Stonegate - Some light summer reading.
All,
Please find our updated analysis of Stonegate here.
The 18-Month plan underlying the recapitalisation was presented some 18 months ago, and we’ve had a look for its effects. We’d be cynical to say we didn’t find any, but it has almost entirely been absorbed by demand elasticity and labour cost headwinds, so that Stonegate has never stopped and continues to burn cash for the foreseeable future. It’s a fresh debt structure with few triggers for the coming quarters, and the coupon is high, but trading upside is probably less than five points from here, suggesting it’s time for some light summer reading.
Investment Considerations:
- We are not taking a position in this name now. It’s not going well. We regard Stonegate as a very levered bet on the UK consumer, mixed with some secular trend away from alcohol. It is not yet clear how interested Gen Z is going to be in this estate. 10% YTM do not compensate for this bet. However, we are also lacking triggers on the short side. Pub companies are slow moving beasts, and Stonegate still has significant liquidity and covenant headroom. We foresee disappointment, but no short-term fiasco.
- The turnaround program has been absorbed in high price elasticity and labour cost headwinds. We don't think the Alix Partners project can be large enough to put bondholders back in the money.
- The bonds are covered by the asset BV of the estate, but at over 85% LTV some of the debt has equity characteristics and should be priced that way. Also, our DCF has EV lower than BV.
- On the upside, the bonds still benefit from call protection, but should become capped at approx. 105p/£, giving us just over 4% upside. On the downside, however, we do not know the terms of the 2027 Platinum debt, and a restructuring would position the SSNs as fulcrum. If they were to trade at 70% LTV, they'd trade at 65p//£ (ignoring Platinum complexities).
Key Insights:
- Price increases have failed to offset volume declines. With cost pressures and higher NLW/NI, Stonegate never stopped burning cash and relies on pub disposals to fund interest (Current Trading).
- Across divisions, revenues have fallen short of expectations, particularly M&P. By way of cost cutting, the Alix Partners efficiency project is too small to materially change creditor outcomes (Model).
- DCF indicates EV is slightly below Book Value of the Pub Portfolio, which we view as too high; we base valuation on DCF since such a large asset may not attract bids at BV (Valuation).
- Structural seniority of Unique and especially Platinum estates leaves bonds more exposed than meets the eye; Platinum itself seems to require support from Stonegate (Structural Analysis).
- Pub numbers continue to decline structurally across the UK, though Stonegate’s scale (4k+ pubs) has allowed it to outlast smaller independents (Industry).
- Stonegate’s high exposure to entertainment and late-night London venues, long perceived a strength, has become crippling in the downturn, while Slug & Lettuce is being repositioned (Company).
- Managed gastro pubs, once revenue drivers, are now heavily exposed to wage and tax rises; the estate is only stabilising and likely to face another poor year before a turnaround emerges (Company).
- Aggressive run-rate EBITDA add-backs overstate profitability, with many one-sided adjustments and a two-year lag before executed measures flow into actual EBITDA (Turnaround EBITDA Bridge).
Summary:
- Stonegate Pubs went from a medium size pub company to the UK's largest when it acquired EI (aka Enterprise Inns) in 2020.
- The estate is 67% Leased and Tenanted and 33% Managed / Operator Led (revenue share agreements).
- In Pub companies, tenanted estates have long been seen as a profit extraction system tipped in favour of the landlord.
- Stonegate, has historically been balancing the secular trend towards lower alcohol consumption against economies of scale and concentration on high turnover city centre pubs, bars and dining. Following hard times during the pandemic, the onset of inflation, with its resulting squeeze of disposable income, has required that the business pass on significant cost increases to its customers. Price Elasticity of Demand for beer in the L&T segment has allowed that segment to continuously generate a profit. However, in the more discretionary formats of bars and gastro pubs, consumers did not absorb these price rises and stayed away.
- Stonegate's traditional model of converting low-profit L&T pubs into managed pubs has therefore since gone into reverse and the new target format is therefore Operator Led.
- The company has refinanced with a fresh cash injection of £250m (£50m more than we thought) and converted the PIK loan held by AlbaCore into a minority equity participation. It remains controlled by TDR and now has runway for another 4.5 years. However, without selling approx. 60 pubs p.a., Stonegate is still unable to service its interest bill.
- The company's turnaround plan is being absorbed by demand elasticity and further NLW and NI rises.
Key Value Drivers:
- Hiring Alix partners to wield the axe is the right thing to do. However, we are not sure there is enough fat to cut at HQ to make enough of a difference. Curiously, we have not been given a number.
- Land and Buildings book value covers the debt. We think the company has some more value corrections to do, but overall, this provides strong downside protection.
- Stonegate has renegotiated its supply contracts, which should move the estate generally up-market (slightly - OLed a little bit down-market) and consequently improve beer margins.
- Inflation feeding through to average wage growth should bolster discretionary spending and thus revenues for Stonegate's bars, city centre venues and gastro pubs.
Key Risks:
- We consider the turnaround plan largely failed or insufficient. 18 Months later, revenues are lower and so are costs, but only just enough to offset higher one-offs and maintain EBITDA.
- The turnaround plan did not adjust for the pubs that would have to be sold to fund it. We expect the sold pubs to be below-average earners, but some of the touted gains of the plan should be offset.
- The current UK consumer environment does not allow for much price rises. The company raised prices by 5% in April '24 and 4.6% in April '25, but revenues are down, even on a LfL basis.
- We struggle to see how the Platinum vehicle can sustain its debt, unless the pubs that have been transferred are significantly bigger than (management-protested) average. The significant debt load now sitting structurally sr. to Stonegate is raising the risk of the bonds.
- Managed pubs and in particular bars are still deteriorating and have not yet found their bottom. This estate could be largely beyond repair.
- We are still not seeing Gen Z flogging to pubs the way previous generations used to. For an average of £5 / Pint, they could not afford it if they tried.
- Further National Insurance and NLW rises.
Here to discuss this name with you,
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk