Pub group stock remains an attractive buy

FROM a high of £2.57 in August, Mitchell and Butlers’ share price has underperformed the wider British market by 11% over the past month.

Concerns centred on the possible ejection of the stock from the FTSE 100 at the September quarterly review. This would have triggered selling from index-tracking funds, a fact anticipated by active investors who sold the stock ahead of the review on concerns over the potential for technical weakness.

The concerns have proved unwarranted. Mitchells and Butlers has remained a FTSE 100 constituent. Recent price weakness provides an attractive buying opportunity.

Mitchells and Butlers is Britain's leading operator of managed pubs, bars and restaurants. The group began its independent life as recently as April 15 this year when it was demerged from Six Continents.

Pubs are the largest part of the business, accounting for nearly 60% of turnover and over two thirds of group profits. The O'Neill's brand is probably the most recognised of the company's pubs brands among Irish investors. Restaurants account for the remainder of the business and include such brands as Vintage Inns, Harvester and All Bar One.

In total, the group operates from over 2,050 sites, over 2,000 of which are in Britain and the majority freehold.

Similar to the British retail sector, the British pub sector has seen a lot of interest from private equity investors over recent months, with asset backing and stable cashflows the prime attractions.

As recently as March, management turned down a £2.8bn cash bid, with reports at the time suggesting two other private equity firms had also expressed an interest.

Management, however, have chosen to remain independent, focusing instead on improving trading and the efficiency of the company's balance sheet.

A key change in group strategy has been a shift to organic sales growth. Price promotions are currently being rolled out across 1,000 pubs, with 1,400 targeted by year end.

How successful management will be at delivering remains to be seen. Their track record to date is poor.

Growth over the past decade has come primarily from asset churn and heavy investment with £470m having been invested over the past three years alone, a figure expected to fall to £100m over the next three years.

Having withdrawn their interest in bidding for Scottish and Newcastle's pub business, management are now pressing ahead with the commitment made in May to return £400m to shareholders. The structure of the share capital return should be in place by the autumn and is expected to consist of a share buyback.

With a current market capitalisation of £1.7bn, a buyback of this size is significant. At current levels, it would allow the company to repurchase over 20% of group share capital, enhancing profit per share by nearly 15%.

Trading already at an 8% discount to rival JD Wetherspoon, the earnings enhancement expected from the buyback should widen this discount to near 25%, allowing significant scope for Mitchells and Butlers to re-rate.

Risks certainly exist, continued poor trading in London and the provincial high streets being the most significant. Also, a threat to profits could come from the cumulative 15% increase in the British minimum wage over the next 12 months.

The threat for investors, however, should not be overstated. There is currently nothing in consensus profit forecasts for the company delivering on its new strategy. Hence, any success on the part of management should result in upgrades.

Trading now at £2.35, a 10% move from current levels does not look too demanding.

For further information on Mitchells & Butlers, please contact Goodbody Stockbrokers; telephone (021) 4279266, (01) 6670400.

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