JD Wetherspoon – Walton on Thames
Mar 2021 (£13.20)
“There is only one boss. The customer. And he can fire everybody in the company from the Chairman on down, simply by spending his money somewhere else.” – Sam Walton, Wal Mart founder
True EDLP businesses, i.e. businesses that share the benefits of scale are a rarity for UK investors. Yet in JD Wetherspoon we have one whose owner manager treks to Omaha, writes an annual report cloned from Berkshire Hathaway and distributes Sam Walton’s biography to its top 100 executives. Oh, and its customers save an aggregate c.£500m in a typical year!
Like Sam Walton, Tim Martin is an obsessive owner manager who ‘gets’ that retail success is a result of a thousand cumulative details. Martin and his team are playing a long game, deferring today’s profitability in order to build market share, cement customer satisfaction and loyalty. Martin regularly admits he could double profits at the drop of a hat simply by raising prices. Few investors, we think, realise the inherent future growth that today’s 20-30% lower prices vs. peers almost guarantees. It seems customers love ‘Spoons’ far more than investors.
In January, at the time of the (second!) placing, we outlined a roadmap for assessing the earnings power of this business. Our work today suggests a plausible earnings power of £140m in Net Income looking out three years or so. Today’s market capitalisation of the business post new capital raised is a 12x multiple of those earnings.
Scale Economics shared
In today’s investing world there is a strong following of ‘Scale Economics shared’ business (or EDLP in old money). JDW is one such scale economics shared business we have studied now for a decade and it is one we feel is underappreciated. Few franchise or compounder investors own the shares and of the sector analysts that cover it, no less than 40% have been ‘sellers’ for the last 5 years.
This note is not about JDW’s COVID-19 recovery or its balance sheet; both of which we/others have discussed ad-nauseam. We will comment briefly on each at the end just to remind readers of our conclusions.
Back to the beginning – A 2012 snowball
We have written reams on JD Wetherspoon since we laid out our original thesis on the company in 2012 (Holland Views – Snowball On a really long hill – July 2012 – 426p). Since then, we opted to focus less on the underlying business model and more on the hidden sources of operating leverage within the business. Today, we get back to basics and refresh readers on why this is such an excellent business. As much as the threats and opportunities that arise from COVID-19 need to be considered by all, it is the core EDLP model at the heart of this business that first and foremost needs to be understood and recognised.
- We review our thoughts on JDW as a rare beast: a flywheel EDLP business. Most importantly, we think JDW’s current estate can support significant volume growth (50-100%) and thus we expect important sales density increases.
- We also address a long time retort from clients – that JDW’s low ROIC (9%) and declining margins calls into question the existence of a moat. But ask yourself how many competitors would survive at -25% lower prices vs. peers (and then pass on the recent VAT cut?). We counter that the last 5-10 years have been a period of extensive investment in JDW freeholds, staff and food preparation facilities. In short, a period of under-earning and what Jeff Bezos might call ‘deferred gratification for shareholders’.
- The crux of our view on JDW centres on the operating leverage pent-up or hidden within this excellent business. In the context of a business that has seen headline margins decline steadily for years, clearly this is an unconventional view. But it is not an uncomfortable one for us. 10% operating margins are not at all far-fetched. In fact we see them as an easy target.
In short, Wetherspoon is following a well-worn track led by Wal-Mart, Costco, Geico et al to try and delight its customers. What we are about to describe is a UK business that, as its owner-manager states, “tries to continually make customers feel a little bit better off”.
Shareholders of those aforementioned pioneering EDLP businesses needed to defer gratification and JDW shareholders need to do the same. Maybe, its not that so few understand that Wetherspoon is an EDLP business, perhaps its more that few have the patience to own it?
In this note
In this note, we focus on:
- Scale economics: one of our big ideas
- Returns, Moats and dividing the spoils
- A Mo Farah Stock
For those that seek a refresher on the business ‘from the horse’s mouth’, we highly recommend the following interview that Tim Martin gave in 2018. It offers excellent insight into the man and the business[1]
Scale economics/EDLP: what’s the big idea?
We have spoken in the past about the importance in investing of knowing what you are looking for.
