Analysis of JD Wetherspoon and Greene King

The following report addresses the likely reasons behind Greene King's (GK) undervaluation in the stock market compared to its competitor JD Wetherspoon (JDW), the TLS and FAS in general. GK's higher debt level, lack of investor optimism about future growth, low DC albeit high DY, and recent decline in EPS are likely reasons. Revenue and profit for GK and JDW has been impacted by intense competition, tradition conditions, price competition, changing consumer behaviour and impairment charges. JDW is operating in line with its business strategy of focusing on its core business, with net pub increase of 37. GK in contrast drifts from its organic growth strategy, with the net closure of 22 pubs. The following report addresses the likely reasons behind Greene King's (GK) undervaluation in the stock market compared to its competitor JD Wetherspoon (JDW), the TLS and FAS in general. GK's higher debt level, lack of investor optimism about future growth, low DC albeit high DY, and recent decline in EPS are likely reasons. Revenue and profit for GK and JDW has been impacted by intense competition, tradition conditions, price competition, changing consumer behaviour and impairment charges. JDW is operating in line with its business strategy of focusing on its core business, with net pub increase of 37. GK in contrast drifts from its organic growth strategy, with the net closure of 22 pubs. Both companies have similar gearing and solvency ratios, illustrating stable companies. GK has stronger financial ratios (current - 0.73, liquidity - 0.66), compared to JDW (0.23 and 0.16 respectively), however its interest cover lies at 1.39, compared to JDW 2.6, which may increase the likelihood that GK would default if profit keeps declining. It is therefore predicted that economic and market conditions would continue affecting profitability in both firms; though low property prices may be an advantage. GK may experience revenue dip if it does not increase revenue and expand pub locations. In accordance to the EMH, share price and financial performance is linked. Therefore GK should aim to reassure its investors on the possibility of future business growth, which could in turn drive share prices higher. The following report addresses Judy Holt's questions regarding the effect of financial performance on Greene King's share price, in relation to that of its competitor (JDW), its market sector (TLS), and the UK market (FAS). The report is outlined as following: The following chapter introduces PE and other valuation ratios, with particular reference to GK, JDW, TLS and FAS, in order to explain the differences in valuation. Following that, a review of both companies financial performance is conducted in light of economic situations and predicted future occurrences, and finally, Judy's question on the link between share price and financial performance would be answered, whilst the report is concluded with clear advice in the final chapter

INVESTMENT VALUATION EXPLAINED

The price-earnings multiple is widely used in investment valuations for comparing the values of companies within an industry, and industries within a market. It is calculated as follows: PE = Share price / Earnings per Share. The PE ratio is a form of earnings multiple, and denotes that the price paid for the shares is a multiple of the earnings per share generated by the company (Damodaran, 2002). Therefore a PE of 10 means that investors buying the company's shares would realise their money back in 10 years. The nature of the PE (being a measure of the price, in relation to earnings) makes it unique to a firm, and most importantly, easily identifiable across a sector. Similar companies are prone to similar economic situations, so investors perceive their actions and operations with similarities. Therefore adverse conditions are prone to affect investor mood to all companies operating within a sector, rather than a single company. PE is also used to depict an undervalued, thus cheap company, from another within its secto. The PE multiple for the travel and leisure sector (TLS - 15.38), FTSE All-Share Index (FAS - 17.47) and JDW (15.1) are all similar, thereby depicting that the shares of JDW are trading at fair value, while those of GK are undervalued at 10.9. The likely reasons why the PE ratio is different between GK, JDW and the TLS are explained below: Ehrhardt and Brigham (2008) explain that companies with higher debt usually represent higher risks, with relation to their ability to repay interest or avoid bankruptcy. Both GK and JDW have similar revenues for FY09 at £955 million each (FT, 2010), with similar number of pub outlets (785 and 746 respectively), yet GK has higher liabilities of £2.36 billion compared to JDW (£689 million). Repaying such liability with similar revenues may render GK's shares temporarily unattractive due to its inherent risks. The low PE for GK illustrates that the price of its shares are not as high as they should be, compared to competitors. This could be because investors do not generally have high optimism regarding the growth prospects of GK, its earnings forecast or its business activities, regardless of past earnings. The Dividend Cover (DC) is the ratio of a company's dividend in relation to its earnings. It represents the number of times the profit could be used to pay dividends. GK currently has a DC of 1.4, compared to JDW - 1.9 (A2), thereby illustrating that JDW is better able to sustain its level of dividend payout even if its profit drops by a considerable percentage, compared to GK. The earnings per share (EPS), depicts how much the company earns on every share issued (A7). JDW's EPS grew by 18% in FY09, while that of GK fell by 10% (Digital Look, 2010). Utilising PE as an effective method of comparing the value of any two companies within a sector have been criticised by Damodaran (2002) for a number of reasons. The earnings per share of several companies usually vary due to forecast earnings and management stock options, which may in turn affect the PE multiple derived. PE does not account for differences in the fundamentals of each company, which may explain differences in earnings per shares, or stock market prices. Other investment ratios exist, such as the Dividend Yield (DY) and Enterprise Value Multiple (EVM), which could be utilised in valuing and comparing companies operating within TLS. The Dividend Yield (DY) of both shares represents how much a company pays out each year related to its market price per share. In the absence of stock market appreciation, the DY represents the investors' return on stock market investment (Ehrhardt and Brigham, 2009). GK has a DY of 5.27%, while JDW has 2.82% (A3), thus illustrating that GK generally pays investors higher than its competitors based on its share price. However, the DY is not as important as the DC, which is related to the company's earnings (Tsoukalas and Sil, 1999). They assert in the absence of genuine growth, DY only temporarily increases stock returns.

