Stock Watch: Revolution Bars Group
Revolution Bars Group (RBG) has been listed on the stock exchange for just over two years after being sold by its previous private equity owners. Its shares have been fairly volatile but have performed very strongly since last October.
RBG is a premium bar operator and the investment case for its shares is based on a roll out of new bars over the next few years. In this article, I take a closer look at this very interesting company.
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The Business
RBG operates two distinct bar formats. It has 53 bars which trade under the Revolution brand and 13 under the Revolucion de Cuba brand. Both brands are based in town centre locations with no exposure to out of town or suburban areas.
Revolution sells premium drinks and food throughout the day. Its target market is aspirational students and young professionals under the age of 35. The typical customer is not particularly price conscious and is prepared to pay premium prices for premium products and service.
Since 2011 RBG has been rolling out its Revolucion de Cuba outlets. These are very upmarket bars with a Cuban and Latin American theme. The bars sell a very impressive range of cocktail drinks, Mexican and Spanish beers and premium snacks.
The target customers are people with high levels of disposable income who are not price sensitive and are looking for an upmarket bar experience. The roll out of Revolucion de Cuba bars over the next few years is the key to whether RBG's shares will turn out to be a successful investment or not.
The company rents rather than owns its bars. Typical rental agreements are for 25 years with upwards only rent reviews every 5 years. The company also benefits from rent incentives in some cases.
Renting rather than owning freehold properties changes RBG's financial performance in comparison with some of its peers. When you are analysing a company which is a renter rather than an owner of assets you need to make some adjustments so that you are getting the correct picture of its performance. I'll have more to say on this shortly.
Financial performance
Prior to its listing on the stock exchange back in 2015, RBG conducted a thorough review of its business strategy. The new roll-out strategy has only really been in place for the last couple of years.
Since 2015, RBG has seen steady growth in turnover but profits growth has been harder to come by. Let's take a closer look at some key performance indicators.
Like-for-like sales growth
The company has been able to consistently grow its sales from its existing bars which is a good sign.
| Year | LFL Sales % | Sites |
|---|---|---|
| 2012 | 4.7 | 56 |
| 2013 | 0.9 | 60 |
| 2014 | 3.0 | 59 |
| 2015 | 3.0 | 57 |
| 2016 | 2.3 | 62 |
| 2017 H1 | 2.0 | 66 |
| 2017 weeks 26-34 | 1.7 | 66 |
What is a little more concerning is that the growth rate of like-for-like sales has been slowing down for the last 18 months. In that period, RBG has opened up 9 new bars. Most of these have been of the Revolucion de Cuba format which management says is more profitable. Many of these new bars will still be excluded from the LFL sales calculation (because they have been trading for less than a year), but some of them will be contributing to the figure.
I would have expected the LFL sales figure to have benefitted from the maturation of sales (a gradual build up in trade from opening) of these new bars and give the numbers a boost. As an outsider, it's difficult to know if that is happening or not. Either the new bars are taking some time to get up to speed or the existing bar estate's sales are not growing or even shrinking.
So whilst the current 1.7% LFL sales growth rate is respectable given the highly competitive nature of the pub sector is not really saying that RBG is experiencing outstanding growth either.
Profit margins
RBG's bars are not highly profitable. It's trailing twelve month EBIT and EBITDA margins are 6.8% and 12.2% respectively. These margins are not really improving either.
One of the desirable characteristics of a profitable retail roll out is improving profit margins due to the benefits of operational leverage - where profits increase faster than sales due to the existence of fixed costs such as rents, wages, maintenance and utility bills. This does not seem to be happening at RBG.
In fact this lack of significant operating leverage was seen at the company's recent interim results. Sales increased by 12.7%, adjusted EBITDA increased by 13.6% but adjusted EPS only increased by 7.1%.
EPS growth was restrained by an increase in the effective tax rate, but as you can see from the slide above there are grounds to question whether there was any profits growth at all.
