For U.K. Pubs, A Long Recovery Is On Tap

With good progress on vaccinations and a roadmap for easing of lockdown and restrictions, pubs and restaurants in the U.K. can open their doors over the next few weeks. The reopening is set to be gradual and staggered, with venues in England allowed to have outdoor operations from April 12 and indoors from May 17; rules and dates vary across Scotland, Wales, and Northern Ireland.

While the welcome prospect of opening after several months and pent-up demand (booking levels remain very healthy) will drive footfall, S&P Global Ratings expects operating prospects will remain tough over the medium term. We expect many operators will take up to three years to rebuild their financial profiles to 2019 levels. Following the pandemic, customer behavior will continue evolving, so pub operators will have to be nimble with their offerings and formats to stay on top of fast-changing consumer preferences.

Larger Chains Will Gain Market Share As COVID-19 Escalated The Pace Of Pub Failures

The closures and restrictions that aimed to control the spread of COVID-19 have taken their toll on the hospitality sector. Pubs have not been able to stem their cash burn even after the support extended by the government (furlough and rates holiday), suppliers (who have taken on most of the burden of inventory impairments), and landlords (through rent waivers and deferrals). The strong uptick in July and August, due to pent-up demand following the easing of lockdown restrictions, and government incentives like the eat-out-to-help-out scheme were too brief to offset losses in the rest of year. Many smaller businesses have exited the sector. According to CGA and AlixPartners, almost 10,000 licensed premises, including pubs, clubs, and restaurants, shut their doors permanently last year. With substantially fewer new venues opening during 2020, the net closures stood at 5,975 sites across Britain, an increase of 175% from 2019 levels.

While COVID-19 exacerbated the extent of pub closures, the number of licensed premises in the U.K. were already in decline over the past couple of decades following falling on-trade beer demand. Data from the British Beer and Pub Association show that before the pandemic, the overall U.K. pub estate had shrunk by close to 15% in the past 10 years to 47,200 pubs. This reduction in supply, in our view, has supported the low-single-digit like-for-like growth for trading sites in the five-to-six years pre-COVID-19.

Among rated pub operators, which comprise large corporate and securitization issuers, pub estate reductions were much lower than the industry average. In our opinion, this points to the larger rated players--with breadth of footprint and format diversity and better access to capital markets--withstanding the pandemic better and supporting their pub tenants. Post-pandemic, following the spate of closures, especially from smaller and independent operators, we expect the larger players to gain market share in the face of decreased supply in the market.

Larger Managed Pub Chains Have Better Recovery Prospects

In our view, during the recovery phase, the flexibility and direct control the managed model offers will allow larger and better-capitalized operators to react swiftly. While managed operators who directly run their pubs have had to bear higher costs during no-trading periods, limited rent outlays (from vast property ownership, furloughs, and business rates holiday) and prudent cash management have allowed them to get a better handle on their liquidity. Historically, managed operators also generated greater earnings and cash flow per pub. We attribute this to their brand awareness and greater vertical integration, consistency of offering, and better logistics across sites. These factors allowed managed chains to have greater control over all aspects of operations, including staff, menus, inventory, repairs, and capital investment. Post-pandemic, we expect the historical trend of gradually converting leased and tenanted (L&T) pubs to managed pubs will likely gather pace, especially for properties in more attractive catchment areas.

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By contrast, operators under the L&T model, which generate revenue from rent and, in most cases, tied-in drink supply agreements, benefit from higher margins and steady earnings, although net earnings and cash flow are typically lower than those of a managed operator of the same estate size. L&T operators depend more on publicans, who manage the pubs. Independent and L&T publicans are more susceptible to business failure, because they bear the bulk of the operational and financial risks. Publican tenants, who are typically smaller or self-employed, often have limited access to capital markets and are more affected by economic downturns. During the pandemic, L&T operators had to share the pain with their tenants and bear write-offs of beer stock, as well as rent holidays, reductions, and deferrals. We expect L&T operators will continue supporting tenants in the recovery phase, leading to a potentially slower improvement in earnings compared with that of managed operators.

Earnings Will Define The Quality Of Underlying Real Estate

For many rated pub operators, their significant freehold property portfolios have offered substantial operational and financial flexibility. As a result, they fared better than lease-heavy casual dining restaurant operators, such as Mabel Topco (Wagamama) and other discretionary retailers such as Matalan.

The high share of real estate ownership was also a factor behind some of the merger and acquisition (M&A) activity over the past few years. This involved several of the largest names in the industry, such as Stonegate Pub Co. Ltd. and Ei Group PLC (owner of the securitized Unique Pub Properties Ltd.) (2020) and Greene King (2019). Other noteworthy transactions were the merger between Marston's Issuer PLC and Carlsberg's U.K. brewing units in 2020, the recent failed buyout of Marston's main pub operations, and the shareholder consolidation in Mitchells & Butlers in February 2021.