FINANCIAL PERFORMANCE REVIEW

GK and JDW presently operate in a highly competitive industry, their major business is in the pub market, wherein they own, manage or lease pubs. Their major competitors are Punch Taverns Plc, Enterprise Inns Plc and Marston's Plc, all of whom operate on similar business models and sell the same products (Datamonitor, 2009). According to Mintel (2009), pubs are being affected by a reasonable decline in pub visits, nationwide pub closures and a rise in overhead cost of doing business. Figure : Revenue figures for GK and JDW. Source: Orbis (2010) Due to these adverse effects, and also the effect of the economic crisis on the spending power of the average pub visitor, GK and JDW only witnessed marginal increases in their revenue in 2009 (A1). As illustrated in figure 1 below, GK grew its revenue by 1.3% to £954.6 million, while that of JDW grew 5.2% to 955.1%, JDW thus experienced higher growth rate than GK. According to GK's annual report (GK, 2010), its marginal increase in revenue is largely as a result of the adverse trading condition within the market, while JDW attributes its revenue increase to its focus on opening new retail pubs, which increased by 37 in 2009 (JD, 2010), thereby boosting its revenue growth. GK closed 22 retail pubs, and experienced a 5.2% revenue drop in its partnering business. GK's strategy, according to the Chairman's statement in its FY09 annual report is to "create shareholder value by delivering organic growth across our divisions", however the company has been achieving only marginal growth in its core areas. JDW in contrast aims to maintain its current growth momentum by concentrating its efforts on the sales of foods beverages and net machine income within its pubs. GK's revenues have grown at a faster pace (34.93%) than JDW (17.93) over the past five years (A4). However, the effects of the economy and increasing costs have had a major toll on the profitability of both businesses recently (Walsh, 2009), as illustrated in figure 2. Figure : Net Income for GK and JDW. Source: Orbis, 2010 GK's net income increased steadily over the past five years up until 2009, when its net income fell by 68.2% from £124.3 million to £39.5 million. While that of JDW also fell in 2009, albeit at 28.7%. The impact on profitability for both companies has been jointly attributed as being due to the impact of the economy on the trading conditions of pubs; however, several other factors have been outlined as affecting the profitability of both businesses within the UK. Competition is intense amongst players within the industry. Pubs are located in close proximity and often compete to attract customers. JDW for instance slashed the price of several drinks to as low as 99p, starting a price war amongst several other pub companies (Walsh, 2009). The decline in property values as a result of the economic crisis has resulted in situations whereby pub companies have had to revaluate their assets, and impose impairment charges for changes in value. GK for instance posted an impairment charge of £53.5 million against the value of its pubs in 2009 (GK, 2010). The changing customer-spending pattern and visiting habits to local pubs are in turn affecting revenue growth in pub companies, which in turn affects the average profit per pub. Increases in overhead cost also affect profitability (Mintel, 2009). Though both businesses operate within the same sector, GK's business is somewhat more diversified than JDW. GK's interest spans across pub ownership, pub lease, brewing, and a Scottish business, while JDW focuses mainly on pub ownership, with some interests in Hotel. Therefore, their profitability differs significantly as expressed in figure 3. Up until FY09, when the economic crisis took a toll on the profitability of most UK businesses, GK maintained a net income margin range of 9 - 13%, while that of JDW hovered from 3.2 - 5.27%. The general decrease in profitability across both companies is as a result of factors explained above. However, with relation to JDW and GK's main businesses, GK made a profit margin of 18.5% on its pub management business, while that for JDW was 10%, thus illustrating that GK is a more profitable company. In 2008, GK's profitable rose by 1.57 percentage points (ppt), while that for JDW fell by 1.36ppt. Figure : Net Income Profit Margin for GK and JDW. A8 In accordance with the