QUALIPORT
Is SFI A Qualiport Share?

By Maynard Paton (TMFMayn)
November 12, 2001

Carburton Street, London -- SFI (LSE: SUF) is a company that attracts a lot private investor attention. Although valued at just £142m, the pub operator has a long record of robust sales and earnings growth, coupled with high margins and a decent return on shareholders' equity. Furthermore, the shares, currently at 191p, sit on a forward price to earnings (P/E) ratio of just 8. So, following this prompt from Foolish discussion board favourite TimDJ, is SFI Qualiport material?

Growth

Here's SFI's five-year record:

Year to 31st May             1997    1998    1999    2000    2001

Turnover (£m)                16.4    29.8    41.0    61.8   115.2
Operating Profit (£m)         2.9     6.3     8.6    12.4    22.2
Pre-tax profit (£m)           2.3     5.4     7.2     9.8    16.4

Earnings per share (p)        4.7     7.8    10.5    14.0    20.2
Dividend per share (p)        0.7     1.2     1.8     2.2     2.5

On the surface, it's a great record, especially with operating margins presently at 19%. But while the company's development has been driven mainly by organic growth, acquisitions have played their part. And it's this corporate activity, combined with a broadening of the company's brands, that really takes the shine off SFI.

From my own experience, successful operators in the restaurant and pub game have one thing in common: focus. On the fickle High Street, where competition for food and drink is everywhere, simplicity is key. Management operating with just one proven chain can concentrate on digging a deeper competitive moat than those with two or more to run. In short, the more brands and diversity throughout your estate, the more thinly management talent will be spread, and the more logistical and operational hiccups that will occur.

It's no surprise that proponents of the focus approach, specifically PizzaExpress (LSE: PIZ) and JD Wetherspoon (LSE: JDW), are the consistency benchmarks within this sector. On the other hand, the likes of Regent Inns (LSE: REG), City Centre Restaurants (LSE: CTC), Yates Brothers (LSE: YTB) and Chez Gerard Groupe (LSE: GCZ) have all come to grief as various operational problems have dogged their brand "enhancements" and diversification.

Brands

At the end of May 2001, SFI operated:

* 44 Litten Tree venues;
* 32 Bar Med outlets;
* 32 Slug and Lettuce sites;
* 7 Havana bars;
* 3 For Your Eyes Only venues, and;
* 25 other pubs.

The Litten Tree chain, which began life in 1994, is described by SFI as a leading "chameleon brand". The venues are essentially cafés by morning, turning into restaurants by mid-evening and then into "party venues" during the night. Bar Meds, developed in 1997, are "Ibiza style" nightclubs that serve Mediterranean-type food during the day.

Last year, SFI acquired fellow pub group Slug and Lettuce for £44m. The purchase diversified SFI's operations by entering into the premium all-day bars market. During 1999, SFI bought six Latin-themed bars from Capital Radio (LSE: CAP), which were all subsequently revamped and renamed under the Havana tag.

Other purchases over the years include Richardson's Inns. This 1997 acquisition included a For Yours Eyes Only adult entertainment club, of which three more have since been opened. The remainder of SFI's estate includes a handful of "Break For The Border" outlets, acquired from Capital Bars (LSE: CPB) last year, and a bevy of other non-branded pubs.

All in all, there's plenty going on at SFI -- lots of different brands, involving different themes, different activities, different food and different drinks. Needless to say, there's plenty of room for operational headaches.

In general, I cannot understand why SFI would want to acquire and develop the likes of the smaller Havana operation when, according to the company, there's plenty of scope for expansion at the Litten Tree and Bar Med chains. Why take the additional risk when you've got, as SFI state, "proven" chains already? What's more, SFI's three main brands are all placed at the premium end of the sector and have yet to be really tested against a tough economic climate.

Financials

SFI's cash flow profile is shown below.

Year to 31st May             1997    1998    1999    2000    2001

Operating Profit (£m)         2.9     6.3     8.6    12.4    22.2

Change in working
capital (£m)                 (0.5)    0.0    (1.9)   (2.7)   (1.6)

Depreciation (£m)             0.5     0.7     1.3     3.4     6.2
Capital Expenditure (£m)     (7.0)  (12.8)  (20.9)  (29.8)  (37.5)

While cash absorbed into working capital appears minimal, it is actually a relatively poor performance. Retailers ought to be cash fountains in this respect, as customers pay at the point of sale while suppliers are paid on credit. JD Wetherspoon, for instance, has consistently reported substantial inflows of working capital cash over the years.

But the main feature of SFI's cash flow statement is the large expenditure on fixed assets. SFI is reinvesting all of its profits -- and more -- into expanding its estate. That's no bad thing if the investment is generating superior returns. But what sort of return is that retained capital returning?

Calculated on a traditional basis, SFI 's return on average equity for the year ending May 2001 was 19.9% (£14.1m/£70.9m). In the five years ending May 2001, £74.4m was added to shareholders' funds to improve earnings by £12.9m. The resulting incremental return on equity figure comes to 17.3%. All good stuff.

That said, those enticing returns have been aided by debt and a favourable tax charge. Since June 1996, debt taken on to fund SFI's expansion has ballooned from £9.7m to £109.0m. It's worth noting that had SFI raised its funding via shareholders rather than through borrowings, the return on average equity for fiscal 2001 would have been a less appealing 12%.

What's more, SFI's earnings are enhanced by a low tax rate, the level of which is currently at the 10% mark. Although relatively low tax payments should continue into the future, the benefit of capital allowances will reduce over time. With debt levels and taxation benefits as they are, it's difficult to say whether the equity returns of yesteryear can be sustained into the future. Certainly with interest payments covered just 3.7 times during 2001, there's limited scope for further borrowing to boost shareholder returns. Prospective SFI shareholders must determine to what extent debt and tax will have on their equity returns in the future.

Summary

While SFI's record looks good, I remain unconvinced. In a very competitive sector, the management run the risk of trouble from the group's operational diversity. I have a feeling that SFI's rapid expansion could result in some sort of (costly?) brand restructuring/reduction in the future. In addition, the constant fiddling with minor chains and acquisitions is a definite management turn-off. On the financial side, disappointing working capital characteristics and copious amounts of debt don't add any encouragement. Overall, SFI isn't Qualiport material.

More: Anyone For Cheap Beer? | Just How Much Is "Too Much Debt?" | Qualiport discussion board