Pubs ‘n’ Bars
Initiation of Coverage - Buy at 16.5p

Pubs ‘n’ Bars Plc listed on AIM with an estate of 51 pubs in September 1999 following the reverse takeover of Real Leisure Ltd. The company proceeded to pursue a strategy of disposing of underperforming sites inherited from Real Leisure while buying sites which were capable of generating greater returns. In 2003 the company formed a joint venture, Community Taverns Ltd, with Bank of Scotland’s integrated finance division to acquire 32 pubs from the receiver of the Balaclava Pub Company and proceeded to acquire nine pubs in 2005, disposing of three, and selling two in 2006 – with no acquisitions being made in that year as examination of a large number of potential targets saw most fail to fit the company’s strict criteria. However, 2007 saw Pubs ‘n’ Bars strategic positioning and patient approach reap rewards as it concluded the acquisitions of Moorgate London Ltd, Community Taverns Ltd and Moorgate Taverns Ltd, bringing 18 freehold and 24 leasehold pubs into the group. Meanwhile, the profitable churning of the estate continued with the leaseholds of pubs in Brixton and Clapham sold in November at profits to book value of £34,159 and £22,058 respectively – demonstrating notable resilience in the midst of the ‘credit crunch’.

The first acquisition in 2007 was completed in April with Moorgate London Ltd acquired for £6,639,500, including the assumption of £4.3 million of bank debt, with the remainder satisfied by the issue of 5,440,698 shares at 43p each. This brought seven additional freehold pubs, each within Hertfordshire or Oxfordshire and already leased out, into the group, adding £7 million of fixed assets to the balance sheet. This deal is anticipated to generate additional net revenues before interest charges of approximately £400,000 per annum to the group.

This was followed in May 2007 by the announcement of a £2.45 million buy-out for the whole of Community Taverns. The consideration paid compares with an initial £150 payment and £750,000 investment in the venture when the company became a 15% shareholder and, with Community Taverns’ last audited full-year accounts prior to the acquisition showing gross assets of £10.6 million, shows how strategically astute the initial joint venture agreement was. The one freehold and twenty-four leasehold Community Taverns estate showed a pre-tax loss on ordinary activities of £1.2 million for the year ended 31st December 2005, though this was after a £480,000 annual management fee which Pubs ‘n’ Bars charged; depreciation and amortisation costs of £860,000 and loan interest of £604,000. The underlying business was therefore at an operating level soundly profitable.

In December 2007, the company announced its third acquisition of the year, exchanging contracts to acquire Moorgate Taverns Ltd for £9.277 million, including the assumption of £7.08 million of bank debt. The remainder of the consideration was satisfied by the issue of 7,575,862 shares at the then market price of 29p each. This brought a further ten freehold pubs into the group, adding £10 million of fixed assets to the balance sheet and is anticipated to generate additional net revenues of approximately £670,000 per annum before interest charges for the 2008 calendar year.

The result of the company’s acquisitive strategy is an estate portfolio comprising 106 community public houses – 53 freehold and 53 leasehold - located mostly in the south of England. Of these 64 are managed (94% of the leasehold properties and 26% of the freehold) and 42 tenanted.

* Includes 5 ‘virtual freeholds’ – local authority leases.

The managed houses are actively monitored with area managers visiting regularly to gather feedback from the pub manager and offer feedback and support from the company’s operational management team. Pubs ‘n’ Bars aims to maximise profit by pushing its managers to take an entrepreneurial approach and this is also encouraged in the tenanted estate, although the company has no direct involvement in the day-to-day management of this side of the business.

The company’s properties are overwhelmingly wet-led, with over 77% of revenue coming from drinks sales, though food is available in around 70% of the managed estate. However, the level of food offered is largely at the discretion of the site manager with the company only directly involved in 8 sites serving food. As such, ‘dry’ sales – with their circa 48% gross profit margins compared to the circa 66% the company is achieving on drink sales - account for 1.8% of revenue.

In addition, the company manages two pubs on behalf of others and the contribution from these as well that made by a one year contract from Kilmartin Property Group for the management of 7 pubs in 2006 has encouraged it to actively seek further such opportunities to grow its revenue streams without the need to invest – and raise – additional capital.

As well as pursuing additional management opportunities, the company will continue to look to purchase suitable community based freehold pubs principally in London and the South East. Pubs ‘n’ Bars will also continue to actively manage its portfolio and will, if it can achieve a suitable price, sell the less strongly performing units. Although the company operates with a comfortable level of interest cover, its high gearing offers some restriction on the pace of its expansion unless it can use its paper as currency or realise cash from selling some of its weaker properties.