The company has excluded non-recurring pre-opening costs of £0.8m from its adjusted results. I don't agree with this as to me this is a normal cost of business when you are opening new pubs. By all means disclose it so that investors can see the effect of the costs of new pubs and take it into account, but excluding this from adjusted profits is a bit too aggressive in my opinion.
If these are taken into account, then there was no growth in operating profit during the first half of the year. These costs will be incurred for many years to come if the company meets its target of increasing the number of bars from 68 in 2017 to ultimately 140. The effect on profits should diminish as the number of new bar openings as a proportion of total bar numbers falls.
Investors need to keep a close eye on the removal of one-off or so called exceptional items by companies in order to boost their underlying profits. These are one of the most abused practices by companies as these costs often occur year after year meaning they are not one-off or exceptional.
To be fair, in the case of RBG it is not a big issue. However, if it wants investors to give it the credit for the growth potential of opening new bars then it is only right that the costs of opening them is included in the calculation of its underlying profits. What we have learned from RBG's interim results is that opening costs are a short-term drag on its profitability. Hopefully, this will become less of an issue in future years.
Return on capital employed (ROCE)
ROCE tells the investor what return on investment a company is achieving. When you are looking at a company such as RBG which rents rather than owns its bars, it looks more profitable than it really is.
The rented bars are not on RBG's balance sheet and so understate its capital employed and overstate its ROCE compared with an identical company which owned the same bars. Ignoring the capitalised value of rents or leases shows that RBG's ROCE in 2016 was just under 20%. This would be a very impressive number for a company in the pubs and bars sector.
If the value of annual lease payments are capitalised and profits and balance sheets are adjusted, then a truer and fairer view of the company's ROCE is just over 11%. That is the best performance in quoted pubs and bars sector but represents a good rather than great performance.
Yet, RBG states that its bars are generating returns on investment of 38% at a site level. So why is its ROCE nowhere near that high?
The explanation comes from the management's definition of return on investment (ROI). They define it as EBITDA divided by the cost of building out the bar with its fixtures and fittings or capex. That is a definition of ROI but one that investors should not really pay attention to in my opinion.
First and foremost, the investment costs make no account for the capitalised value of leases. It is also important to note that RBG's total lease-adjusted capital employed is understated by rent incentives and rent free periods at certain bars. For example, the Milton Keynes bar is rent free for 18 months, there are rent incentives in Nottingham whist the Stafford bar is rent free for two years according to RBG's investor presentations.
If you look closely at RBG's total rent expenses, they have not been increasing even as the number of bars has been. Management deserve credit for this as well as reducing the ratio of rents to turnover from the extra sales generated.
However, it could be that rent incentives and rent free periods are temporarily flattering RBG's profits and the rent to turnover ratio whilst understating its true rent-adjusted capital employed.
The other important issue is that EBITDA is not a very good measure of profitability for asset-intensive businesses such as bars. Depreciation is a real cash cost for these businesses as fixtures and fittings do need to be replaced. It is not uncommon for bars and pubs to be refurbished every six years. If they were not then they would become run down and scruffy and customers would do their drinking in more pleasant surroundings.
EBITDA is therefore not a measure of profit that can be paid to investors in the long run (but RBG's management bonuses are related to it). When you come across a company that mentions EBITDA a lot, it is a good idea to see what proportion of it is made up from depreciation and amortisation (the "DA" bit). If it is a high percentage then in most cases you can be fairly certain that the maintenance or replacement capex of the business are quite significant.
This seems to be the case with RBG as "DA" is over 40% of EBITDA and has been consistently high. However, during the last couple of years its maintenance capital expenditure has been significantly below its depreciation expense. I got the figures in the table below from RBG's accounts.
RBG Capex to Depreciation (£m)
| Year | Maintenance Capex | Development Capex | Total Capex | Depreciation | Maintenance Capex to Depreciation | Total Capex to Depreciation |
|---|---|---|---|---|---|---|
| 2015 | 4.6 | 1.1 | 5.7 | 6.2 | 74.2% | 91.9% |
| 2016 | 4.9 | 7.9 | 12.8 | 6.3 | 77.8% | 203.2% |
| 2017(H1) | 2.5 | 4.4 | 6.9 | 3.7 | 67.6% | 186.5% |
Yet the point is that at some point money will have to be spent to keep fixtures and fittings in good condition and this is not taken into account with EBITDA.
