20 Nov 2012

Enterprise Inns released its fiscal 2012 results today. It is a pub operator that expanded too enthusiastically and became dangerously indebted. Leasing pubs to landlords who want to run them is fundamentally a very profitable business. Enterprise makes operating margins of 47% which is about as good as it gets (Apple’s operating margin is 36.5%, for instance.) To the banks, Enterprise must have looked like a cash generating machine that was close to a licenced printer of money. Probably the Enterprise management felt the same way. Consequently the business borrowed and borrowed and expanded its pub empire. Naturally, when recession hit and pub customers and landlords started to suffer, Enterprise was left with a declining business trying to support a balance sheet designed for growth. At such times such as this, financial creditors, who always have one motivation only – to be repaid – become very worried and will foreclose – probably making the equity worthless – if it suits their purpose. Enterprise is crawling up the road to recovery but it’s a long road. In the last four years it has reduced its debt by >£1bn, which is around 25%. Yet it remains a very indebted company. At today’s share price (67p) the enterprise value of Enterprise Inns is c.£3.07bn of which net debt is £2.74bn and equity (the market capitalisation) just £335m. So the enterprise value is 9 parts debt to 1 part equity. If the value of the business falls by 10% and the debt remains constant, the shares will be effectively worthless. That is the risk of investing in Enterprise Inns now and the potential penalty if the progress along the road to recovery falters. But let’s skip quickly to the upside. Let us say that the business marks time but further progress is made in reducing debt through cash flow and, perhaps, some disposal of zombie assets. The enterprise value of the company sticks at £3.07bn but net debt is cut by another 10% to £2.47bn. In this case, the value of the equity rises from £335m to £600m. That makes 120p per share or a rise of 79% without the overall value of the business having changed. All...