The focus on local, community premises rather than high-street operations provides the company with greater certainty of revenue since due to their nature the former are much less susceptible to an economic downturn or changes in fashion or drinking trends. The preference for freehold properties offers the group the potential to deliver long term capital growth and is preferred by bankers as security for debt allowing Pubs ‘n’ Bars to increase the leverage on its own balance sheet. The company will generally continue to lease out any further freehold properties acquired except when it considers profitability would be enhanced by a more direct, self-managed approach. The strict acquisition criteria the company has historically employed will remain in place with price, local market dynamics and a wet-led nature amongst the series of key factors.

The emphasis on a wet-led nature is the result of factors including clientele demand and the lower level of operational gearing of such pubs seeing them offer more consistent returns. This branch of Pubs ‘n’ Bars strategy therefore looks set to help insulate it going forward – particularly as the company should also be able to minimise the significant inflationary cost pressures on food which are currently squeezing the operating margins of many of its competitors.

Meanwhile, the company will continue to seek to release value from its estate through the profitable selling of selective sites. It has recently been successful in this aim with, for example, a profit of £125,000 being realised on one freehold pub disposed of in 2005 along with the profits to book value realised on the pubs in Brixton and Clapham sold in November, despite the prevailing market conditions and their relatively poor operational performance.

The company sees increasing acquisition opportunities in the current market climate as less well run operators find themselves unable to compete for pubs that come up for sale and indeed looking to sell some of their existing estates in order to strengthen their balance sheets. This should reward Pubs ‘n’ Bars approach, which has seen it walk away from numerous opportunities over the past few years as intense competition for freeholds has pushed up the prices commanded by licensed premises. The sale of the Meyrick Arms in Clapham and the Brixton Hobgoblin also indicate an ongoing willingness to trade out the poorer performing sites although a weaker pubs market generally may make that process more difficult going forward.

Much of the focus on the domestic pubs and bars industry presently centres on the recent smoking ban and the, even more recent, Budget Statement.

On the smoking ban, Pubs ‘n’ Bars warned in the report accompanying its 2005 year-end accounts that “there is little doubt that the ban will, initially, badly affect all pubs and bars” and reported in its interim results for the six months ended 30th June 2007, released in September, that it believed there had been an initial negative effect on turnover – which had fallen by 4% since the beginning of July on a like-for-like basis - although it was impossible to distinguish between the impact of the smoking ban and the wettest summer since 1868.

In the longer-term however there is wide optimism in the industry that the ban will have a positive effect with lost customers drifting back as they become used to the situation and smoke-free environments appealing to both non-smokers and families. Indeed, this seems to be the experience from Scotland where the ban was implemented in March 2006. In the 20 weeks to 5th January 2008, for example, like-for-like profit in rival Punch Taverns’ Scottish leased estate was up 1.6%, compared to a 0.8% decline overall. Moreover, even in the short-term Pubs ‘n’ Bars looks better positioned than various of its competitors since most of its premises have outside spaces which the company has sought to make attractive for smokers by providing covering, lighting and heaters. As well as aiding customer retention, these should also be a key facilitator in the process of customers returning as they become used to the ban.

The Budget saw alcohol duty rates increase by 6% above the rate of inflation effective from Monday 17th March 2008 and will mean alcohol duties are increased by 2% above the rate of inflation in each of the next four years. However, while this is likely to have something of a negative effect on the pubs industry, we note that the clientele of the type of local, community establishments Pubs ‘n’ Bars owns and operates tend to view the pub as a convivial neighbourhood meeting place rather than an outlet for their discretionary expenditure. This factor should also somewhat cushion the company from the threats posed by cut-price competition from the supermarket groups and the cyclical threat of a downturn in consumer confidence and spending.

A further threat is that the company is facing increased rental charges as a result of reviews on a significant number of its leasehold properties. Its substantial freehold estate means it is in a superior position to various of its competitors in this respect, but any increases in such costs will clearly have an adverse bottom line impact.

Seamus Murphy – Non-Executive Chairman. Involved in the licensed trade since the 1960’s, Murphy has operated as a sole trader and then as a director of Standwood Ltd. While with Standwood the company grew from under £200,000 of turnover in 1992 to around £8 million for the year ended 31st October 1997 and he later assumed the role of Chief Executive of Real Leisure Ltd when it acquired Standwood’s public house interests.

Mel Belligero – Chief Executive. Involved in the retail leisure industry all his working life, Belligero has hotel, restaurant, pubs and bars experience from both an operational and strategic management perspective. He started his career at Whitbread and also worked for Allied Domecq where he was Southern England general manager for the company’s unbranded estate and later general manager for new project development. He was appointed Chief Executive of Pubs ‘n’ Bars in 1999.

