IAS 1 para 25, material uncertainty on going concern, COVID – 19, hospitality, viability statement, emphasis in audit report

Mitchells & Butlers plc – Annual report – 25 September 2021

Industry: food and drink

Notes to the consolidated financial statements (extract)

Going concern

The Group’s business activities, together with the factors likely to affect its future development, performance and position are set out in the Strategic report on pages 10 to 46. The financial position of the Group, its cash flows, liquidity position and borrowing facilities are also described within the Finance review on pages 43 to 46.

Note 4.3 to the consolidated financial statements includes the Group’s objectives, policies and processes for managing its capital; its financial risk management objectives; details of its financial instruments and hedging activities; and its exposures to credit risk and liquidity risk. As highlighted in note 4.1 to the consolidated financial statements, the Group’s financing is based upon securitised debt and unsecured borrowing facilities.

The Directors have adopted the going concern basis in preparing these financial statements after assessing the impact of identified principal risks and their possible adverse impact on financial performance, specifically revenue and cash flows.

Liquidity

As at 25 September 2021, the Group had cash and cash equivalents of over £200m, and undrawn committed unsecured facilities of £150m. We expect to retain headroom against these facilities throughout the going concern assessment period.

The Group’s primary source of borrowings is through a secured financing structure made up of ten tranches of fully amortising loan notes with a gross debt value of £1.5bn. These are secured against the majority of the Group’s real estate property assets and the future income streams generated from those properties. The periods for repayments of principal vary by class of note with maturity dates ranging from 2023 to 2036, but at a current aggregate annual debt service cost of c£200m. Interest rate and exchange rate fluctuations have largely been fixed with currency and interest rate swaps which qualify for hedge accounting under IFRS 9 Financial Instruments. Within the securitisation structure, the Group maintains a Liquidity Facility of £295m, which is a condition of the securitisation documents. On 15 February 2021, alongside the announcement of the equity Open Offer, the Group announced revised financing arrangements that had been agreed with its main creditors to provide additional liquidity and financial flexibility in order to meet the challenges presented by Covid-19. These are summarised below.

Unsecured borrowing facilities of £150m fall due for repayment in February 2024, outside of the term of the going concern assessment period.

Revised facilities and covenants

During the period, and as a result of the Covid-19 pandemic, material trading restrictions were imposed on the Group and the sector by governmental authorities, including mandated closure for significant periods. Mitigating action was swiftly taken which included agreeing revised arrangements in the secured financing structure with the consent of the controlling creditor of the securitisation and the securitisation Trustee. These can be summarised as:

  • an extension of the waiver of, and amendment to, the 30 day suspension of business provision, where such provision was waived because the suspension arose due to the enforced closure during the Covid-19 pandemic;
  • a waiver of the two quarter look-back debt service coverage ratio test up until April 2022 and a waiver of the four quarter look-back debt service coverage ratio test up until July 2022. The covenants are then initially tested on reduced levels, before full reinstatement of both tests from January 2023;
  • a waiver of the requirement to appoint a financial adviser which would otherwise have arisen for any periods where the debt service coverage ratio falls to below the required level up until January 2023;
  • a reduction in the minimum amount required to be spent on maintenance during FY 2021 arising from the business having been temporarily suspended; and
  • a waiver to facilitate drawings of up to £110m in total under the Liquidity Facility providing the Group with additional facilities in order to meet payments of principal and interest, provided such drawings are repaid in full by 15 December 2021.

In order to secure such amendments and waivers, the Group gave certain undertakings in relation to its own financing arrangements, namely, to secure additional equity funding and an extension of £150m of the liquidity facilities referred to below, and an undertaking to provide funding into the securitisation of up to £110m in line with new drawings on the Liquidity Facility. Furthermore, it was agreed with the Group’s unsecured relationship banks that the term of existing £150m committed unsecured facilities be extended to 14 February 2024.

Full details of the Group’s debt arrangements are provided in note 4.1.

Significant judgements and base case

These revised financial arrangements provide a stronger platform for the business to meet uncertainty ahead, ensuring that liquidity is not expected to be a main concern during the going concern assessment period. The level of sales drives the EBITDA of the business which is a critical measure for covenant compliance tests. Following periods of enforced closure in response to the Covid-19 pandemic, substantially all of the Group’s sites have now been open for trading since May 2021. Since ‘Freedom Day’ in July 2021 this has been in an environment largely free of restrictions. Key judgements made by management in arriving at the level of future sales concern the depth, duration and continued recovery profile of the pandemic and therefore the level of sales that the business is able to achieve. To this end we assume that no further periods of mandated national or regional closure, or of material trading restrictions, will be enforced.

