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Income Investor: Enterprise Inns and the urge to grab a profit

Citywire's yield-hunting columnist considers whether now is the time to sell out of Enterprise Inns corporate bonds.

 
Income Investor: Enterprise Inns and the urge to grab a profit

‘A bird in the hand is worth two in the bush’ the traditional adage tells us. Is this right or wrong for investment? Is this just a manifestation of one of our human behavioural biases – the urge to grab a profit?

I’m facing such a decision in the form of my holding of my corporate bond holding in Enterprise Inns paying a 6.5% coupon and maturing in 2018. These were viewed by the market as quite risky when I bought them and came with a hefty current yield of 9%. What was strange (to me at least, no doubt I was missing some other risk) was that these bonds were (unusually) backed by a dedicated pub property portfolio and the probability of an outright loss of my investment seemed quite remote.

Fast-forward to the present and I am showing a 35% capital gain, as the market has developed a taste for high-yield securities. What is a more relevant measure to me is that this gain is equivalent to four years’ income (from the coupon). My own metric for considering a sale is a capital gain of five years’ income, so this situation has me thinking

‘Bird in the hand’...

  • It’s a nice profit
  • Times are hard for pubs
  • Pub property prices must be depressed - Lloyds recently sold its Admiral pub estate at a huge loss
  •  can re-invest the cash

Or ‘two in the bush’...

  • If I hold on until maturity, I’ll get this price anyway (it’s nearly 98p in the £)
  • There are potentially five more years of coupon to come

The current yield has fallen to around 6.6%, but this is not bad at all in the current yield climate. So what to do now?

There is a lot of evidence that we humans are not good at estimating probabilities. Logically, I can exclude most of the maturity value, so the difference comes down to the five years of a reasonably attractive coupon. Assuming that I could reinvest the sale capital at a fairly similar yield, the risk comes down to the risk of loss on the new security versus this one. So what is the probability of Enterprise Inns failing?

The 2012 Annual Accounts for Enterprise Inns puts a brave face on it, seeming to show in its headlines a recovery situation, with lower losses, reduced debts (still £2.7 billion, though!) and bank financing extended to 2016. However, there is a declining trend in profits before tax and exceptional items, cash flows and adjusted earnings per share. Looking at the cash flow, the company’s interest bill has nearly doubled since the previous year – equivalent to over half the operating cash flow. The company has been quietly buying back £52m worth of its own debt during the year as well as repaying £340m of other loans, but financed partially by taking out £160m of new loans – presumably at lower coupons.

So, it looks like the company is likely to limp forward for a few more years, although with some improvement. But is it likely to be ultimately a success story? This seems unlikely to me – a lot of corporate activity seems to revolve around financial re-engineering. My particular piece of debt is part of a chunk valued at £600m, coming due in 2018: that’s a lot of refinancing to handle.

I think I’m heading towards the exit soon. With my bird in my hand.

If you've enjoyed this article, why not visit DIY Income Investor's blog? The views in this article are the author's own, and do not constitute advice.

9 comments so far. Why not have your say?

Daniel B

Jan 09, 2013 at 11:05

I completely agree with your analysis - Enterprise Inns is struggling, and with a 35% capital gain this might be a well-timed exit at the top of the market.

Have you considered where to reinvest the proceeds? The upcoming launch of the TwentyFour Income Trust (which will invest mostly in European mortgage-backed securities) with a target yield of 6% appeals to me. Would be very interested to hear your thoughts on this one.

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deeply realistic

Jan 09, 2013 at 12:25

I bought some of these a couple of months ago, plus some shares to average the risk. The market for the shares has presently peaked, but in this low yield environment, I still think the bonds offer safe value. Mr Cable's attack on Pub Owners today has not been helpful.

Looking at the yield on my original capital is a mug's game, but even now, about 7% Gross Redemption yield is respectable.

If 5.5% yields becomes the norm, the capital value may still go up to match, as these bonds are very low risk.

Alternatives? Structured investments are looking much less attractive in the last two months. Suggestions?

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Little John

Jan 09, 2013 at 15:14

I'm pretty much in agreement with the analysis too. My own gains are a more modest 16% but over about 5 months and I've had some income. As the bond is almost at maturity value I could reinvest the proceeds and get 7-8% from Raven Russia Prefs or Nat West Prefs

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deeply realistic

Jan 09, 2013 at 15:27

My decision to keep the bond seems justified by today's value hike to above par. I also had shares, but sold about 40% to lock in some gains.

Raven Russia Pref shares are doing OK but my matching Share purchase to spread risk/reward is not doing so well.

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The Expat

Jan 15, 2013 at 13:27

Keep in mind that these bonds are debentures secured on the freeholds of a large portfolio of pubs. The covenants mean asset cover has to remain above 170% and interest cover at 2 times. This is tested annually and if asset values have fallen, Enterprise Inns has to put up more collateral. The debenture structure gives holders of these bonds better protection than most securitizations. The company now has a clear run way until the bank facility matures in 2016. The problems with the securitization (potential cash lock) appears to have been resolved with the recent bond buy-backs. In short, there is nothing to trip them up until they will have to refinance the £600 million debt mountain in 2018.

What they SHOULD do is take advantage of the strong equity rally and do a rights issue to repair the balance sheet. This would allow the company time to right-size its portfolio without having to keep selling assets to pay down bank debt. However, from what I know of the management, that doesn't seem likely.