Siva Namasivayam – Finance Director. A Chartered Accountant, Namasivayam worked as a financial accountant and as a manager at James & Cowper Chartered Accountants before joining the Standwood group of companies in 1993. He was appointed Group Accountant in 1999 and to the board in January 2005.

Keith Chapman – Non-Executive Director. A senior partner of Crouch Chapman Chartered Accountants, Chapman joined the board of Pubs ‘n’ Bars in 1999 as Finance Director, standing down from that role in January 2005 but remaining on the board in a non-executive capacity.

Jeffrey Coburn - Non-Executive Director. A director of John East & Partners Ltd, a specialist smaller companies corporate financier, Coburn has spent his entire career in the City as a fund manager, stockbroker and corporate financier. He was appointed to the board of Pubs ‘n’ Bars in July 2004.

Pubs ‘n’ Bars currently has 39,673,358 ordinary shares in issue and there are 1,897,686 share options outstanding. Those holding more than 3% of the current issued share capital are:

The company’s most recent results were for the six months ended 30th June 2007 and were released on 20th September. These showed an 8.89% increase in operating profit to £1.33 million on the back of a 15.64% increase in turnover to £8.87 million as the company benefited from the April acquisition of Moorgate London and May’s Community Taverns deal. However, a £111,758 increase in the interest charge to £807,614 - largely as a result of increased borrowings to finance the acquisitive activity – saw the pre-tax profit fall slightly from £548,005 to £541,819 and basic earnings per share decline from 1.56p to 1.35p. The dividend was unchanged at 0.75p per share, signifying the company’s optimism for the future.

The balance sheet showed total assets of £51.07 million (of which current assets comprised £3.76 million) against £27.14 million in non-current liabilities and £4.91 million in current liabilities. As such, the net debt at period end totalled £28.28 million although we believe that it has now increased to around £35 million due to the debt assumed following the December acquisition of Moorgate Taverns. Interest cover in the half year was 1.84 times though operational cashflow cover was more comfortable at 2.58 times. We would be concerned were the level of interest cover to fall too much lower however the new acquisitions should boost operating profit whilst a potential reduction in interest rates paid would also serve to boost cover. Presently, just over £14 million of the company’s debt is hedged at interest rates of 6% or less.

Moreover, the company’s significant tangible asset backing (£45.71 million at 30th June 2007 before the £10 million added by the Moorgate Taverns acquisition) together with the £1.35 million in underlying net cash generated from operating activities in the six months to 30th June 2007, serve to provide significant reassurance.

Reported results for the full year to 31st December 2007 look set to be adversely impacted by the smoking ban and wet weather as well as a change, required by the introduction of International Financial Reporting Standards, to the way the company treats the revaluation of assets. On this latter point, any diminution - below cost - in the value of the company’s leasehold properties is now to be charged to the P&L account rather than be reflected on the balance sheet with the result, the company believes, being a £1.12 million charge before taxation for the year ended 31st December 2006 and an estimated £650,000 for the 2007 calendar year. However, it must be noted that these charges are non-cash items in the P&L account and thus do not affect the underlying operating performance or working capital requirements of the company.

On an underlying basis, before the asset revaluation charges, we expect the approximately 4% decline in like-for-like turnover the company reported it had experienced since the beginning of July in its interim statement to translate into a calendar 2007 pre-tax profit of £925,000 on the back of £16 million of turnover. Diluted earnings should hit 2.23p as Pubs ‘n’ Bars begins to utilise the historic tax losses from the Community Taverns acquisition.

For the current year to 31st December 2008 we anticipate the company resuming a growth track as a result of the 2007 acquisitions feeding through. We therefore see normalised pre-tax profit rising slightly to £944,000 on turnover of £23.19 million, generating diluted earnings of 2.27p. Our forecasts do not include the impact of the purchase of any additional sites although we consider it likely that such purchases will be made during the current calendar year.

Looking beyond the current year, visibility is slightly clouded by the smoking ban and the increases in alcohol duty rates announced in the recent Budget. However, with recent sentiment towards this sector meaning the company is now trading at a discount of 65.6% to net asset value as reported at the calendar 2007 interim stage and with the shares yielding 10.6%, they look to have significant appeal. We believe the 1.75p per share annual dividend to be sustainable and with the shares at 16.5p therefore regard Pubs ‘n’ Bars as a strong income play. On this basis, we initiate our coverage with a buy stance.