It is a common misconception that Lemmings will-fully commit suicide. In reality, Lemmings just have a particularly strong sense of group-thinking and some peculiar biological hardwiring. Add this to population bubbles and an arctic habitat the natural perimeter of which tends toward the precipitous and so is born the Lemming death cult.
It is a common misconception that shareholders in Punch Taverns own a pub business.
Punch today reported its third quarter results. The headline numbers are pretty good:
- Profit before tax of £262 million (2007: £282 million) in line with market expectations, reflecting a 7% reduction in the average size of the estate following non-core divestments
- EBITDA of £623 million (2007: £664 million)
- Basic earnings per share of 80.2p (2007: 84.4p)
- Strong cash flow generation with free cash flow before investing activities of £298 million; year end cash balance of £321 million (2007: £268 million)
- Interest cover maintained at 2x EBITDA and no refinancing requirements before December 2010
Considering the seriousness of the financial crisis, Punch is showing its resilience.
But as we’ve noted before here at FT Alphaville, Punch Taverns has significant cliff risk. Cliff risk is normally a term seen in structured finance: bonds issued by investment vehicles can be perfectly stable in terms of cashflow up to a point, beyond which a knockout trigger can render them worthless.
The term is applicable to Punch because 97 per cent of its assets are securitised: they belong not to shareholders, but to three investment vehicles: Punch A, Punch B and Spirit. Shareholders don’t own a pub business, they own a holding company which invests in and manages pub securitisations.
Cliff risk in the Punch holdco’s case thus comes in the form of two triggers on each of the securitisations: the first, when tripped, cuts off the flow of surplus cash back to the parent company (Punch) and the second, when tripped, cuts off the securitisation altogether.
The triggers are tested by Debt Service Cover Ratios: a measure of the ability of the income from assets within each securitisation 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 per cent of debt payments.
A Deutsche bank note summarised the ratios and the triggers a few months back:
Spirit has since seen its DSCR fall through 1.7 and so has tripped its cash trap covenant. Punch A and Punch B have also seen their DSCRs fall:
In these exceptionally difficult market conditions, we have maintained significant headroom in the key financial 4-quarter DSCR (Debt Service Cover Ratio) covenant test with headroom of 26%, 42% and 50% for the Punch A, Punch B and Spirit securitisations respectively.
The headroom has narrowed quite a lot in the space of just one quarter.
All this in spite of efforts to try and bolster the DSCR. Since Spirit triggered its cash trap, Punch has had it buy pubs from Punch A. This in turn, along with surplus cash from Punch A and B has allowed the Punch holdco to repurchase and cancel debt from the securitisations:
During October 2008 we re-purchased £77m of Punch A debt at a cost of £73m, £25m of Punch B debt at a cost of £20m and £68m (accreted value) of Convertible Bonds at a cost of £50m. The repurchase of the Punch A debt will reduce the level of debt service charge in 2009 for this securitisation by £22m, resulting in a substantial increase in the headroom against the restricted payment test. In addition, we have secured a renewal of our existing undrawn RCF which was due to expire in December 2008, with a revised RCF now expiring in October 2010, on broadly similar terms.
The level of debt to ebitda, though, continues to rise – 7.3x vs 7.0x for 2007.
All this and the consumer recession has not yet really begun to bite: which, nevermind banking crisis, is actually what will threaten Punch.
Someone should model what happened to pub earnings during previous recessions. We doubt it will look good.
It will be a race against time.
On Punch’s side, debt amortisation will naturally bolster the DSCRs as time passes, so the question of shareholder risk will be very much dependent on how soon and how sudden the consumer spending downturn is; how quickly us drinking lemmings push Punch off its cliff.
Related links
Pubs fall victim to the perils of lone drinking – FT