As fallout from the pandemic and pub closures, we expect significant impairment charges, in addition to the property write-downs many rated pub groups have already recorded. Furthermore, we have yet to see meaningful large-scale valuation support from conversions or alternative uses for pub properties. Based on these trends, we expect the pubs' quality of earnings to be a more defining factor in the credit profile compared to the quantum of real estate ownership.

While financial flexibility to undertake ambitious expansion or capital expenditure has been severely constrained, we expect the larger and better-capitalized pub companies to actively evaluate their pub estates and take advantage of competitors being forced to sell properties. We anticipate these groups will continue to undertake selective acquisitions and disposals to optimize their property portfolio in relation to demand trends and their coverage footprint. We also expect pubs in suburban areas with outside space like beer gardens to see greater interest vis-à-vis city center properties.

Lower Beer Volumes And On-Trade Consumption Will Continue To Dampen Profitability, But Premiumization Trends Could Lend Some Support

Over the past two decades, on-trade beer consumption in the U.K. has declined gradually but persistently, driven by an increasingly health-conscious consumer and a shift toward premium offerings, especially for craft beers and spirits. This has been especially noticeable in on-trade channels, which have a more direct effect on beer and resulted in on-premise beer volumes falling by 16.4% over the past 10 years (according to data from the British Beer & Pub Association). The growth in at-home (or off-trade) consumption has limited the overall decline in beer volumes to 3.6%.

After a near-term spike in pent-up demand following the upcoming reopenings, longer-lasting changes to consumer behavior post-pandemic could continue to favor consumption at home at the expense of bars and pubs. Despite stress on incomes, we expect the premiumization of drink offerings in favor of greater variety and spirits to benefit the hospitality sector.

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In our view, the pub sector has lagged other segments of the hospitality industry like events and casual dining, in adopting technology. This has exposed them to higher labor intensity--staff costs typically account for 35%-40% of pubs' operating costs. Hefty increases in the U.K.'s national minimum and living wages had resulted in a progressive deterioration of profitability metrics before the pandemic. However, while wage growth has exceeded inflation before, we expect to see labor cost increases to slow in the near term. Over the medium term, we expect these costs to be affected by two contradictory trends. On the one hand, Brexit could supress the migrant labor inflow from European countries; on the other, higher unemployment could keep a lid on wage growth. We forecast unemployment in the U.K. will rise to 6.3% in 2021 from 4.5% in 2020, as employers' contributions to the furlough scheme increase over time, and as some businesses fail despite support during the recovery when economic activity is still weak.

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Changing Consumer Behavior, Sustainability, And Regulation Will Continue To Shape Pubs' Business Models

We expect earnings visibility to remain low as the sector grapples with several issues. On top of that, the sector's ability to invest in transforming its business model will remain limited. Also, pubs and restaurant groups (which we rate under our corporate methodology) had some of the highest leverage levels across sectors even before the pandemic.

Notwithstanding pent-up demand on reopening, we expect full-year revenue to recover to 2019 levels only by 2022. Factoring in the significant cash burn during the closures and deferral of maintenance capex, we expect pub operators to prioritize investment over deleveraging. We therefore forecast that credit metrics will take time to recover to 2019 levels, with our current expectation being 2023. For rated pub companies and corporate securitization transactions, our expectations of recovery in profitability and credit metrics in 2022 and 2023 will be the key factors in shaping our views of issuers' underlying credit quality and will be the main reason for any rating actions.

At the same time, as the pandemic continues in the U.K., we anticipate that food-led operators with takeaway models and pubs that appeal to families, will fare better than their drinks-led counterparts. Still, we expect government policies, incentives, and support to continue to play an important role in shaping the prospects for the sector.

As a leading contributor to employment, the hospitality sector, and the pub sector in particular, will also remain exposed to regulatory scrutiny and potential changes. The 2007 smoking ban was a momentous move, and progressive increases in beer taxes ate into profitability, although we are yet to see a significant impact from the market-rent-only regulation of 2016 on earnings.

In our view, the sector will have to innovate to cater to changing customer preferences. We expect greater collaboration of pubs with brewers and alcoholic beverage manufacturers to focus on new products and formats. This will also stem from the growing importance of digitization and sustainability factors. While environmental aspects such as recycling and food waste management continue to be important for the pub sector, post pandemic the social aspects concerning health and safety, responsible drinking, and healthy eating will become more prominent.

U.K. Pub Rated Universe--Peer Comparison

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Related Research

• How The Geographic Footprints Of U.K. Pub Corporate Securitizations May Influence Their Performance, Feb. 8, 2021
• Industry Top Trends 2021, Retail and Restaurants, Dec. 10, 2020
• COVID-19 Will Shape The Future Of Consumer Goods, July 1, 2020
• COVID-19 Will Shape The Future Of Retail, May 27, 2020
• Credit FAQ: As Alcohol Makers Look To Uncork Growth, Some Suffer Market Share Spills, Feb. 25, 2020