Stockwatch: Grinding higher with limited downside

Does this £191 million brewer - Britain's oldest - and pub manager Shepherd Neame continue to offer upside? Also, are NEX Exchange stocks worth the risk?

Kent-based Shepherd Neame has traded on various small-cap markets: its latest interims show operating profit up 5.3% to £7.6 million on turnover up 7.4% to £79.2 million, which is plenty fair for the sector, Shepherd Neame being relatively small in sector context.

Pubs represent about 60% of group revenue, while brewing has recently contributed only 10% of operating profit such that an overall group margin of 9.6% is below 16.4% enjoyed by Greene King, the £2.1 billion mid-cap with a similar brewing/pubs split.

AIM-listed Young & Co's Brewery enjoys a 16.3% margin, though nowadays is pubs-only. The operating margin for JD Wetherspoon is less attractively 6.3% for a £1.1 billion Mid-250 group.

So, Shepherd Neame is middling according to a basic performance ratio. Its results also show like-for-like growth rates slightly down, e.g. managed pub estate sales up 5.5% versus 6.5% a year ago, and operating profit on the tenanted side up 1.7% versus 2.7% previously. Acquisitions are, therefore, boosting growth, with long-term bank debt up 40% to £86.2 million in context of £105 million credit facilities and £2.1 million cash.

Attractions for long-term defensive growth

Bear in mind quality brands and tangible asset backing at this fairly late stage in the business cycle. There are racier stocks available, yet Brexit is encroaching and a lesson from the 2009 recession and "austerity years" was of southern-England pubs doing well as people kept eating and drinking out – especially at pubs whose standards were rising.

I originally drew attention to Shepherd Neame in March 2010 at about 750p when it traded on the PLUS market, and its balance sheet net asset value was just over 900p with profits advancing modestly. The price crept up to 1,350p, currently offered at 1,310p, with dividends contributing about 2% annually.

Shepherd Neame hasn't been dynamic like Weetabix whose shares multi-bagged on the 1980's Over-The-Counter market that became Ofex, before the breakfast cereals group was acquired. Yet there are parallels by way of well-established brand: Shepherd Neame produces Spitfire, a leading bottled ale also sold on draught; Bishops Finger, a strong premium ale; and Master Brew, an original Kentish ale.

It also brews and distributes under licence from the US, Samuel Adams Boston Lager and Angry Orchard, America's leading hard cider. While the majority of liquor sales are made in the UK, the company exports to over 35 countries, so should start to benefit from weaker sterling.

Ale is one of Britain's fastest-growing food and drink exports, mainly to the US, Japan and Scandinavia albeit with China and Brazil rising as Western brands have aspirational appeal. There's an agreement with Kuehne + Nagel, a Swiss-based global distributor, also Moosehead in the US.

So, although beer sales are modest in context and lower sterling has raised brewing input costs, export prospects can at least offset this. The interims show beer sales up 2.2% against a market down 2.2% during the period.

Considering the way Young's sold off its brewing side, it's possible this eventually happens if the industry consolidates to better manage costs, possibly with Shepherd Neame pubs becoming part of another group.

I speculate as regards corporate activity, but this stock currently trades on a 4% premium to net tangible assets, and the industry will price in more than that by way of brand values. Circa £250 million isn't a big ask for a mid-size pub/brewing group, while interest rates remain low, and this one could usefully enhance value for a parent.

Acquisitions and development in pubs/restaurants

Of 335 pubs at the calendar year-end, 26 are tenanted/leased, 67 managed and 6 held as investment properties free of ties. Acquisitions were stepped up in the first half-year from two (in 2015) to 13, with six tenanted pubs sold and more in due course.

Overall, this helped the managed estate grow revenue by 17.7% to £29.6 million, although integration costs and a higher national living wage checked the operating profit rise to 6.2% to £4.5 million.

Refurbishments at quality locations include an historic inn near Heathrow with 11 rooms and an upgraded restaurant, facilities at the Isle of Thanet and Chatham, and on tenanted estates at Whitstable and Marshside.

Like-for-like food sales growth has slipped from 7.4% to 3.3%, although last November's £11.9 million debt-funded purchase of Village Green Restaurants introduced five more outlets. So, for the time being they have compensated for an aspect of growth slipping, which they at least need to stabilise.

Net asset value growth has underpinned value

Deducting the modest £0.75 million intangibles from £188.5 million net assets, Shepherd Neame's end-2016 tangible value was 1,261p per share, hence the stock trades at a near 4% premium based on 1,310p to buy.

When I last drew attention at 935p in March 2014, net tangible assets were 997p per share, while the stock traded on about 20 times earnings and a 2% yield. Interest had revived in defensive growth, with equities plunging as Russia meddled in Ukraine.

I was also exploring what parallel there was with Young's, which had delivered consistent growth since my drawing attention in July 2012 at 600p – quite similarly on a price/earnings (PE) of about 20 times, yielding 2% and a modest discount to net assets.

Young's has steadily advanced to an all-time high of 1,350p versus its net tangible asset value around 1,475p, so there probably isn't the same margin of safety aspect in Shepherd Neame's balance sheet, albeit with smaller size in its favour to grow.

Capital protection virtues

Shepherd Neame is not a stock able to excite like Purplebricks and other internet-oriented plays enjoying colossal ratings. But, if and when the mood does cool, also within the economy, a steady developer like this in pubs and brewing offers capital protection relative to highly-rated growth stocks and cyclicals.

During its interim period management has spent £6.1 million on organic investment across the group and also edged up the dividend by 3.1% to 5.62p. This may not be as good a long-term tuck-away as Young's has proven, but its results reflect coping with current challenges, and of good positioning, e.g. "further exciting new products in development and significant new distribution for our beers to start in this second half year."

The stock is, therefore, likely to keep grinding higher with limited downside, and the off-chance a rival sees some/all of the operations as an attractive buy.