JD Wetherspoon (LSE: JDW) has just reported a year of record sales.
And I reckon the pubs industry has some attractive qualities for investors.
Furthermore, stock valuations in the sector don’t look too demanding right now. In fact, I think they may prove to be on the cheap side.
I’ll focus on Wetherspoon here, but it’s worth mentioning there are a number of other pub chains listed on the stock market. These include Mitchells and Butlers, Young And Co, Fuller Smith & Turner and Marston’s. Investors aren’t short of choice.
Industry in decline
According to the British Beer and Pub Association, the number of pubs in the UK has fallen from 60,800 in 2000 to 45,800 in 2022.
A quarter of pubs gone. An industry in decline. Can this sector really be of interest to investors?
I believe so. Many independent pubs have exited the market. This means less competition for well-funded chains like Wetherspoon.
And while the company has managed down a reduction in its estate in recent years, investments in new pubs, pub extensions, and refurbishments have helped it gain market share.
Attractions
As well as declining competition from independents, the sector has a couple of other notable attractions for investors.
It has some ‘defensive’ qualities. That’s to say, business tends to hold up relatively well in difficult economic times. And Wetherspoon’s cheap and cheerful offering is an added attribute.
Also, pub chains’ balance sheets are typically backed by substantial freehold property. According to Wetherspoon, expected future cash flows from many of its pubs would result in a valuation considerably in excess of current book value.
Revenue
As I mentioned, the company has just reported a year of record sales. Revenue of £1,925m for the 52 weeks ended 30 July was 10.6% up on the prior year. It was also ahead of the previous high-water mark of £1,819m in the year before the pandemic.
There’s an old saying in the financial world: “Revenue is vanity. Profit is sanity. Cash is reality.”
Wetherspoon delivered a strong sales performance for the year, but how did it do on profit and cash?
Profit
The company reported a pre-tax profit of £43m. A welcome swing from losses in the three pandemic years totalling £230m.
However, the £43m profit is considerably lower than the £102m the group made in 2019. The profit margin is down to 2.2% from 5.6%.
This is because of high cost inflation over the last year, and the company keeping its prices affordable for customers.
However, it looks like we’re past peak inflation. It’s not a given, but I can see no reason why Wetherspoon’s profit margin won’t normalise towards its pre-pandemic level over the coming years.
Cash
Last year’s profit may not have been spectacular, but cash flow was. Excluding an exceptional £169m made on the sale of interest rate swaps, Wetherspoon generated impressive free cash flow of £102m (compared with £97m in pre-pandemic 2019).
Net debt of £642m at the year-end was down from £892m at the start of the year, a decrease of £250m. The balance sheet is now stronger than before the pandemic. And I expect it to continue strengthening as time goes on.
Valuation
At the end of 2019, Wetherspoon’s shares were trading in the region of £17. Today, they can be bought for around £6.50.
As such, the market is pricing the stock at 19 times last year’s pre-tax profit. That’s a fairly rich valuation. However, as noted, the profit margin is currently depressed.
If it normalises towards pre-pandemic levels over the next few years — as I believe it will — the share price should rise accordingly.
A pre-pandemic margin on last year’s revenue would represent a rating of just eight times pre-tax profit. This suggests the shares have the potential to more than double on a margin recovery, if the valuation were to stay in sync with the market’s current 19 times rating.
Growth vs income
Wetherspoon has never been a big dividend payer. The real value of a 12p per share annual payout in the decade between the financial crisis and pandemic was progressively eroded by inflation.
The company hasn’t paid a dividend since the onset of the pandemic. Even if it were to reinstate it at the 12p level, the yield would be a pretty paltry 1.8% for buyers at the current share price.
No, for me, the main attraction of Wetherspoon is the aforementioned potential for a substantial re-rating and rise in the value of the shares.
