It might have seemed clever back in 2006 to securitise 97 per cent of your assets. In 2008, not so much.
Punch Taverns is a punch drunk stock. Or at least it was in 2006. Analysts have since rather tortured the hangover metaphor (though hepatic failure might be more appropriate).
The stock closed down 12 per cent on Wednesday (at one point down 18 per cent). Today it’s up 2 per cent. Things are volatile when you’re at the bottom of the beer barrel.
Deutsche, JPM and Blue Oar all came out with notes yesterday emphasising the ongoing viability of Punch and it’s ability to function, even with its ridiculously complex structuring arrangements and securitisations in place. Most though, cut the outlook to hold.
There are plenty of reasons to be negative. Punch’s own numbers predict only a mild downturn in revenues going forward. There simply isn’t the expectation of a dramatic downturn in the leisure sector.
Perhaps there should be, if historical precedent is anything to go by.
Punch isn’t best analysed as a equity. It’s best looked at as a fixed-income asset. It’s from that field that one term in particular, should be borrowed: cliff risk.
Spiked punch
The structure of Punch Taverns is probably one that needs clarity straight away. To wit, if you’re a shareholder you don’t really directly own Punch’s assets.
In fact, effectively, you own a stake in an unusual holding company.
That holding company nominally controls - and ‘owns’ - three securitisation vehicles, legally seperate companies, which have in them £7bn of assets. In comparison, the holding company is left with direct ownership of around £90m. The trio of securitisation structures is Punch Taverns (A) Punch Taverns (B) and Punch Taverns (Spirit).
Under normal conditions, you could envisage Punch’s ownership and control over those structures as being effected through two chords:
Firstly, Punch is a financial beneficiary from the structures. After bondholders have been paid, it takes, effectively, a dividend from the securitisations. This is basically Punch’s income.
Secondly, Punch exercises control over the securitisations. It runs the assets within them and it controls the flow of cash within the securitisation - just as if each was a separate business, with separate P&L’s.
Covenants
There are, however, protections available to the bondholders of those securitisations: covenants and tests which, when tripped, give the bondholders more control. This is where things can get a little messy. And this is where the risk to shareholders lies.
There are two important tests to bear in mind with Punch’s securitisations, both of which track the Debt Service Coverage Ratio.
The DSCR is basically a measure of an asset pool income’s ability to cover bondholder debt payments. A DSCR of 1.2, for example, would mean in that securitisation, income on assets was sufficient to cover 120% of debt payments.
The two relevant DSCR tests for Punch are known as the cash trap and the default covenant.
If a DSCR cash trap test is tripped, then that first “chord” between Punch holdco and the securitisation is severed: Punch is no longer allowed to take money out of the securitisation, except to pay tax. Instead, all income from assets within the securitisation stays within the securitisation.
But Punch still has “control” over the assets in the securitisation. It still controls the cash flow within the securitisation: it can reinvest the money, develop assets, etc. It remains connected through that second chord. If the DSCR default covenant is tripped though, that second chord is severed.
If both chords are cut, Punch has no control of the assets: indeed, they are no longer Punch’s assets in any sense of the word. The securitisations drift free of their former parent company.
Snap
What then, is the likelihood of those tests being tripped? This - from Deutsche analysts yesterday - is the important table:
It shows the test levels for the DSCR cash trap and default tests on each securitisation.
On Punch Taverns (A) for example, they are 1.5 and 1.25 respectively.
The current DSCR for Punch, reports Deutsche, is 1.65. Meaning income from assets in that securitisation is sufficient to service 165% of the debt payments. It only need fall 10 per cent though, before the cash test is tripped, and all income from Punch A’s £2bn plus of pub assets to Punch is cut.
If it falls 32 per cent, Punch loses the assets.
Why then, you have to ask yourself, are most sector analysts so positive?
It all cuts back to their sector forecasts. The bottom line is that most do not see income declining significantly. Punch forecasts stable revenues from its assets for the next three years. The analysts broadly concur.
Anyone with experience of a serious downturn or recession though, might have to disagree. Anecdotal tales of pub landlords facing hard times are filtering through already. It’s perhaps a shame that there’s no public house price index. Were there, perhaps we’d be more worried about the fact that a roughly 30 per cent decline in income - notwithstanding a costly restructuring - would instantly knock Punch out of business.
There’s an added quirk too: Deutsche’s note points out the 1.65 DSCR is overly optimistic:
Punch (A) Q2 DSCR was at 1.51x, and the rolling two quarters was at 1.61x. The 1.65x shown here is the MAT (moving annual total) for the 52 weeks to March 2008. It was refinanced and tapped last year in July, so has yet to be tested on a full 12 month basis.
In other words, the current economic climate has the Q2 DSCR already at 1.51 - within a whisker of tripping the DSCR cash trap test.
Cutting the dividend
Knowing as they do that the Q2 DSCR 2008 is at 1.51 already, Punch’s management clearly think that they’ll trip the DSCR cash test. Which is what precipitated the dividend cut.
The holdco has debt of its own: an estimated £250m in convertible bonds that come due in 2010.
And with the cash tests on its securitisations tripped, there won’t be any money coming into the holdco, so it needs cash to avoid insolvency. The few assets Punch holdco has direct control over will likely be ’sold’ to the securitisations to raise another £90m. The dividend cut should free up another £90m.
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Punch is facing trouble.
The upside risk is that it gets spotted by a private equity firm. The company could be radically restructured to free up value.
The downside risks though, are greater.
Even if the pub industry avoids a serious downturn, at best Punch will be a stagnant company held back by its sclerotic structuring and restrictive cash flow situation. No dividends for a while.
And if the industry does experience a significant downturn - and all historical evidence suggests it will - then Punch has immense cliff risk.
Cliff risk is normally talked about with CDOs, SIVs, CPDOs or other structured bond exotica. It’s the point at which a vehicle triggers a covenant that forces a mandatory unwind; oftentimes one that obliterates the equity stake. A vehicle can go from having a value, income and functioning balance sheet to being wiped out.
In Punch’s case, a basic read-across from the numbers would suggest a 40-50% fall in revenue could sever the company utterly from its assets. Even a 30 per cent fall might be enough to knockout a large part of them. Punch Taverns (A) is in the weakest position.
Shareholders would then be left with a very very very overpriced holding in a Burton-Upon-Trent business park.
