in 1992 they were changing hands for around 30p each. Today they’re going for just under £10.50. Factor in the small mountain of dividends paid out over that period and you’re looking at total returns in excess of 15% per annum; a phenomenal performance given the general troubles of the pub industry.
The driving force behind those returns has undoubtedly been the company’s successful business model of providing discount food and drink. Back when it first listed in 1992 the JD Wetherspoon estate numbered around 50 pubs. Today that figure has grown to well over 900; many of them converted listed buildings such as old banks, churches and even an opera house.
Profitability & Growth
Without going into too much detail I think you can get a feel for the business model based on the following three points. Firstly, you tend to find Wetherspoons pubs in town centre locations. The second point, somewhat tied to the first, is that they tend to attract a high footfall (i.e. a lot people drink there). Finally, its pubs have a larger retail space than usual. It’s also worth noting that all its pubs are actively managed by the company. In other words it controls the management and direction of its properties rather than simply collecting rents from tenants. Considering the need to adapt to changing consumer trends (e.g. providing food to counter the decline in traditional drinkers) this has probably been a fairly significant factor in the success story to date.
Whilst you tend to encounter a fair bit of snobbery around Wetherspoon what is undeniable is that on the whole its pubs are quite popular; a pretty important point since as a low cost operator it makes its money on volume. Indeed that has arguably taken on more significance since the company’s operating margins have gradually fallen over the years.
Now at first glance this is a bad sign for a business and its shareholders. If we were dealing with a company relying on brand equity, for example, then contracting profit margins could signal that its products were losing pricing power. The temptation is therefore to view this trend as universally negative for Wetherspoon.
It’s worth pointing out though that often companies choose to sacrifice margins in order to attract sales; retailers being good examples of businesses that might decide to go down this route. You might be able to run one or two local stores with high margins, but expanding into new markets may require you to compete on price. Even though margins may well end up lower the idea is that profits would be higher overall due to increased sales.
To date this is exactly what has happened with Wetherspoon. For example, the company sells a lot more food nowadays than it did back in its early years and food is a lower margin business than drink. The flip side is that this has helped drive overall growth since many people now visit pubs for food first and drinks second. Margins may have decreased substantially during that time, but earnings per share and the dividend have grown rapidly.
The worry for investors is that growth slows whilst margins continue to contract. This is why many City analysts concentrate so much on the company’s costs. Is there any sign of that scenario playing out? To find out let’s take a look at Wetherspoon’s most recent financial information.
Trading Update & Brexit
Last week the company released a trading update covering the third quarter of its 2017 financial year. Like-for-like sales were up 4% during the 13 weeks to 23 April 2017 and are up 3.5% year-to-date. Total sales were up 1.3% over the most recent quarter and 1.4% year-to-date. So far, so good; overall Wetherspoon seems to be doing quite well on the growth front.
The main point of concern is that the company expects costs to rise significantly later in the year. Business rates, staff wages and excise duty are all set to go up in the second half of the year, as are a number of other costs. On the plus side the company expects to post better full year figures as a result of stronger than expected like-for-like growth. In addition, the company’s average operating margin is up around 1% compared to this point last year which will assuage some of the fears set out above. Year-to-date operating margins are up 1.5%.
Now it would be remiss of me to talk about JD Wetherspoon without mentioning Brexit. After all it is technically a cyclical stock (plus chairman Tony Martin isn’t shy in sharing his views on the subject either). So should shareholders be concerned? Well, as far as I can see when it comes to Brexit and Wetherspoon there are two obvious talking points. The first covers possible cost inflation due to a weaker pound as well as possible labour cost rises. Since Wetherspoon sells a lot of food it also needs to import a lot of ingredients from abroad. A weaker domestic currency makes these imports more expensive. On labour costs it’s possible that Brexit will push these up due to immigration reform (but it’s probably not worth speculating on at this point).
The second issue is a possible economic downturn as a result of leaving the EU. All-in-all I’m perhaps slightly more sanguine than most on this. The good thing about being a discount pub operator is that in a weaker economic environment Wetherspoon should perform better than its peers. Check out its performance during the 2007-2009 financial crisis for instance. Like-for-like sales actually grew during fiscal years 2008/09 and 2009/10 and like-for-like profits only dipped slightly. Overall revenue and profit grew significantly as the company continued to open new pubs, and you’d have barely noticed the worst economic crisis since the 1930s was going on based on Wetherspoon’s finances. In other words if Brexit does indeed prove to be a negative for the economy (and that’s a big if right now) then Wetherspoon is better placed than a lot of other cyclical players.
As you’d expect this deep into a bull market the more pertinent issue is one of valuation. As it stand analysts currently estimate fiscal year 2017 net profit will come in somewhere around the £65m mark. That puts the shares at around 18x earnings based on the current market-cap of £1.2 billion.
At first glance that looks a tad on the expensive side of things. It’s worth bearing in mind that since 2012 the shares have gained 22% per year on average (excluding dividends) whilst earnings-per-share have only grown by around 4% a year on average. In other words the lion’s share of shareholder returns has come from an expanding valuation multiple.
The issue for investors going forward is that the reverse happens. If the value multiple contracts, perhaps in the face of tough trading conditions or a general stock market correction, it would naturally eat into shareholder returns. How that plays out in the long run will of course depend on whether, or rather by how much, Wetherspoon can grow its profits.
On that score I think it’s safer to err on the side of caution. As mentioned above earnings per share have grown by around 4% per year on average since 2012 and it seems unreasonable to expect the company to do much better than that going forward. Ideally we’d therefore be looking for a lower price-to-earnings ratio in order to lock in some kind of margin of safety. Despite being one of the better pub shares for long-term investors to own there will probably be more attractive entry points in the future.