In reaching this assessment, the Directors have reviewed what they consider to be a plausible base case forecast scenario. Sales are assumed to largely recover to FY 2019 levels, supported in H1 by the 12.5% VAT rates on food and non-alcoholic drink for the 6 months from 1 October 2021. Stripping out the VAT benefit, this assumes sales are 5% below pre-Covid levels through H1 before moving back in line with pre-Covid sales in H2. In future years sales through FY 2023 are assumed to be 4.5% up on pre-Covid levels, with a further 3% increase in FY 2024.

Operating margins in FY 2022 are assumed to be lower than those pre-Covid, with notable cost inflation across food and utilities, labour costs (additional pay increases for certain roles suffering from supply shortage and a 6.6% NLW increase impacting hourly pay) and increased non-pub costs.

Whilst some reversion in utility costs is assumed after FY 2022, these still remain well ahead of pre pandemic levels.

Under the base case forecast, the Group continues to remain profitable with no forecast breach of covenants.

Reverse stress test

The Group has also undertaken reverse stress test modelling, being the identification of that level of downside forecast at which the business model becomes unsustainable for either solvency or liquidity reasons. Due to the complex capital structure of the Group, involving the interaction of both secured and unsecured estates, with quarterly covenant testing (on both a four quarter and two quarter look-back basis) within the securitisation and monthly and quarterly tests in the unsecured estate, there is a very wide range of scenarios on which the reverse stress test can be constructed.

In examining vulnerabilities, management have considered the performance in the forecast case above and made an adjustment to reflect sales growth rates in FY 2022 at 7.4% lower than the forecast alongside further increased levels of utilities costs, cost of goods increases and NLW wage increases. Very limited mitigation action is assumed other than labour costs flexing to reflect the lower level of sales volumes and lower bonus awards. In this scenario, solvency breach first occurs in Q4 of FY 2022 under both the securitised four quarter look-back test and the unsecured four quarter look-back test. There is no issue in respect of liquidity headroom, in that existing facilities remain sufficient.

In the absence of further lockdown or material restrictions being imposed, the Directors believe that it is unlikely that the Group would experience sales shortfalls combined with cost increases, as set out in the reverse stress test, of a scale sufficient to result in a breach to its covenants over the review period. However, given the prevailing high level of unpredictability and uncertainty concerning the future incidence of the pandemic, the Directors are unable to conclude that the prospect of either such a further lockdown or of material restrictions being imposed is remote. As such a material uncertainty exists which may cast significant doubt over the Group’s ability to trade as a going concern, in which case it may be unable to realise its assets and discharge its liabilities in the normal course of business. This uncertainty stems directly from the lack of forward visibility of potential restrictions that might be imposed in response to the pandemic such as enforced closure, minimum social distancing measures, limitations on party sizes, and reduced opening times, all of which have an impact on consumers’ ability and willingness to visit pubs and restaurants and therefore the Group’s operational performance translating to sales and EBITDA that determine the Group’s continuing covenant compliance.

Any breach in covenants would result in a need for a further waiver of the banking covenants or for the Group to renegotiate its borrowing facilities, neither of which are fully within the Group’s control. A breach of covenants would also result in the reclassification of £1,416m non-current borrowings to current borrowings. The Directors have, however, assessed that: given the strength of the underlying business including its property estate and brand portfolio; the Group’s existing relationships with its main creditors; its historical success in obtaining covenant waivers and in raising finance; they believe that a waiver of the covenants or renegotiation of the facilities should be achievable.

Going concern statement

Notwithstanding the material uncertainty highlighted above, after due consideration the Directors have a reasonable expectation that the Company and the Group have sufficient resources to continue in operational existence for the period of at least twelve months from the date of approval of these financial statements. Accordingly, the financial statements continue to be prepared on the going concern basis and do not include any adjustments that would result if the going concern basis were not appropriate. A review of longer term viability is provided on page 41 which assesses the Group’s ability to continue in operation and to meet its liabilities as they fall due over a longer, three year period.

Corporate Viability (page 40)

In accordance with Provision 31 of the 2018 UK Corporate Governance Code, the Directors have undertaken an assessment, including sensitivity analysis, of the prospects of the Group for a period of three years to September 2024.

Assessment period

Three years continues to be adopted as an appropriate period of assessment as it aligns with the Group’s planning horizon in a fast moving market subject to changing consumer tastes in addition to economic and political uncertainties, and is supported by three-year forecasts as approved by the Board. This period also aligns with the triennial process for pensions valuations, a key consideration in respect of future cash flows. Beyond this period, performance is impacted by global macroeconomic and other considerations which become increasingly difficult to predict, an example of which has been the profound impact of the Covid-19 pandemic.

