Intelligent investor:

Mickey Mordech on pub owner Redcape

Once-in-a-century pandemics aside, pubs are attractive investments for their resilience. In normal recessions, a parmigiana and pint are usually affordable luxuries while electronic gaming machines often benefit from government stimulus measures.

But there’s another side to the optimistic picture: Australians are getting less boozy, tend to put less money into poker machines and are moving to other forms of gambling. Still, aided by population growth, pubs and gaming volumes have generally enjoyed modestly growing sales.

This highlights the battle pubs face to eke out growth. A regular refurbishment program is therefore a must: replacing worn carpets and repainting faded walls, plus the occasional major revamp to modernise for the younger generation, keeps the punters coming. The problem is that such refurbs are costly and disruptive and have different payoffs for the landlord and tenant.

Take the case of pub landlord ALE Property. Its tenant, ALH, is responsible for all refurbishments with rent reviews every decade. It doesn’t make sense for ALH to commit to a major refurb close to a rent review – even if it’s badly needed – because it would be “thanked” with higher rents.

But the alignment of interests in the owner-operator model of the rival Redcape Hotel Group solves these problems. By acquiring underperforming pubs and applying the owner-operator model, Redcape’s venues benefit from regular refurbishments, which attract more patrons, leading to more profit, faster growth and higher valuations.

Further gains can be made by introducing membership and loyalty programs, centralising food ordering, software and hiring processes and supplying in-house beer from the company’s “Australian brewery” at attractive margins.

While not of the same ilk as ALE, Redcape’s portfolio is a good one with 21 of its 32 properties in greater western Sydney, where much of the land bank is empty. Feasibility studies have shown how apartment blocks could bring in attractive profits. The rest of the portfolio is located in regional towns like Mackay, Townsville, and Wollongong, where we’d expect less upside.

Once major gains have been made, management can sell assets, recycling capital into new pubs and repeating the process. This model could lead to higher growth rates than the industry’s and higher returns for shareholders. It does, however, depend not only on management’s judgement and operating nous, but also its incentives.

This is what puts us off. For someone allocating shareholder capital, even before selling two-thirds of his holding in February, chief executive Daniel Brady didn’t have much skin in the game.

There are further issues. When Redcape was listed in 2018 by Moelis, the latter put in place cushy 10-year operating and investment management agreements with its own subsidiaries. These entitle Moelis to collect substantial fees to manage the portfolio and operate the pubs.

In effect, Moelis acts as Redcape’s board and management. This lack of accountability to minority shareholders is a major worry.

Worse, ending these agreements is unattractive, given their punitive termination fees. Redcape’s profits will be garnished for the foreseeable future to pay ultra-generous cheques to Moelis.

The fees are extensive and substantial. Moelis receives fees every time Redcape buys or sells property, conducts a renovation or refinances corporate debt. All act as an incentive for management to churn properties, add debt, value assets aggressively and over-renovate, just to keep the fees coming.

We can’t say that’s what’s happening, but it might explain why Redcape turns over its portfolio so often, recently completing the most expensive pub deal ever for Byron Bay’s $100 million Beach Hotel.

Moelis-related entities do own 40% of Redcape stock so they do have skin in the game. But we’ve no idea if they plan to hold it for the long term or if this was simply a requirement to get Redcape’s float away.

The management structure is one black mark, relatively high debt is another and the potential for a capital raising a third. But Redcape does own real assets and therefore contains real value. Its current price also atones for plenty of sins.

Assuming that a capital raising isn’t needed, Redcape trades at a 29% discount to its reported net asset value of $1.15 per share. It also offers a prospective 11% dividend yield based on pre-virus dividends.

Redcape is modestly undervalued at current prices, but given the lofty fees and the chance of a capital raising, it deserves to be.

Relatively high debt and a potential capital raising are also black marks