differences that exist in both companies' profitability, the balance sheet ratios of both companies differ as expressed in figure 4. GK has a current ratio of 0.73, illustrating that it can afford to pay off 73% of its current liabilities (due within one year), with its current assets (cash, investments, and payables due within the year). Therefore in light of any financial difficulties, GK would only need to raise funds for 27% of its current debt, compared to JDW that has a current ratio of 0.23. Given the current economic conditions, the relative difficulty in obtaining credit and likely threats of interest rates hikes (Datamonitor, 2009); both companies are at a disadvantage. JDW's low current and liquidity ratios illustrate that in the face of severe tradition conditions, which may affect cash flow or profitability, the company may find it hard to meet short term obligations. While, GK's debts of over £2 billion, though securitized, pose a significant risk, given its revenue of £955 million (similar to JDW that has lower debt and recently similar profitability). At 6% interest rate (GK, 2010), the company is likely to face yearly interest charges of up to £120 million (5% of £2bn). If its profitability continues to decline just like in FY09, the company may also find it hard meeting its future debt obligations. Figure : FInancial Ratios for GK and JDW. Source: Orbis (2010). A6 GK's liquidity ratio also stands at 0.66, which emphasise that in the absence of any inventory sales, GK can still settle 66% of its debt, compared to JDW (16%). However, the interest cover differs, as JDW can pay off its interests 2.6 times with its net income, compared to GK (1.39 times). This show that JDW is better able to service its £388.2 million in net borrowings, compared to GK that has over £2 billion in securitized debt, thereby posing a risk to any of its 2,035 pubs (used as loan security) which could be seized in the event that it cannot maintain interest repayments. Similar profitability levels, albeit different debt levels, puts JDW at a structural advantage, however, this is mediated by its low current and liquidity ratios. Both companies (GK and JDW) have similar gearing ratios of 327.26% and 308.35, and solvency ratios of 21.44% and 19.58% respectively. Thus showing that high gearing is a norm within the Pub industry, and may not represent speculative practices by any of both businesses. The solvency of both companies represents a financially healthy business, being an average of 20% (Hillier et al, 2010). This shows that both companies are likely to continue meeting long term obligations in the foreseeable future, irrespective of their debt levels. In light of the need to conserve cash for future business uncertainties outlined by the CEO of both businesses, GK had a Free Cash Flow (FCF) of £29.8 million in FY09, while JDW had £7.15 million. Both companies had substantial retained earnings (£120.5 and £23.6 million respectively), though they both invested substantially in capital expenditures (£57.6 and £48.3 million respectively). Thus following through on their corporate strategy focus on organic growth and continuous investments. The following are predictions for likely future performance in GK and JDW Given the current UK economic condition, predicted Alcohol Tax (Fletcher, 2010), and consumer lifestyle change - which has reduced the total pub visits, it is likely that both companies would experience a future decline in visitors, and impact on profits. Low property prices pose a significant opportunity for both firms to grow their main businesses, by purchasing and developing more pubs in growth areas. Price wars are likely to continue amongst competitors as they fight to attract and retain customers. Given this, revenue may increase due to an increase in number of pubs; but profits may only increase marginally, due to declining profitability. JDW faces a higher threat due to its business model that focuses on pub management, as opposed to GK that has a diversified portfolio, and makes more profit (45.7% - GK, 2010) by leasing its pubs. GK is likely to experience a dip in its revenue if it does not expand its number of retail pubs, or find ways to profitably diversify its business. A major portion of the profit decline resulted from property impairment, which may not be as severe in the future, thereby supporting a rise in net income.

SHARE PRICE AND FINANCIAL PERFORMANCE

The question as to whether there is a link between the share price of a firm, and its financial performance would be explained both theoretically and empirically given present data. The Efficient Market Hypothesis (EMH) theoretically argues that the share price of a firm already represents all past, present and sometimes the likely future events, such that no news regarding the company's activities could significantly rise or fall a firm's share price beyond market expectations (Hillier et al, 2010). This would mean that GK's current share price and undervaluation represents the market's perception of the company's true value, given all available information. Tsoukalas and Sil (1999) express that cash dividends, with high dividend yield, usually convey information regarding the future prospects of the firm. However, in the event that the increase in dividend payout does not translate to future business growth, the stock returns are only temporary. GK has a high dividend yield, but low dividend cover, as expressed initially, which illustrates that with current earnings, GK may not maintain its dividend payout. The adverse economic conditions affecting the pub industry, marginal revenue growth the company experienced, and the 68.2% crash in its profitability, all serve to deter investor optimism regarding future growth. JDW in contrast is experiencing higher revenue growth, albeit lower profitability, but its pub openings and pricing strategies, represent an aggressive growth plan, which investors would respond positively to, hence its higher PE. According to Sunde and Sanderson (2009), investors are more interested in future potential, than past performance, because according to the EMH, past performance has already been accounted for in the stock price. In comparison with JDW, GK has higher levels of debt, higher risks of bankruptcy, and as they both have similar solvency and gearing ratios, then JDW may seem to investors as the safer choice even though it has lower current and liquidity ratios. Therefore considering that the link that exists between financial performance and share prices lies in the firm's future potential, JDW has the right to be valued more than GK. As illustrated in the predictions earlier, GK may likely experience a dip in revenue if it is not as aggressive as JDW in increasing revenue, while price wars and changing customer behaviour may likely erode profitability. Increasing its DY, without a corresponding growth potential, may only serve to increase its share price temporarily. In answering the question on whether there is a link between share price and financial performance, yes there is. According to the EMH, the share price already accounts for present, past and likely future performance. In the case of GK, it can only achieve reasonable increase in its share price if it can confidently and truthfully assure investors of the likelihood of future growth, or growth in future earnings and profitability, which could in turn invoke optimism, and revalue the share price higher. Fundamental measures need to be taken to invoke positive investor reception.

REFERENCES

Damodaran, A. (2002). Investment Valuation. New York: John Wiley & Sons. 782pp Datamonitor (2009) JD Wetherspoon and Greene King Company Profiles, publication data 2009, www.ebscohost.com, accessed 19/05/10 Digital Look (2010) Financial Figures for GK Plc and JDW Plc, www.digitallook, 2010), accessed 19/05/10 Ehrhardt, M. C., and Brigham, E. F. (2009) Corporate Finance: A Focused Approach, Cengage Learning, 680pp Fletcher, N. (2010) Pub shares lifted by Wetherspoon results, www.guardian.co.uk/business, accessed: 19/05/10 FT (2010) Greene King Plc and JDW Plc Financials, www.markets.ft.com, accessed 20/05/10 Greene King - GK (2010) Our Financials - Annual Report FY09, ww7.investorrelations.co.uk/greeneking, accessed 18/05/10 Hillier, D., Ross, S., Westerfield, R., Jaff, J., and Jordon, B. (2010) Corporate Finance: European Edition, McGraw Hill, 895pp JDW (2010) J D Wetherspoon - Interim report 2010, www.jdwetherspoon.co.uk/home/investors, accessed: 18/05/10 Mintel (2009) Pub Visiting - UK - November 2009, www.mintel.com, accessed: 18/05/10 Misra, A., and Anil, K. (2007) Economic Value Added as most significant measure of financial performance, Journal of International Business and Economics, Jan 20 2007, accesed from www.britannica.com/bps on 19/05/10 Orbis (2010) Greene King Plc and JDW Plc Financial Data, www.orbis.bvdep.com, accessed 19/05/10 Sunde, T. and Sanderson, A. (2009) A review of the Determinants of Share Price, Journal of Social Sciences, Vol. 5 (3), pp188 - 192 Tsoukalas, D., and Sil, S. (1999) The determinants of stock prices: evidence from the UK stock market, Management Research news, Vol. 22 (5), pp1 - 14 Walsh, D. (2009) JD Wetherspoon to cut price of a pint to 99p, www.business.timesonline.co.uk, Jan 3 2009, accessed: 19/05/10

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