Assessment of prospects

The Group’s financial planning process comprises a detailed forecast for the next financial year, together with a projection for the following two financial years.

The Group’s strategy provides long-term direction and aims to protect the viability of the business model given prevailing and evolving market and economic conditions. The Directors’ assessment of longer-term prospects has been made taking account of the current and expected future financial position and the principal risks and uncertainties, as detailed within the Annual Report.

At the current time uncertainty facing the business remains high due both to potential further impacts of the Covid-19 pandemic, which have previously inhibited the Group’s ability to trade freely thereby reducing sales and activity, and to increasing cost headwinds in areas such as wage inflation and utilities. Longer-term risks are further identified around evolving consumer demands and tastes and the economic and political environment.

Key factors considered in the assessment of the Group’s prospects are a strong market position with a broad range of brands and offers trading from a well-positioned and largely freehold estate, supported by the resumption of capital investment focused on premiumisation of offers and an appropriate remodel cycle, all anticipated to contribute to outperformance against the wider market.

Assessment of viability

The current funding arrangements of the Group consist of £1.5bn of long-term securitised debt which amortises on a scheduled profile over the next 15 years. Covenants are tested quarterly, both on an annual and a half-year basis, although as set out in the note to the financial statements on going concern, a refinancing was undertaken during the year resulting in a number of waivers followed by amendments through to January 2023 being obtained. Unsecured committed facilities of £150m were in place at the year end, having been extended during the refinancing and equity Open Offer. These facilities expire within the three-year term of this assessment, in February 2024, and at the current time the Group has no reason to conclude that they will not be refinanced ahead of their expiry.

Following the end of the third national lockdown in April 2021, and subsequent lifting of the majority of restrictions in July, the principal short-term risks facing the business are assessed to be the recovery of demand, back to pre-Covid levels and beyond, and increased cost inflation notably in wage rates and utilities. The Group has reviewed a number of forecast scenarios and sensitivities around these risks, including additional stress testing that has been carried out on the Group’s ability to continue in operation under unfavourable operating conditions. In assessing these, the Group has also included the impact of remaining temporary Government support measures – notably a reduction in the rate of VAT to 12.5% on selected products until March 2022. Whilst the experience of Covid-19 is expected to lead to lasting changes in both customer behaviour and competition in the hospitality sector, in making this assessment the Group has taken the view that the material adverse impact of Covid-19 on sales, through trading restrictions, will be temporary in nature and should not extend to any material extent beyond FY 2021. In particular, it is assumed that no further mandated closure or trading restrictions will be reintroduced. In FY 2022 and FY 2023, the Group is forecasting sales growth of between nil and 4.5%, when compared to pre-pandemic levels.

The Group’s three-year plan takes account of these risks, in addition to the prevailing economic outlook and capital allocation decisions, alongside limited planned mitigating activity such as improved operational efficiencies (stock and labour management) to manage these costs. No further Government support is assumed beyond those measures already announced. The resilience of this plan is assessed through the application of forecast analysis, including reverse stress test modelling for the first year, as detailed more extensively in the going concern note to the financial statements, focused in particular on recovery of demand and input cost inflation during the current financial year as well as on a longer-term basis. Sensitivities of the following risks described in the Annual Report have also been applied to the base plan:

  • declining Sales Performance (Risk event 2): 2% lower sales growth rate in FY 2022, FY 2023 and FY 2024;
  • cost of Goods Price Increases (Risk event 9): 2% increase in direct Cost of Goods (Drink and Food) in FY 2022, FY 2023 and FY 2024;
  • increased utilities cost (Risk event 9): additional £10m, £15m and £15m in FY 2022, FY 2023 and FY 2024 respectively against FY 2019;
  • increased Wage Cost Inflation (Risk event 6): 2% increase in NLW wage rate in FY 2023 and FY 2024; and
  • a scenario combining all of the above sensitivities which reduces operating profit by £39m, £48m and £59m in FY 2022, FY 2023 and FY 2024 respectively.

Liquidity and solvency based on financial covenants (Risk event 1) on both secured debt and unsecured facilities are assessed in all scenarios. In all scenarios the Group continues to remain profitable with sufficient liquidity and no forecast unwaived covenant breaches, albeit with minimal headroom in the scenario combining all sensitivities. However, it is noted that there is a requirement to refinance the unsecured facilities and potentially increase the amount in February 2024. It is considered that this can be accommodated within the debt capacity of the business given the anticipated recovery in profitability and the strength of the creditor relationships exhibited in the refinancing exercises during FY 2020 and FY 2021, noting also that by that time a further c.£250m of securitised debt is expected to have been paid down.