The equity is extremely high risk, but the risk of ultimate loss to the debentures remain low. Having said that, the 2018 debentures have exhibited a very high - and unwarranted - level of Beta.

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Outsider

Feb 25, 2013 at 15:31

I am not an investor, but what I do know is that , not only is Vince Cable looking (again) at pub companies - as "Deeply Realistic" comments - but this time there is a big chance that he could remove the tie altogether (at least for pubcos - as opposed to breweries) . if this happened, ETI's cash flow would plummet. This has been the slowest of train wrecks and it could be heading for the buffers.

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Brian Jacobs

Mar 05, 2013 at 10:27

Provisional figures are available on the internet dated November 2012. It is acknowledged that there have been some high value pubs sold and leased back which may marginally distort the following.

Below is an analysis of some of important elements that need consideration.

1. The number of pubs [6060] have fallen from last year [6184] but the apparent average property value appears to have fallen from £736k to £708k. Since it is a fact that Pub values reflect their profitability, and the fact that trade and profitability at retail level has generally fallen, then asset values should be reflecting a fall.

2. The average debt per pub is now about £402k against £478k last year.

3. The average 2012 debt, compared with the average pub is just under 57% of their stated value. But is the stated value a fair value?

4. Net income of the group for 2012 was £374m before admin and equates to £61.7k per pub which compares with £64.5k per pub for 2011. That is a 4.3% drop.

5. In the absence of 2012 using the 2011 accounts average rent per pub equates to £29k per annum reflecting rents agreed over the past five years or so.

6. As a generality Enterprise assume rent and tenant equate. As a result of the economic climate decline over the past five years with the rent being fixed income for the tenant will have fallen lower. Average income is more likely to be £20k per annum or less [the BISC survey revealed £15k per annum].

7. The average 61.7 per pub generated for Enterprise includes the exceptional wholesale profit from bulk buying, which probably averages say £18k per pub. So Enterprise collect as lease rent, wet rent and royalties £43.7k per pub [61.7-18] and 18k as a wholesaler. Wholesale profit should not reflect in freehold values.

8. If all their pubs were trading as owner operated freehold and free generating probable average profit [EBIT] of £63.7k.

9. The freehold value of pub generally relates directly to profit, usually current/historical profit because of its “single use” and need to support the owner operator, their personal use reinvestment and service any debt.

10. A prudent lender would generally limit loan, to a sole pub purchaser, to a maximum multiple of three to four times proven profit provided that the loan was not greater than 70% of the purchase price and 30% being funded by a deposit [not an additional loan].

11. It is fundamental that any balance sheet is fundamental should show a “true and fair view”. Tangible assets, freehold property, should not be valued on the basis of alternative value [unless vacant] or reflect the price of that of a special purchaser, such as a wholesaler. It is only the tangible asset that gives security to a lender, as an “intangible asset” has no substance as security.

12. Applying 3.5 times profit and 30% deposit to the average profit of £63.7k would support a borrowing of 215k and total sustainable value to about 310k. Such a figures should then be compared with Enterprise borrowing for those same pubs £402k and valuing at £708k.

13. Although there have been a few recent bulk transactions of pub sales at around a multiple of six times earnings, given the austerity of the financial climate perhaps even applying a multiple of five times may turn out to be generous.

14. Auditors have a duty of care and need to verify and validate financial statements to certify that the accounts show a “true and fair view”. That includes checking the basis of valuations and the relationship between borrowing and security given to bondholders and lenders

I hope that readers may find this helpful.

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Outsider

Mar 05, 2013 at 12:56

Brian Jacobs is absolutely spot-on. Basically, Enterprise Inns is in serious negative equity. if they carry on selling off as they are, they'll have no pubs left and STILL have serious debt. Many of their sale and leaseback deals have gone toxic. They are receiving less in rent from their tenants (due in part to declining beer sales) than they are paying to the freeholders.

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The Expat

Mar 05, 2013 at 13:31

Enterprise has serious problems and has been frightfully mis-managed. (The share price fell some 95% between 2007 and the low in early 2012.) It remains over leveraged and it is still far from clear that there is a future for their business model. However, the debentures have very meaningful asset cover. Remember that the asset values are tested independently every year and that the accountants then sign off on it. They have to retain 170% asset cover as of the last valuation and the interest cover on the pool securing the bonds has to be above one. If Enterprise goes down, the average asset value would have to have fallen - at least in theory - from 170 to less than 100 from the last valuation for there to be an ultimate loss of capital (or the valuers would have had to get the valuation wrong to that extent).

Brian's analysis is good. However, I don't think it is that meaningful to look at the avarge value of the pub estate. At the low end there are pubs that have no value as pubs but may have some value for alternative use. At the other end of the scale there are properties that are valuable as pubs and also have significan bricks and mortar value.

The 2018s are currently offered at 98.7 giving them a ytm of 6.78%. This is a junk bond, but I still think it represents very good value. Most other bonds available to retail investors do not have any asset backing at all.

EntInn has no short term liquidity issues and effectively no re-fi problems until the 2018 comes due.

Not one for widows etc, but this credit is in far better shape then it was before the last re-financing and if the company goes down, the loss severity on the debentures should be low given the level of asset backing.

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