For us, a good starting point means in the first instance looking for great businesses priced more like ‘OK’ businesses. Next step, we like many others, use our mental models and preferred business models arising from our experience and past successes. We have several of these to help identify great businesses. Big ideas such as ‘scale economics’, ‘rare birds’, ‘untapped pricing power’ etc. In fact our 2012 work on JD Wetherspoon and Ryanair was formative and heavily instructs our ongoing work today on many other companies.
Bezos’ two types of companies
Jeff Bezos tells us there are really just two types of companies in the world: those that constantly try to lower prices and those that constantly try to raise prices. Great examples of the former are Wal-Mart, Costco, Amazon, Geico, Aldi, Lidl and Ryanair – unarguably some of the best companies in the world.
Yet, all are very disparate businesses, some in unattractive, low return markets like groceries and airlines. Yet they all seem to dominate and/or have wide competitive moats that make them extremely hard to compete with. Why is that?
Simple, but far from easy
EDLP as a business strategy is so impressive and effective because it is simple but extremely hard and time-consuming to execute. It requires deep cultural attitudes built over decades – hence the most successful executors have been intertwined with family or owner manager oversight. It is a business strategy based on a big idea (everyday low prices) executed via a thousand small decisions. It is this unwavering attention to detail and low prices, getting little things right which cumulatively compound into customer delight that is impossible to mimic. As Tim Martin puts it, it is about “making the customer constantly feel a little bit better off.” Think how satisfied Geico, Wal-Mart and Costco customers are and thus how difficult it is for competitors to compete/displace them.
One of the reasons these companies are rare is that so few management teams have either the discipline or incentives to remain true to the model. Marginal pricing changes are always hugely impactful on P&L earnings and thus very tempting to play with. Costco’s rigid pricing model of cost-plus (allowing only a 14% gross margin) would not last long with most corporate/turnaround managers tempted to let price rise just a little this quarter. Tim Martin, we think, is cut from a similar cloth as Jim Senegal in this regard – stubborn as hell. In the aforementioned interview posted online two years ago, Martin talks extensively about how a 2018 profit warning could theoretically have been avoided by raising the price of a pint by just 5p. Think about that. Such a candid statement might shock some investors who might find such an attitude almost distasteful and prove that shareholders are being disenfranchised at the expense of customers and staff. To us, it’s the opposite: Martin’s disciplined adherence to the well-worn path of EDLP means that shareholders (including Martin who owns c.22%) will, in the long-run, be huge beneficiaries of the higher customer loyalty and volume and competitor erosion that will result. He also spoke about pub managers’ working hours now being more regular and shorter and the Living Wage commitment being met (but not at the expense of a previously agreed company bonus scheme). This multi-year commitment to arguably significant increases in staff costs reminds us of Schwab’s ‘no trade-offs’ policy. The shorter term costs they incur are visible but the longer term benefits less so (yet).
JDW fits the mould but does not model well
Reading Sam Walton describe Wal-Mart’s not-so-secret sauce will ring a bell for anyone familiar with JD Wetherspoon (quality, range, lowest prices, friendly staff, clean loos, etc.).
“The secret of successful retailing is to give your customers what they want. And really, if you think about it from the point of view of the customer, you want everything: a wide assortment of good quality merchandise; the lowest possible prices; guaranteed satisfaction with what you buy; friendly, knowledgeable service; convenient hours; free parking; a pleasant shopping experience.” – Sam Walton
With c.900 (very large) pubs, JD Wetherspoon certainly has scale in the UK on-trade alcohol market. But, it is also the largest seller of Lavazza coffee and could be considered the largest curry house in the UK by volumes of curries sold! As per Fig.1, Wetherspoon is the fourth most used (as in ‘most frequented’) eating brand in the UK after McDonalds, Costa and Greggs. So yes Wetherspoon’s heritage and brand is obviously a pub chain, but today it has evolved into a 900 unit low-priced, high quality hospitality business that goes head-head (at various times of the day) with fast food outlets, posh cafes, pasty shops and curry houses!
Fig.1: Interesting peers – I thought you said this was a pub company?