If these maintenance costs are taken into account as well as the value of capitalised leases, then the return on investment of new bars is a lot lower in reality than the 38% being mentioned.
In the table below I've had a go at estimating what a more realistic return might be. I've based it on the recently opened Reading bar which cost £1.3m to develop and has a low annual rent bill of £120,000 per year.
| Reading Bar | £'000 |
|---|---|
| Fit out cost | 1300 |
| EBITDA @ 38% return | 494 |
| Rent | 120 |
| Capitalised rent at 7x | 840 |
| Interest on rent at 7% | 59 |
| Lease depreciation | 61 |
| Depreciation @44% of EBITDA | 217 |
| M Capex @ 75% of Depreciation | 163 |
| Total investment inc. leases (A) | 2140 |
| EBITDA | 494 |
| Add back rent | 120 |
| Lease-adjusted EBITDA | 614 |
| Less M Capex | -163 |
| Cash profit (B) | 451 |
| ROI (A/B) | 21.1% |
| Accounting profit | 336 |
| Accounting ROI | 15.7% |
Here's how I've calculated this:
- I've capitalised the rent bill by multiplying it by 7 (a common analyst's technique) to get an estimated value of £840,000. This is added to the fit out cost of £1,300,000 to get a total investment of £2,140,000.
- The rent payment of £120,000 is assumed to consist largely of depreciation and interest. Applying a 7% interest rate to £840,000 gives an interest expense of £58,800. Depreciation on the lease is then assumed to be £120,000 less £58,800 or £61,200.
- The total rent expense of £120,000 is added back to EBITDA to get a lease-adjusted EBITDA figure. Depreciation is assumed to be 44% of pre-lease-adjusted EBITDA (the current run-rate shown in the Financial performance table near the start of this article) and Maintenance capex is assumed to be 75% of depreciation.
- Maintenance capex is taken away from lease-adjusted EBITDA to get an estimated cash profit. This number is then divided by the total investment cost to get an estimated ROI of 21.1%. If the full depreciation expense was taken away from lease-adjusted EBITDA as well as the estimated lease depreciation then the accounting return would be 15.7%.
These are still very good numbers but not as stellar as people might first think. The key thing for RBG is to maintain these against competition and after the low initial rent bill increases.
Future prospects and valuation
City analysts are expecting strong turnover and EPS growth from RBG as it continues to add to its portfolio of bars. As I have mentioned earlier, I would be cautious on some of these EPS figures due to the slowdown in LFL sales growth and the exclusion of bar opening costs from underlying EPS numbers. There is also the issue of rising wage costs, business rates and the rising costs of imported food and drink due to the fall in the value of the pound.
The pace of annual profits growth will be dependent on the speed of the roll out of new bars. RBG will open up 6 new bars in total in the year to June 2017 and has a pipeline of 26 sites. Growth in profitability from new bars therefore does not look to be an issue. That said, RBG may have to increase the number of new openings in future years if it is to maintain healthy annual growth rates. The key test will be in maintaining the sales and profits of the existing bar estate in the face of strong competition.
Rising rents are also a potential headwind to profitability when rent incentives and free rent periods expire. The resilience of up-market bars in an economic downturn is also unproven.
RBG has the best ROCE in a pretty underwhelming sector. Even when off-balance sheet premises are taken into account, it has a reasonably strong financial position given its fixed charge cover ratio. It also has no on balance sheet debt or any pension fund deficit. By leasing its new pubs rather than buying them it can probably finance its expansion from its free cash flow rather than resorting to borrowing.
Its valuation of 13.3 times 2017 forecast earnings is not overly demanding given its growth pipeline. However, I am not sure that its current rates of LFL sales growth and its real incremental returns from new investments warrant a substantial re-rating of its shares at the moment.
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