Viability statement

The Directors have concluded, based upon the extent of the financial planning assessment, sensitivity analysis, potential mitigating actions and current financial position that there is a reasonable expectation that the Group will have sufficient resources to continue in operation and meet all its liabilities as they fall due over the three-year period to September 2024. However, due to the prevailing high level of unpredictability and uncertainty concerning the future incidence of the pandemic, the Directors are unable to conclude that the prospect of either a further lockdown or of material restrictions being imposed is remote. Given this lack of forward visibility, and the material uncertainty highlighted in the going concern assessment, the viability of the business over the three-year assessment period remains uncertain.

Independent auditor’s report to the members of Mitchells & Butlers plc (extract)

3. Material uncertainty related to going concern

We draw attention to note 1 in the financial statements, which indicates that a material uncertainty exists that may cast significant doubt on the Group and Parent Company’s ability to continue as a going concern.

The primary source of borrowing for the Group is secured loan notes of £1.5bn at 25 September 2021 (2020 £1.6bn), secured on the majority of the real estate properties owned by the Group. As at 25 September 2021, the Group had cash and cash equivalents of £227m, and undrawn committed unsecured facilities of £150m. The existing £150m of revolving credit facilities (RCF) was renegotiated and extended to February 2024 with associated covenants being re-negotiated to reflect new post-Covid trading.

There are covenants attached to both the secured loan notes and the unsecured revolving credit facilities. As part of the revised arrangements within the securitisation it was agreed to waive a number of covenants across the securitised borrowings till Q2 2022, including reduced testing levels till Q3 and Q4 2022. The covenants for the unsecured borrowings commence in Q4 2022. The covenants are tested annually and quarterly, based around the Group’s net worth and free cash flow to debt service respectively. The covenants are most sensitive to the macroeconomic recovery and performance of the Group over the short term trading period.

Management has performed a reverse stress test on the forecast and identified that an average decline in sales of 7.4% or more, prior to any mitigating actions or consideration of future government support, would result in a breach in covenants for securitised and non-securitised borrowings in Q4 2022. As explained in note 1, management has determined that there is a high level of unpredictability and uncertainty concerning the future incidence of the pandemic. Accordingly, the Directors are unable to conclude that the prospect of either such a further lockdown or of material restrictions being imposed is remote. A breach of covenants would lead to the need for the Group to negotiate further waivers or renegotiate its borrowing facilities.

As such a material uncertainty exists which may cast significant doubt over the Group’s and Parent Company’s ability to continue as a going concern. Our opinion is not modified in respect of this matter.

The Audit Committee has included the adoption of the going concern basis of accounting as a key risk on page 77.

In auditing the financial statements, we have concluded that the Directors’ use of the going concern basis of accounting in the preparation of the financial statements is appropriate.

Our evaluation of the Directors’ assessment of the Group’s and Parent Company’s ability to continue to adopt the going concern basis of accounting included:

  • using modelling specialists to perform testing on the mechanical accuracy of the model used to prepare the Group’s cash flow forecast;
  • considering the consistency of management’s forecasts with other areas of the audit, including the right-of-use asset impairment review and revaluation of freehold and long leasehold properties (including consideration of management’s expert’s view of the likely recovery);
  • challenging the key assumptions within the going concern assessment including the key assumptions in the performance over the festive period and sales recovery trajectory. We have challenged with reference to the historical trading performance, current trading uncertainty, market expectations, Government announcements and peer comparison;
  • obtaining an understanding of the financing facilities available to the Group, included understanding repayment terms and covenant definitions;
  • assessing the impact of reverse stress testing on the Group’s funding position and covenant calculations, including the appropriateness of performance recovery assumptions;
  • assessing and challenging the mitigating actions available to management, should these be required to offset the impact of the forecast performance not being achieved;
  • assessing the appropriateness of risk factors disclosed in the Group’s going concern statement and the financial impact of those risk factors; and
  • challenging the sufficiency of the Group’s disclosures over the going concern basis and material uncertainty arising.

In relation to the reporting on how the Group has applied the UK Corporate Governance Code, we have nothing material to add or draw attention to in relation to:

  • the Directors’ statement in the financial statements about whether the directors considered it appropriate to adopt the going concern basis of accounting; and
  • the Directors’ identification in the financial statements of the material uncertainty related to the Group’s and Parent Company’s ability to continue as a going concern over a period of at least twelve months from the date of approval of the financial statements.

Our responsibilities and the responsibilities of the directors with respect to going concern are described in the relevant sections of this report.