Source: JDW FY19 results presentations
Sometimes what you cannot measure matters more
But just because JDW’s volume model is obvious to us does not mean it is obvious to everyone. Contrast JDW with Ryanair: Ryanair is a thing of great beauty for city excel junkies. Lovely crisp lines of linear price deflation mirror volume growth through time, clearly confirming the scale/EDLP model at work. No such luck with pub company analysis. First we don’t get the neat disclosure of the airline industry nor do we have a homogenous business. Pub food is an increasingly important part of the revenue mix but the cost and margin profile of food is very different to beer sales. Nor is a pub fungible like an aircraft is. Michael O’Leary can move a low-return aircraft from one route to another overnight – Tim Martin has no such option to move his pubs (though he can and does close low return pubs). In short, pubs (and pubs analysis) is messy.
However, if it walks like an EDLP business and quacks like an EDLP business, then we suggest JDW is an EDLP business. It is very easy (as we have done many times) for any city analyst to walk into a ‘Spoons’ to confirm the tremendous price differential and value that JDW continually offers relative to its local peers. But such unit pricing and volume data is not formally disclosed by JDW management to the financial community. So there is no getting around it, it is just that bit harder for those that rely on quantitative models to get comfortable with Wetherspoon as an EDLP business. More complications arise in the spreadsheets when one begins to consider the impacts of freehold vs. leasehold estates – but more on this later!
“everyone has a ‘tell’” – Agent 007, James Bond
Sometimes you don’t need a spreadsheet for great insight. For example: how many UK hospitality businesses do you know that passed on the recent VAT relief to their customer in full? We only know of three: McDonalds, Greggs and JD Weatherspoon. Every other company we spoke to (including prominent JDW peers and small privately held niche restaurants) kept prices static and pocketed the difference.
The passing on of such tax savings is true EDLP in action.
Volume upside potential: the EDLP growth key
If our assertion that Wetherspoon is an EDLP business is correct, then volume must be the core driver of growth. More to the point, the business must have scope to meaningfully grow its volumes in the future to be an attractive investment from here.
This is perhaps a crucial point for those new to analysing JD Wetherspoon, as the whole point of EDLP business is driving consistent volume growth to compensate for low pricing. In simple terms to understand EDLP businesses, this shows itself in rising asset-turns (i.e. more sales per fixed amount of assets).
Fig.2. JDW Asset turns
Source: Holland Advisors
A key assertion of ours is that Wetherspoon’s current estate is in fact materially under-utilised. The company does not disclose sales density per se. However last August upon reopening, whilst the effective allowed capacity was only 50% of the estate, yet, (wait for it), it still enjoyed record weekly sales across the group. Anyone who thinks Weatherspoon’s sales densities are maxed out needs to absorb that point: record sales on 50% capacity utilisation. As for flat lining asset/turn as the above chart seems to suggest…we will return to that data shortly.
In an ideal world, pub companies would disclose classic retail metrics like estate square footage, product volume and average pricing. That would make life far easier for us city scribblers to analyse each data point to its nth degree. All is not lost however, as we will show later, the disclosed LFL sales figures are in fact very instructive (for a business that rarely raises prices, Wetherspoons’ LFL sales predominantly reflect volume).
“A computer can tell you down the dime what you’ve sold. But it can never tell you how much you could have sold.” – Sam Walton
To get a little more granular on volume trends, it is instructive to look at Wetherspoon’s LFL sales growth over time in the context of the number of its pubs. Fig.3 below shows this clearly. Given what we know about pricing (prices are typically flat), we can largely attribute LFL sales growth (the bars in the chart) to volume growth. One thus can determine that Wetherspoon has driven significant volume growth (notably in the face of fewer pubs in the last five years) through its estate. Such volume growth is EDLP in action.
Fig.3: LFL sales (a proxy for volume growth)
Source: JDW results presentations
A common refrain – Why couldn’t competitors cut prices to match?
Client: “Wetherspoon’s has really low margins – the lowest in the sector.”
Us: “That’s the whole point!”
We highlighted Tim Martin’s comments that JDW could double profits today if it chose to. It would be exactly the same for almost any EDLP company, we suggest. Let us look at the opposite scenario: What would happen to say JDW’s London competitor Young’s financials were it to match Wetherspoon’s London prices? (Already >50% below Young’s) We happen to know Youngs’ business quite well so feel we have some credibility here.
- Young’s had 2019 revenues of about £311m and operating margins of c.15% (this predominantly London based chain does not employ an EDLP model and quietly pocketed last year’s VAT cut). Young’s 2019 EBIT was c.£45m.
- Now let’s assume Young’s decides it has to pivot and match JDW prices. So it cuts prices by – let’s say by 30% across the board. What happens next?
- Well, revenues drop by -30% too! So, £311m of revenues becomes £220m (-£90m). More pressingly, unless Young’s can find some new volume to compensate, those lofty profits margins are decimated and go (£45m less £90m = -£45m)…swiftly negative! That’s the funny thing with marginal pricing.
This is a theoretical exercise of course. Yet there is insight to be had. Price adjustments are the easy part. The culture change required to withstand the shock of a -30% cut to your longstanding pricing practices (staff compensation, supplier relations etc.) is such that very few companies could manage it from a standing start. Especially when the guy whose prices you are matching has already been doing it for four decades!
But also, how would the average Young’s customer react? Well, there would likely be a South London drinking binge for a week (and not a great deal of work done in the insurance market!). But after the initial excitement would its existing customers structurally drink more, and could they drink enough to compensate for the price reduction? Furthermore, are Young’s pubs sized correctly to cope with such a necessary demand uplift? The answer to all three of those questions we think is: ‘no’. We also suspect that were any CEO of Young’s to try such a strategy he might find himself out of job within a month, maybe less.
Indeed going through this exact exercise explains why EDLP business like say Ryanair or Lidl prevail and keep growing. Because it is very very hard once they have any sort of scale for the incumbent competitors to change their model to directly compete with them without going out of business in the process! This is not a market that Silicon Valley has figured out how to disrupt either we might add.
OK, so we are being a bit sensationalist here – but you get the point. The comfy band of competitors with their higher prices and lofty profit margins would find their businesses decimated were they to try to match the pricing structure of the ingrained EDLP leader. This is as true for Wetherspoon’s peers as it is for Geico’s, Schwab, Ryanair or Lidl. The interesting point in the UK pub sector is that there is only one sizable EDLP player – JDW. This inability of competitors to match pricing, in the long run can give a long runway for volume growth. This grudging acceptance that someone else can do it cheaper than you – is evidence of EDLP in action.
Returns, Moats aka “dividing the spoils”
So Wetherspoon is an intentionally lower priced business. It tolerates a lower margin than peers and in recent years has tolerated a declining margin (i.e. the price gap with peers has widened but the margin gap has too). That’s the thing with EDLP businesses: their operating leverage is often not obvious from the outside as the benefits of scale (i.e. what would normally be rising margins) are instead reinvested in the customer on long time frames. It is for this reason that not all EDLP businesses are externally obvious from their financials all of the time. JDW is today one such business.
But let’s not forget, many low margin businesses can still enjoy decent returns. Indeed these businesses are interesting because they are low margin!
Before we go on to discuss returns and moats, we remind you that we have always seen in Weatherspoon’s untapped pricing power. In other words, there may be a time (and post COVID that time might be sooner than we thought) for JDW to allow prices to rise just a little to offset past cost inflation. We have addressed this point in previous notes and remind you that even a measly 2% uplift to 2019 prices would have lifted Wetherspoons’ 2019 pre-tax profits by a whopping 36%. (There’s that marginal pricing again!). To be clear we have never expected any sort of action by the company to step up pricing to recoup pasts cost burdens; only an expectation of a little gradual inflation or just greater volume throughput instead.
In thinking about returns, we might change tack and move from margins to asset turns. We should state up-front, this is clearly not an asset light business. Tim Martin, like Mike Ashley, is ‘long’ property and he has often shared publicly that his experience of past cycles showed him the value of owning freehold property and the avoidance of market-based or onerous rent clauses. At a deeper level the use of freehold property gives not just freedom but also permanence and we think this speaks to the way that Martin and his team think about the longevity of the Wetherspoon’s business.
Return on Capital 101
Investment returns are still derived from principally two factors whoever you are: Margins and asset turnover as summarised in Fig.4 (thanks to Mr Du Pont).
Fig.4: The Du Pont equation
Source: Holland Advisors
JDW as an investment has been a hard sell to some Franchise investors because both sides of this return equation have been under-pressure. JDW operating margins have fallen from c.12% in 2000 to today’s 8% for reasons we hope are clear from the earlier part of this note i.e. EDLP pricing and investment. (We will address the P&L in more detail in the next section). In many earlier pieces we have outlined the reasons why margins have fallen. These include greater investments in staff and that required for a better food offering. That the group is now poised to benefit from these multi-year investments we think is becoming self-evident. However, while asset turns rose consistently until c.2012 and thus the business looked like a classic EDLP retailer (low margin, rising asset turn) the last six or seven years of stagnating asset turns suggests it might not be such a company….?
Asset turn study
What we want to do in in this piece is look closer at asset turns, the normal life blood of every EDLP business.
Does the stagnation of asset-turns post 2012 show a business that is in decline? Those who see that stagnation and then look at falling EBIT margins often conclude it is. However, we think they are too quick to be assessing the company through their own financial eyes rather than the eyes of customers or employees. Look again at Fig.3 earlier. It shows excellent rates of LFL sales growth since 2012 suggesting customers have never been happier. We also know that the company has invested significantly in staff pay and conditions during this period.
So why is the key metric for an EDLP business (i.e. assets turns) not rising? Freehold property is the answer.
The chart in Fig.5 below clearly shows that the group has chosen to commit greater and greater amounts of its capital to a higher freehold property mix in the last decade. We hope that Fig.5 gives important context on why asset turns have stagnated – because of the marked increase in Freehold property investment.
It is our contention that had JDW’s freehold mix stayed at 2012 levels (i.e. 45%, not 65%), then asset turns would mechanically be a lot higher today as would overall return on capital.
Arguably, with the property estate also not having been revalued for 20 years, recent additions add to capital values in marked way, perhaps greater than their true effect on the intrinsic value of the business. It is interesting we think to understand these quirks for it is the reason why some global investors that should own JDW, we think, do not. Simply put they are not local enough to understand the value proposition the business offers and the asset turn and operating margin metrics does not illustrate the business model to them easily enough from a distance.
Fig.5: JD Wetherspoon Freehold %age of Estate vs. Asset turns
Source: JD Wetherspoon, Holland Advisors
We could now spend a great deal of time adjusting JDW’s historical balance sheet to produce a neat rising asset turn trend line. In doing so we would better prove its EDLP credentials to those looking for (and not finding) confirmation of the JDW model in spreadsheet form. But in truth we see no need. After all what is asset turn? It is the amount of sales that is passing through the asset base of the company. A quick look again at Fig.3 shows that in 2012 (when asset turns plateaued) the company had c.900 pubs, the same number it has today. And yet (as per the sales per pub chart in the Appendix shows) sales per pub has increased +50% over this same period.
That this company has chosen a changed property model (i.e. more freehold) has, to our mind, actually made it a more robust business. That it might not screen so easily for those that know it less well, we say: tough luck!
Defining a moat aka ‘how to divide the spoils’
Whether we call it EDLP or Scale Economy Shared business – whatever you want to call it – what most investors really want to see is evidence of a moat.
A competitive moat is, at its most basic, derived from how customers are treated vs. the competition but proof of its existence can still be quite subjective.
The thought experiment of Young’s cutting prices is surely part of the puzzle but let’s pursue this a little further.
At the end of the day, what EDLP companies do best is share the benefits of scale. Most companies claim to seek economies of scale but in truth most have limited appetite (or fail to see the long term benefit) in actually sharing the benefits of scale with customers and staff. It is this long term, more holistic approach that feeds the EDLP flywheel. So let’s look for how JDW shares its benefits of scale.
A typical refrain from the city is that JDW is a low margin business because its business shares too much profit with customers (lower prices) and staff (wage increases). A glance at 2019 costs below in Fig.6 shows £623m staff costs vs. £350m of pub (gross) profit (as highlighted in yellow) and one can sympathise with this view. However, in our opinion, this is very short-sighted and ignores the long-term value that accrues to a company that looks after its staff and customers in such an honest and open way.
Let’s look at the numbers.
Fig.6: JDW 10-year financials
Source: JDW, Holland Advisors
Sceptics will rub their hands and quickly point out that over 9 years:
- Actual sales (aka volumes) have compounded at c.7% cagr from 2010-19
- BUT, headcount has compounded at 4% and worse, staff costs (i.e. headcount + wages + bonuses) compounded at +10% per year a clear sign they might say of a weak model.
- They might also ask “where are the shareholders yachts?!” (after all, EBIT compounded at only 4%).
Unfazed, we turn to Mr Buffett. Adopting a clever method he once employed in an analysis of Geico’s moat shared in the 2005 Berkshire letter. We can look at the value accruing to each of JDW’s stakeholders as a proxy for the moat that also gives context to JDW’s 2010-19 investment period.
Looking at each of the three constituents in turn:
- The Happy Customers. JDW’s customers save -20% (vs. competitor prices) i.e. circa £500m in FY19 (20% of 2.5bn gross sales) in savings. Or more pertinently over £3.5bn in savings from 2010-2019!!
- The Happy Employees. Employees now enjoy a premium working wage plus a £46m bonus scheme (c.10% of benefits) + job satisfaction (as per the 11y average tenure of pub manager) + growth opportunities as business grows.
- Happy Shareholders? They certainly used to be. The share price cagr was 19% from 2012-19. Actually there might have been a yacht or two bought!
- Clearly what can aid shareholder returns is great allocation of capital and JDW as a serial cannibal (purchaser of its own shares) is enhancing investor returns at rates in excess of simple EBIT growth
This strikes us as a win-win-win situation that is reinforcing as each stakeholder group is aligned. Crucially, however the scale required to compete with the company or displace its competitive position increases as time goes on and these scale economics are reinvested. This is surely Buffett’s moat in action. We do also believe that we are assessing this business at an unfavourable snapshot in time when opex costs are elevated. Repeating this work in say five years from now if sales were 30% higher but EBIT margins were 10-12% would obviously give far better shareholder outcomes. However, staff and customers would likely still be delighted.
Mo Farah Recovery Stock
Tim Martin and his management team we assess as a prudent bunch. The scale of debt (3x EBITDA) that the group entered COVID-19 with was a function of the need to finance the group freehold estate rather than any attraction to leverage. The opposite we think is true. The scale of the assets supporting this debt are significant at £1,363m (freehold) but importantly not revalued since 1999 and the very low cost of borrowing secured (c.3.3% until 2023) gave us great comfort even in the depths of 2020 when the share price plunged.
Whilst the company does not publish its covenants it is obviously in technical breach of them (how would you not be when EBITDA is currently £0m). However, importantly, we think its bankers have a strong feel not just for the latent earnings power of this estate but also for the current true value of its freehold assets. Its low level of cash burn when closed and the ongoing government support measures for this sector brought further comfort as COVID unfolded.
During 2020 and specifically in our Mo Farah recovery piece, we talked to the outsized recovery potential a business like JDW had post COVID-19 particularly relative to smaller competitors in the sector. The more we look at the company and the surrounding industry the more convinced of the view we became. The opportunities we see are both operational (its pubs are low cost, well maintained and ready to open with capacity). But also strategic with opportunities for accretive additions to the business (London) as the recent placing alluded to.
Indeed in our Mo Farah piece (Oct 2020) we observed the following:
Might these be the crisis Tim Martin needed?
Readers know that we are admirers of the JDW pricing policy. Also, that we think one day a little operational gearing will show up in this business when they just cannot find any more staff to pay and any more beer to give away at silly low prices! A few years ago, we managed to get a few minutes with Tim at the back of the Crosse Keys. We asked about this point. I.e. when might the long awaited operational gearing arrive, and it be good to be a JDW shareholder rather than just an employee or customer? Tim answered by describing the competitive situation in the pub sector in the 1990/2000’s and the restaurant sector today. He pointed out that during past over-investments in the UK pub estate (via companies like Punch and Enterprise) JDW sales and profits were depressed. When that bubble burst, he noted JDW did really well. He went on to say that there had then been a huge over investment of capital in the restaurant sector (we were talking in c.2018). He cited new branches of Jamie’s and Carrluccio’s across London-all half empty. He observed that when that capacity left the restaurant sector, like it left the pub sector, JDW would do well.
At the time this was not the answer I wanted (rarely are they!) The Sam Walton in him knew that he just had to keep charging the low prices, build the brand and… wait. As Covid has decimated the restaurant sector this year Tim’s reflection on that day in 2018 has often returned to me. With the company in technical breach of its covenants, losing £14m a month and the pubs shut it feels a strange time to talk about their competitive strength. We will see. Source: Holland Views: Mo Farah Recovery Portfolio, Oct 2020
The future of JDW….+ Valuation (we repeat our view at the time of the recent placing)
Those wondering as to the future of Wetherspoon need look no further than it’s past. It will simply be a ‘more of the same’ strategy of great food, great breakfasts, great coffee and of course beer, at unbelievable prices. One thing that might just change…. the profits..? A read of our past pieces will tell a story of coming operational gearing that did not/has not yet arrived. We think it is only delayed, nothing more. The operational gearing the business possess is significant and powerful, but its focus on customer value is relentless, and year after year customers reward this price/value re-investment with their feet…. by coming back. Yesterday’s Wetherspoon’s (i.e. the one of the last 5-10 years) grew but it had to invest a lot; In kitchens, staff (70 hour week managers reduced down to a more humane 40 hours) and the minimum wage. Tomorrow’s Wetherspoon’s will grow too, likely by 50-100% through the same estate we estimate, but costs will not need to grow as fast this time. The result, the long-awaited operational gearing will arrive. When it turns up we don’t know, but turn up it will.
Whilst some may look at the companies published profit and free-cashflow scenarios in detail we might dream out a little further.
- In the 12 months pre-COVID JDW turned over c.£1.9bn. At an 8% operating margin that would equate to an operating profit of £152m (margin was 8.6% in Jan 2020).
- If LFL (predominantly volume) were to continue to compound at 5%, turnover would be £2.2bn in say 3 years’ time.
- Now for the dreamy bit: per chance margins were 10%, not 8%, in 3 years’ time, thanks to increased scale, EBIT would be £220m.
- With debt at say c.£1bn (with a fixed interest rate of c.3% BTW, but 4% assumed) this might produce PBT of £180m and PAT of £140m.
- Will margins then rise many years into the future for this company? No of course not. As a serial price re-investor that would be suicide, but a look at its past margin structure seems to suggests that it might be under earning it recent years and could recover some ground without giving up anything in terms of competitive position (London JDW beer price per pint is half that of one in a Young’s pub).
Much uncertainty but….
That there is uncertainty looking forward in a business like JDW we cannot dismiss:
- What will the competitive environment look like on re-opening?
- Will the sector have a 1920’s like boom for a period?
- Will VAT tax boost be lasting?
- Will the group choose to run at a lower rate of leverage in future?
- Why did Tim Martin sell stock recently?
- Might the group buy significant London assets?
Analysing any one of these points can cause an investor uncertainty but a key question we think should be considered. One that was raised by an excellent investor many have been reading the letters lately:
“Does this event change the relationship between company and customer?” Nick Sleep
We have studied a great many companies that invest back in their customers in the way that JDW does and it is NEVER right to underestimate the longevity of their growth. There was a time when we used to ask Tim when he would put prices up to compensate for the cost inflation he was suffering in a recent year. We now realise we were missing the point. Like Wal-Mart, Costco, Amazon and so many other great businesses this company is not about ‘cost +’, it never was. Even if the company is having multi-year cost pressures. It was/is about scale economics shared. Its staff and customers see little change, only improvements in the company’s offering in the last 10 years, Mr Market is less sure. Therein lies the opportunity. When margins are higher but sales are still strong and maybe a little less cash is needed for freehold site purchases, more investors we think will admire the Spoon’s model. For now we are happy to have it all to ourselves.
We remain fans of J D Wetherspoon.
Andrew Hollingworth & Mark Power
The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as manager to.
Appendix
Source: JD Wetherspoon annual report, Oct 2020
Source: J D Wetherspoon annual report 2019
Disclaimer
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