Punch - Tight in more than one way.
All,
Please find our updated model of Punch here.
Punch SSNs are the type of bond that at any time tends to trade just a few points tighter than where we would like. Trading tight in the mid 80s going into the call, the bonds moved up to 90 afterwards - deservedly up, but again quite tight now for a story that won’t unfold until 18 months from now and even then promises to remain tight. With short-term events more likely coming from Stonegate and with FCF still as tight as bond trading levels, we are remaining on the sidelines, “hoping" for an off-day in the market, rather than chasing the paper now. All in all, however, we think the bonds will be fine, despite some loopholes in the documentation.
Investment Considerations:
- We have been thinking about taking a position in Punch for a few months now, but the bonds continue to trade just a few points too tight for our liking. On the Q4 call management provided a positive outlook, even more positive than we had been, but bonds traded another four points tighter since. Beer demand is proving perfectly inelastic, allowing pubcos to pass on their cost inflation in full. On our calculations, however, 2025 EBITDA would just about value cover the bonds, although there is upside to our model, chiefly from lower cost inflation going forward while beer inflation could stay high for a little longer - as all pubcos are struggling.
- Cashflow is limited and the low CapEx forecast (considering another 70 pub conversions) has us concerned that the company is sweating the estate, but we do not see Fortress losing the company over any valuation gap at bond maturity. The equity injection to achieve an amend and extend should be limited.
- We may be throwing out an older investment in the coming days to replace with one in the Punch notes. At 10% yield on the bid side, the bonds are not very juicy, also because we hesitate seeing them necessarily as a pull-to-par trade, but we recognise that they have virtually no net debt ahead of them, which de-risks the profile considerably.
Current Trading:
- The company is successfully passing on its cost inflation via a 12% rise in beer prices. Gauging from our simplified arithmetic, UK demand for a pint at the pub is proving near perfectly inelastic. We calculate volumes to be going sideways these days.
- FY23 EBITDA overcame a £4m headwind from a new energy contract that had come into effect around September 2022.
- Expenses have risen significantly YoY, raising concerns among investors. But management attribute much of the increase to "building out teams” (not further specified), adding that from here onwards the cost expansion should be limited to inflation.
CapEx and Conversions:
- Management guided towards relatively low CapEx of £20-30m, half of which would be for maintenance - equating to approx. 1.5-1.7% of BV.
- So far, so similar to FY23, but the company also revealed plans to convert another 70 pubs over the coming three years from L&T into MP. The cost for that remains unchanged at £230k per pub, i.e. lower than for the last batch when taking into account inflation. We understand that the new formats will be less food-led and more drinks-led than the last one, but management did not want to be drawn into a discussion of the format. Rolling out slightly smaller or fewer kitchens, however, would save a lot of expense build-up.
- Converted pubs only mature some 18 months after conversion, and are expected to produce incremental EBITDA of approx. 20-25% or £50k per pub. At that rate and considering the program will be backloaded, we estimate that Punch will not have made their money back before it is time to refinance, but the multiple on the incremental EBITDA should make it accretive by then.
FY24:
- Management said Q1 thus far was “significantly ahead” of last year, both in revenue and EBITDA as pub conversions are maturing and beer inflation is lifting L&T performance. We find this hard to calculate from the sparse data the company releases, but do not really doubt it.
- Going forward, we see beer inflation only drop after cost inflation as all pubcos are in a tight spot and need to pass on much the same headwinds to grow back in their leveraged capital structures. As a result there may be some upside to our model.
FY25 Refinancing:
- Maturing in June 2026, the bonds require a strong FY25 (ends in August, reported in October). Taking into account some of management’s bullishness, we arrive at £90m EBITDA, which with some add-backs (which Punch are fans of) would put leverage back where covenants were set originally. We still see that as a tight proposal, because FCF would cover interest only 1.5x and only a little more when normalising WC.
- In the scheme of things, however, we would be surprised if Fortress were prepared to lose an asset like this over what should only be a small fresh cash demand to hold on to their £400m investment and considering how aggressive the original financing was. The company is moving in the right direction.
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk