Stock to Watch: Marston's

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A recently robust trading statement from leading brewer and pubs group Marston's (MARS) underlines its defensive qualities in a difficult financial environment.

A relatively low range in the long-term chart, shares trading around tangible net asset value and a 6% prospective yield make the FTSE 250 shares worthy of consideration.

I believe there is a tussle between growth and income-oriented investors here that it is important to recognise if you want to understand the dynamics affecting this share.

Like various other pub groups, Marston's ended up with a lot of debt to fund expansion, during years of easier lending. Not to the extent say of Punch Taverns (PUB), but enough that the balance sheet has nearly £1.2 billion net debt - the net interest on which clipped nearly half of £154.3 million operating profit in the financial year to 1 October 2011.

If the UK economy - to which Marston's is wholly exposed - takes another lurch down, as was feared late last year, this would defer repaying debt and continue to eat into diminishing profit. That's hardly appetising for investors seeking growth.

But if the UK economy avoids a double dip, or just taking a longer-term view, Marston's looks attractive, especially to income seekers. From their perspective and with fresh money, the debt has usefully depressed MARS shares to exact a higher yield as compensation; yet the overall risks are limited by net tangible assets of about 100p a share. The 1 October 2011 balance sheet shows nearly £2 billion property, plant and equipment against relatively low goodwill and intangibles of £224 million and £25 million respectively.

The prospective yield is about 6%, twice covered, making MARS competitive against other income shares. While the total dividend was unchanged at 5.8p in the last financial year, cover to earnings edged up from 1.7 to 1.9 times and should improve further with modest earnings growth projected.

Company REFS shows a consensus for the dividend to rise to about 6.3p per share this financial year or next, supported by annual earnings per share up 7-9% to about 11.6p this year and 12.6p next, based in turn on normalised pre-tax profit up from £80 million to £85 million and £93 million in 2012/13.

So while the dividend should at least be held, you need to be comfortable with this modest growth scenario. A forward price-earnings multiple of about eight times suggests the market is cautious anyway.

Mind that REFS shows the price to earnings multiple averaging single figures in each of the last five years; but if management can prove modest growth in generally difficult times, especially to make progress paying down debt, there ought to be some re-rating of the shares' capital value otherwise the dividend would be seen as over-generous for a comparatively less risky firm.

So the crux for group trading is whether Marston's can capture more of the British "eating out" market with good value food and drink, in pleasant locations, helped by customers trading down from restaurants. Premium ales may also benefit from a shift from relatively expensive wine. The environment is quite akin to how PizzaExpress made its mark as a listed company in the early 1990s: there remains an "eating out" market to capture, if more value-conscious.

In this regard the 27 January Christmas and New Year trading statement was pretty good. Over 16 weeks to 21 January, like-for-like sales in managed pubs rose by 5.0% with similar operating margins, and the objective to build 25 pub-restaurants in the current financial year remains on track. In leased, tenanted or franchised pubs the growth was easier at about 3.0%, only keeping pace with inflation. Brewing benefited from a focus on premium ales, with sales growth of 3-7% according to cask or bottle.

It is worth taking a look at a presentation on the recent prelim results, which sets out some interesting projections for 2012. Cost inflation (energy and barley) will be mitigated via price rises and efficiencies; while a mix of new-build (such as garden areas), innovation with food menus/pricing, and premium ales, are hoped to deliver growth with lower gearing and higher return on capital.

It sounds a nice wish-list and sceptics may understandably feel cautious in a competitive pubs market. Much depends on UK disposable income being satisfactory enough; that recession and unemployment do not bite harder. While you can consider all the worthy initiatives Marston's is taking, for the near term the shares look mainly a macroeconomic call.

If you can trust the latest forecast for steady improvement from 0.2% economic growth in the first quarter of 2012 with 0.9% expected for the full year, then pubs should do quite well. A cynical view however is that an employers' association would likely get more criticism for undermining confidence by being pessimistic, than getting its forecasts wrong (in line with others).

The risk/reward profile still weighs on the upside, for long-term investors. Marston's asset base and dividend look sound, even to withstand further recession; the main uncertainty is what extent of growth management can grind from a competitive gastro-pub market, with beer still quite expensive. The 2010/11 cash flow statement showed that after net operational cash flow of £182 million (slightly down) net interest paid was £70 million relative to £33 million on dividends, while making no inroads into net debt. So the next update, due 14 March to indicate first-half performance, will need to sustain progressive digits.

As an indication where the directors see compelling value, last December the finance director added 15,000 shares at 90p to own 92,959 shares, and a non-executive director added 100,000 shares at 96.58p to own 268,000 shares. Since January's running was mainly made by higher-risk shares, MARS has not really advanced much since then.

For more information see marstons.co.uk and for more Stocks to Watch, visit Edmond's archive.