The sector's hidden health issue

There was a wake-up call from a slightly unusual quarter last week.

Peter Hansen heads the sector's leading mergers and acquisitions boutique advisory firm Sapient Corporate Finance and he argued that there are some in the City who were failing to understand what's been happening within the tenanted sector since 2006.

Some commentators and analysts do not have a clear enough picture of what's been happening within the estates of the quoted tenanted pub companies. There's been a trend towards claiming that tenanted estates have an 80% stable core and a 20% declining tail. The truth is that the 80% core is stable only from the point of view of the pub company, he argued.

In reality, tenants have seen an average 30% drop in income in the period 2006-09. The decline in tenant profitability had led to tenants "falling off substantive agreements in record numbers". Within one tenanted pubco estate modelled by Hansen, 50% of pubs are in growth for lessees, 30% are in decline and 20% are in catastrophic or severe decline.

Key to this whole issue, of course, is tenant profitability. If a pub is unable to produce an income of between at least £20,000 and £25,000 for the tenant, it has no place belonging to a quoted pub company. Once a tenant stops making this sort of income, he is likely to leave, which usually has a catastrophic effect on pubco profit. "Lots of (sector) analysis ignores tenant profitability," Hansen told last week's Tenanted Pub Company Summit.

It's very hard to disagree. Listen to a conference call at results time and there is little close scrutiny of tenant profitability by City analysts. There's a host of legitimate questions they can ask the bosses of the major companies that simply do not get broached. It seems to me that keeping close tabs on tenant profitability is a no-brainer for a tenanted company or anyone looking to examine the investment case.

Last year, though, both Punch and Enterprise took a step backward on this by, for the first time, declining to produce any figures at all on this. You only have to cast your eyes across to Domino's Pizza, which is quoted and has 608 franchised outlets, to see the information disparity within our sector.

The firm regards franchisee profitability as the "Key Performance Indicator" of its success. It can give chapter and verse on this. It has 135 franchisees who run an average of 4.5 outlets each and make around £115,000 profit per store. Overall profit generated by Domino's in the UK is £90m, split two thirds to franchisees and one third to the company.

Tenanted pubs and pizza outlets are not directly comparable, of course, but there's an over-riding principle. Understanding what's happening to tenant/lessee profit is the key to understanding the real financial health of a pub company.