Stockwatch: big risks remain at the UK’s favourite boozer

Valuation and debt leaves Wetherspoon's exposed to any shifts in expectations for eating/drinking out. So what would our companies analyst do?

I have nothing personal against Tim Martin and his Brexiteer rants, but I am coming out with another ‘sell’ stance on JD Wetherspoon (LSE:JDW), wary that a second wave of Covid-19 infections pose a real risk in the UK.

Last September, with the share price at around 1,550p, I suggested that a forward price/earnings (PE) ratio of 20x, 5x net asset value and a 0.8% yield, implied an exposed valuation, especially with profits for the year to 28 July being slightly down. This was significantly due to not passing on higher drinks costs to customers to gain a temporary competitive advantage, helping sales up 6.8%.

What a valuation contrast to nine years before, when I drew attention to Wetherspoon when it offered value on 11x forward earnings as it capitalised on demand for its meals, including new breakfast sales. Yes, the likes of Young’s (YNGA) are also on 20x earnings nowadays, with a scant yield, but they are fully supported by net tangible assets and are not weighed by Wetherspoon’s circa £850 million of debt. 

Such debt has, I believe, enhanced Wetherspoon’s volatility, causing a plunge from around 1,530p late February to an intraday low of 492p by 19 March, then a volatile rebound to around 1,180p currently, on hopes that pubs will soon re-open.   

Source: TradingView. Past performance is not a guide to future performance.

Richly valued, yet prized by enough market participants

Analysts such as at Peel Hunt were more positive last September, arguing that Wetherspoon's had scope to raise drinks prices and the profit sensitivity would be great. But I was also concerned at the company carrying out share buybacks – seemingly at a premium to fair value – instead of adopting a progressive dividend policy rather than the steady 12p a share payout. I was not questioning the business, only its valuation.

The chart proceeded in a volatile-sideways pattern for the six months to 10 December 2019, until news that it would pump £200 million into new pubs over the next four years prompted a re-rating to 1,725p. 

So, in a near-term technical sense, my ‘sell’ call was premature; Wetherspoon remaining a priority stock within the sector. It did, however, then cede its gain, down to around 1,500p by February, before the virus-linked plunge.

Also, last February, short-selling appeared to have unwound completely, having declined from 6% of the issued share capital three years ago.

Clearly, then, the stock has its fan club based on Tim Martin’s marketing prowess; Wetherspoon is seen as having further to run across the UK. Yet its valuation and debt leaves it exposed to any shifts in expectations for eating/drinking out, on which basis, an experienced investor/trader might want to consider the utility of a short position, if looking to hedge an equities portfolio from a second viral wave triggering panic.

A real risk remains of Covid-19 rebound

For the short to medium term I suggest it is “all about the virus”; whether social distancing based on a two metre rule can justify pubs and other retail/leisure type businesses re-opening; whether the rule is eased to one metre; and if this actually works by way of such businesses gaining enough clientele to cover operating costs. 

Consistent with the life cycle of a pandemic, there will likely be a second wave albeit weaker perhaps.

It seems to me, much uncertainty remains, and no one has a crystal ball. If enough people recklessly flout even lowered lockdown restrictions, it is possible they get tougher again. The confusion and uncertainty arising – even if another hard lockdown is avoided – would prick optimism across equity markets, at least those with domestic operations. 

The UK has ended up with the worst mortality rate for Covid-19 per head of population, and Boris Johnson’s mooting a lifting of the two-metre rule seems more related to backbench Tory critics who want “back-to business” as soon as possible, than medical opinion. In a few weeks we will know if the current easing of restrictions has been wise, or if infection rates have jumped unacceptably. If they have, the question becomes: “how effective is track-and-trace?”

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Reports cite the Department for Business drawing up new rules for pubs, such as ordering by app rather than crowding around a bar, with all tables two metres apart. Guidance appears to have been passed on to the industry, with breweries refilling kegs such that 250 million pints will be ready to go by 15 June.

Pubs with beer gardens would be the first to re-open in a phased relaunch of the industry. Besides the risk of virus lingering in the air if people are sat inside, I am dubious as to the way beer gardens will get managed: drinkers will be given timed tickets on entry and be told by staff to leave so as to accommodate the queue outside?

The industry association wants social distancing relaxed to one metre and, indeed, World Health Organisation (WHO) estimates cite the infection risk being 1.3% at two metres versus 2.6% at one metre – no great differential.

The UK, US, Switzerland, Spain and Italy all opt for two metres, however Germany, Poland and the Netherlands are on 1.5 metres and Austria, Norway, Sweden and Finland on one metre. It is difficult to establish cause-and-effect on infection rates however, when these latter countries are less populous.

Politics and confusion weigh in the UK. At last Tuesday’s Downing Street press conference, Boris Johnson said: “Eventually I would like to do such things as reducing the two-metre rule,” although his housing minister Simon Clarke has gone on the record this week saying “the two-metre rule is something which we are determined to maintain.”

Meanwhile, former chancellor Norman Lamont has argued that halving the rule to one metre is “the single most important measure we must take to avoid devastating mass unemployment".

Promised investment is delayed

Versus last December’s plans that raised investor hopes, Wetherspoon’s 20 March half-year results to 26 January cited “most capital projects” being delayed and expenditure reduced where possible, such that, together with business rates relief, the company can sustain operations at a substantially lower level of sales.

On 29 April, the opening programme was delayed until the next financial year i.e. this August onwards, based on around five new pubs opening each year. 

A £141 million share placing at 900p - only a 6% discount to the prevailing market price at end-April - has meant 15% dilution.

This came about due to bank covenants being increasingly at risk: the placing announcement saying that, although none were expected to be breached in the short term, it had requested and received waivers from its banks. One imagines a quid pro quo, by way of expanding equity.

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The 26 January balance sheet had quite groaned with debt: around £850 million, versus £1,459 million in property/plant/equipment and scant intangibles. But there were also £315 million of trade payables versus only £28 million receivables.

Such a liabilities profile versus net assets of £320 million (similar to January 2019) looks the chief reason Wetherspoons scores poorly on the Altman Z2 scale: 0.66 strictly implying a serious risk of financial distress in the next two years, but which looks manageable. £18.5 million interim finance costs took 24% off operating profit. 

The extent of debt has leveraged high returns on equity for the pub trade – over 20% since 2016 – albeit compromising returns on total capital to half of that, and into single figure percent more recently.

Not surprisingly, the interim dividend was cancelled, albeit said for reasons of the pandemic implying “profits being below market expectations so long as the current health scare continues”.

Otherwise, the interim results had shown normalised operating profit up 21% to £76.6 million on revenue up 5% to £933 million and earnings per share up 16% to 43.3p. Free cash flow per share had slumped 31% to 46.7p due to investment in existing pubs up 32%.

A stock to own when the going is good

So, yes to Wetherspoon’s proven formula having further UK scope, but its stock has run into both valuation and financial risk issues, making it exposed to a revenue setback. Everything hinges on whether the virus abates or festers to compromise the retail/leisure sector’s ability to operate at a profit. If a second wave triggers another lockdown: Sell.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.