The culture at Punch Taverns is an open and friendly one. When, as a journalist, you approach with bad news the courtesy and openness stay in place.
It's quick to acknowledge a mistake and doesn't, corporately, bear a grudge. This spirit of openness had not, as yet, extended to admitting fundamental structural problems with its business model. All that changed last Wednesday at its half-year results.
New broom in the tenanted division Roger Whiteside went further than anyone has ever gone at the company before in admitting that some pretty major things need to change. Whiteside and his boss Giles Thorley must have agonised about how far to go in admitting what they did. But, in the event, some sort of straight-talking gene kicked in and there's enormous credit due for this.
Whiteside outlined the serious state of trade in the tenanted division. The good news was that things had not worsened since the start of the year — but things were pretty terrible then, with 12% beer volume declines.
Machine income, meanwhile, is down 16.4%. Pubs are getting re-let (465 of them so far this year), but there's major resistance now to long-term leases — and rents are having to be set lower.
Although 44% of the estate is showing beer volume growth, by definition, 56% is in decline — the beer volume figures here, by dint of the way statistics work, must be pushing scary levels at a fair chunk of the estate.
Whiteside said he expected beer volumes "to bounce" upwards before continuing their long-term decline. He conceded that without income growth licensees will require a "larger share of the cake".
Those pubs that could not be turned around would be sold. Whiteside estimated that a full 70% of the estate was wet-led, a part of the pub market that now needed to broaden its appeal — or risk failure.
Whiteside even alluded to the fact that Punch's beer income growth had been margin-driven not volume-driven, reliant on its ability to pass on wholesale price increases to its tenants. This has traditionally been one of the no-go areas of the pubco-tenant relationship. The wider unanswered question here is the extent to which passing on wholesale increases when the pubco itself has its margin maintained by long-term contracts with the major brewers turns tenanted pubs uncompetitive year by year.
Transparency and trust
Just when you thought that Whiteside could go no further in conceding points made by detractors, he had one more surprise. He admitted that, currently, relationships with licensees had lacked "transparency and trust".
Plans seem a little unformed on how this might change, but Whitside indicated that incoming licensees need more information. He suggested that Punch should be much more proactive in indicating the sort of turnover individual pubs are likely to achieve — and the risk involved.
The long-term plan within Punch's tenanted division involved stabilising its pubs (tenant support is indeed stable at £1.6m a month), providing ongoing support and then creating a platform to allow Punch to go back into growth as a result of "sustainable value creation".
A total of 400 pubs have taken up Punch's new value-food template and 500 tenanted pubs are seeing business rates appeals undertaken by the company.
Whiteside said there was a need for strategic change — a pub-by-pub estate survey was underway, which was looking at the market potential for each pub. The aim was to create a "win/win" partnership with tenants. He made a valiant defence of the tenanted pub opportunity as a low-cost point of entry for entrepreneurial types.
The down side of this is that entry cost is almost too low. Domino's Pizza franchisees, by comparison, are asked to invest around £250,000 per site (and generally show the "right stuff"), but, in return, can expect a turnover of around £13,500 per week per site and tend to earn around £100,000 per annum per site pre-tax.
Effectively, they sign up to get massively into debt to buy Domino's retail expertise, knowing they will work their way into handsome income within a year or two.
Whiteside is just five months into the job so he can be forgiven for not having entirely fleshed-out plans. What seems clear, though, is that, given the damage done to the tenanted estate by extraordinary market conditions, very fundamental thinking is underway — as it should be at a number of the larger tenanted pub companies.
The tenanted division is clearly too big and unwieldy. Although Whiteside would not be pressed on this, it now seems logical that Punch should be around a thousand pubs smaller at some point not too far off. Arguably, now, every pub not capable of taking £5,000 a week needs to move to the departure lounge.
So far, disposals are in line with book value (the estate has now taken two impairment write-downs with some value added back for pubs that have seen trading recover). Potentially, Punch can carry on selling large numbers of underperforming tenanted pubs to its licensees — 1,000 have expressed an interest in buying their pub, although, so far, only 23 have achieved it.
This route makes absolute sense while Punch can buy back its debt at a 34% discount to value — as it has so far this financial year. In fact, it's in Punch and the industry's interests to see those pubs that won't provide a decent income for licensees and Punch passing into private hands as quickly as possible. Punch has a solid 44% core of tenanted pubs enjoying sales growth.
The time has come to recognise that from now on it must start using its existing contractual arrangements with brewers to protect licensees from swingeing increases in wholesale prices — it's only passing on 4% of a 6% rise this year, but could have done more. Protecting its core licensees from large wholesale price increases improves the chance of these pubs having a sustainable future. Whiteside is working on a new lease agreement that will aim to motivate business growth among licensees.
The way ahead for Punch and others has to lie in helping licensees bake a bigger profit pie, and allowing licensees to keep the vast majority of upside they create. Alignment of interests, which is clearly already evident, can go further with the creation of Marston's-style turnover leases. There's much more that can be done in terms of cultivating its best licensees and multiples, offering them better terms for taking on more sites and out-performing. The market itself is dictating many of the changes that are underway in the tenanted sector.
For those bottom-end pubs that Punch can't sell, all options will need to be open. Licensees will be able to properly negotiate terms and employ the full range of contractual bargaining chips you tend to see in commercial leases — options to buy freeholds, rent-free period, break clauses, stepped rents, free-of-tie options, pre-negotiated rent increases tied to a sensible measure.
In the long run, Punch and the tenanted sector stand to benefit enormously by greater flexibility on terms, even closer alignment of interests and total clarity on how a lease agreement will work on time. Not least of the benefits is the opportunity to take all the fractiousness out of the pubco/tenant relationship on the basis that no tenant could claim they didn't know what they were taking on when they signed up to run a pub.
Despite Whiteside's somewhat gloomy analysis of the macro factors bearing down on the tenanted division, the market reacted very favourably to efforts to pay down debt.
At Punch's annual general meeting in January, chief executive Giles Thorley admitted the company had been behind the curve in dealing with debt. The same applies to the number and type of pubs that Punch, and a number of other large operators, own.
There is a very strong tenanted business at the heart of Punch. But I think some of the levers have been hit too hard in recent years. The trick now will be thinking very long and hard about how you really create a sustainable long-term partnership with tenants.