The UK hospitality sector has been one of the biggest casualties of the pandemic and the slowest to rebound.

Enforced closures during lockdowns, surging energy, labour and commodity prices post pandemic and ongoing train strikes mean hospitality has faced more than its fair share of obstacles over the last three years.

The extra challenges mean hospitality has been slower than other sectors to regain lost ground. While annual sales across the sector are broadly back to or above pre-pandemic levels, regaining lost profits is proving a harder nut to crack.

It’s not all doom and gloom though with most pubs and restaurants reporting strong summer trading and with the important festive season starting soon, investors will be hoping for more cheer.

Premium pubs and hotels group Young & Co (YNGA:AIM) told Shares that Christmas day bookings are up 12% compared with record bookings in 2022 mirroring comments made by Marston’s (MARS).

However, rail strikes could still spoil the party. In recent weeks 37 of the UK’s biggest hospitality brands have written an open letter in association with UK hospitality, urging rail unions not to hold further strike action over the Christmas period.

REBUILDING PROFITABILITY

There is still a lot of catch-up potential in terms of profitability across the sector given operating margins have been mauled by rising costs since the end of the pandemic.

Leading pub and hotels group JD Wetherspoon (JDW) lagged the pace of recovery seen at other operators coming out of the pandemic, but sales momentum has increased in recent months and the firm appears to have got its mojo back.

For the 14 weeks to 5 November like for like sales were 9.5% higher than the same period last year. Wetherspoon has outperformed the underlying market as measured by the Coffer CGA Business Tracker for 13 consecutive months.

Profit is a far more important financial metric than sales to investors. This goes a long way to explain why share prices languish well below pre-pandemic levels as the following table overleaf demonstrates.

On average hospitality shares are trading 45% below where they were in 2019. One standout performer on a relative basis is all-day bar/restaurant group Loungers (LGRS:AIM).

Loungers has delivered industry leading like-for-like sales growth since the pandemic and is executing an accelerated expansion plan which puts it on track to end its financial year to 1 April with more than 250 sites.

This means sales will have doubled since the business floated on AIM in 2019 while EBITDA (earnings before interest, tax, depreciation, and amortisation) will have more than doubled if analysts’ forecasts are delivered.

The wooden spoon goes to pubs and hotels group Marston’s whose shares languish 75% below pre-pandemic levels. Chief executive Andrew Andrea surprisingly stepped down (17 November) after only two years in the post.

Andrea will be replaced by Justin Platt who was most recently chief strategy officer at Merlin Entertainments. Platt has more than 30-years’ experience in hospitality and consumer-facing businesses.

Marston’s board said Platt’s combination of operational and strategic experience equips him ‘perfectly’ to lead the next stage of the company’s development.

WHAT’S IMPORTANT WHEN ASSESSING HOSPITALITY STOCKS

A useful metric which companies and analysts focus on when looking at pubs and restaurants is like-for-like sales growth which represents the underlying change in sales on an apples-to-apples basis.

Comparing different companies like this gives a good idea of who’s gaining and who’s losing out. This is important in hospitality because historically there has been an excess supply of restaurants and bars.

This means companies must fight for a share of consumers’ wallets to grow their business. Understanding the customer proposition of a brand is key to forming a view about its likely success.

Luckily most investors can do this by visiting a restaurant as a customer and getting opinions from friends. The most successful brands have a higher proportion of repeat business.

The Coffer Peach CGA business tracker provides market information for different segments in hospitality and is a useful guide to how various companies are performing relative to the market.

Positive like-for-like growth also allows firms to mitigate cost inflation. When considering restaurant or pub chains which have an organic growth strategy it is useful to understand how the growth is financed.

Self-funding growth situations are less risky than those which need borrowed money. Many companies have come under financial pressure from building up too much debt.

For pub groups and to some extent restaurants it is useful to know if the sites are owned or leased. Most of the quoted pub groups predominantly own the freehold property in their estates.

Banks are more likely to lend to companies have freehold-backed properties. Franchising can be an attractive alternative for growing a business quickly and with less risk. Franchisees provide the capital in return for using the brand name and ingredients. McDonald’s (MCD:NYSE) is one of the world’s most successful franchised businesses.

MERGERS AND ACQUISITIONS ON THE RISE

Given floundering share prices it is perhaps no surprise to see greater merger and acquisition activity in the sector from both trade buyers and private equity.

Wagamama owner Restaurant Group (RTN) has attracted interest from activist investors and private equity over the last few months. The group finally succumbed to an all-cash offer from private equity giant Apollo Global Management on 12 October.

The deal was struck at 65p per share equating to a 34% premium and representing an enterprise to trailing EBITDA multiple of nine times.

It seems like an odd decision to sell after management have already radically restructured the group by jettisoning underperforming leisure brands and increasing profitability.

In other words, much of the hard work of getting the business back in shape has already been done, arguably leaving Apollo to reap the upside after a lot of the financial risks have been removed.

Greg Johnson, leisure analyst at Shore Capital argues the proposed takeover price doesn’t fully reflect the potential of the group. Johnson reckons a more reasonable starting point for discussions would be 80p per share.

However, with activist shareholders Oasis and Irenic Capital, who own 17.8% and 1.9% stakes respectively, voting in favour of the offer, it looks increasingly like a done deal.

If Restaurant Group were to disappear from the stock market it would leave a big hole in terms of large quoted hospitality businesses for UK investors.

Mitchells & Butlers (MAB) would be the closest substitute because it owns Harvester, a family-friendly restaurant chain with the same number of sites as Wagamama, Toby Carvery and Miller & Carter steakhouses, albeit with only a few situated on the high street.

The All Bar One operator is the largest player in the sector by market capitalisation (£1.4 billion) and annual sales (£2.4 billion).

The group, which also owns Ember Inns and O’Neill’s, reported better than expected full year results on 30 November with sales up 13% to £2.5 billion as it delivered a record like for like sales outperformance.

Despite higher wage costs from April next year due to the increase in the national living wage the company expects overall cost headwinds to reduce to around £65 million for the year ahead as energy and food inflation pressures to abate.

‘This should allow us to start to rebuild margins back towards pre-pandemic levels,’ the company said.

Another option for UK investors is Premier Inn owner Whitbread (WTB) which also operates restaurant brands including Beefeater, Brewers’ Fayre and Whitbread Inns.

High levels of occupancy in the hotels have given a boost to the food and beverage businesses in the first half of the year taking revenues back to pre-pandemic levels.

However, management said it is looking at a range of options to mitigate the impact from higher inflation on the branded restaurants businesses.

On 16 November premium pub and hotels group Young & Co agreed to buy City Pub (CPC:AIM) for £162 million comprised of 108.75p per share in cash plus Young’s shares.

The implied value of the transaction is 145p per City Pub share equating to a premium of 46% to the 99p prior closing price. Both sets of directors have unanimously recommended the deal.

On 6 December ten-pin bowling and entertainment group Ten Entertainment (TEG:AIM) agreed to an offer from private equity company Trive Capital.

The all-cash bid of 412.5p per share equates to a 33% premium to the prior closing price and is 23.3% higher than the all-time high of 334.5p reached in 2020 just before the start of the pandemic.

OTHER OPTIONS FOR INVESTING IN CASUAL DINING

If Restaurant Group delists, the choice for larger eating-related listed companies will narrow to fast food joints or pubs/bars/cafes.

There are options among US-listed quick service restaurant companies with a presence on the UK high street including McDonald’s and Wingstop (WING:NASDAQ).

It should be noted their earnings are sourced from multiple countries, so they are not a direct way to get exposure to UK hospitality.

The ’golden arches’ has had a good couple of years as its value for money proposition and strong pricing power have allowed the firm to prosper through the cost-of-living crisis.

At an investor day on 5 December the company said it plans to open 10,000 restaurants across the globe by 2027 and more than double revenue from its loyalty programme.

The expansion would take McDonald’s footprint to about 50,000 restaurants across 100 countries and mark the fastest period of growth in the company’s history.

Wingstop shares are up 86% in 2023 and trading at record highs. They have delivered shareholders an eight-fold return since listing on Nasdaq in June 2015.

Earnings per share jumped 53% year on year in the third quarter to $0.69 which smashed analysts forecasts of $0.52 while revenue increased 26% to $117 million.

NATIONAL LIVING WAGE HEADWIND

Hospitality is labour intensive given it is essentially a service industry. In addition, the industry employs a larger than average proportion of younger workers.

The Government has announced a 10% increase in the national living wage lifting the hourly rate by £1.02 to £11.44 from April 2024 in line with recommendations made by the low pay commission.

The qualifying age will fall from 23 years to 21 years of age which Numis reckons will ‘materially’ widen the labour pool impacted.

To mitigate the impact from higher wages UK chancellor Jeremy Hunt gave some help to the hospitality sector after freezing alcohol duties until August 2024 in the recent Autumn statement.

Help was also forthcoming in the form of an extension of the 85% business rates relief to the 2024/25 tax year.

However, increasing wage costs will have a major impact on the hospitality sector. Numis commented: ‘we deem it unhelpful that sector wage inflation will now persist to April 2025 at a time when other costs (utilities, food/beverage) are starting to normalise.

‘Similar to the inception of the NLW in 2016, companies most exposed are labour intensive with low margin buffer, such as JD Wetherspoon and Restaurant Group.’

As the table above shows, Loungers is also relatively labour intensive. To reflect the increase in the living wage Numis has upped its forecast for labour costs as a proportion of sales from 33% to 36%.

Numis still sees scope for Loungers to increase EBITDA margins as scale benefits (better buying power) and operating leverage kick in as the group expands.

Chief executive Nick Collins told Shares that the company anticipates regaining pre-pandemic EBITDA margins as it grows the size of the business.

It is interesting to note that bowling firms Hollywood Bowl (BOWL) and Ten Entertainment are far less labour intensive than pubs and restaurants.

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