Property at valuation, policy for surpluses and deficits, level 3 hierarchy disclosures for unobservable inputs, COVID – 19

Mitchells & Butlers plc  – Annual report 26 September 2020

Industry: food and drink

3.1 PROPERTY, PLANT AND EQUIPMENT

Accounting policies

Property, plant and equipment

The majority of the Group’s freehold and long leasehold licensed land and buildings, and the associated landlord’s fixtures, fittings and equipment (i.e. fixed fittings) are revalued annually and are therefore held at fair value less depreciation. Tenant’s fixtures and fittings (i.e. loose fixtures) within freehold and long leasehold properties, are held at cost less depreciation and impairment.

Short leasehold buildings (leases with an unexpired lease term of less than 50 years), unlicensed land and buildings and associated fixtures, fittings and equipment are held at cost less depreciation and impairment.

All land and buildings are disclosed as a single class of asset within the property, plant and equipment table, as we do not consider the short leasehold and unlicensed buildings to be material for separate disclosure.

Non-current assets held for sale are held at their carrying value or their fair value less costs to sell where this is lower.

Depreciation

Depreciation is charged to the income statement on a straight-line basis to write off the cost less residual value over the estimated useful life of an asset and commences when an asset is ready for its intended use. Expected useful lives and residual values are reviewed each period and adjusted if appropriate.

Freehold land is not depreciated.

Freehold and long leasehold buildings are depreciated so that the difference between their carrying value and estimated residual value is written off over 50 years from the date of acquisition. The residual value of freehold and long leasehold buildings is reassessed each period and is estimated to be equal to the fair value determined in the annual valuation and therefore no depreciation charge is recognised.

Short leasehold buildings, and associated fixtures and fittings, are depreciated over the shorter of the estimated useful life and the unexpired term of the lease.

Fixtures, fittings and equipment have the following estimated useful lives:

Information technology equipment                      3 to 7 years

Fixtures and fittings                                               3 to 20 years

At the point of transfer to non-current assets held for sale, depreciation ceases. Should an asset be subsequently reclassified to property, plant and equipment, the depreciation charge is calculated to reflect the cumulative charge had the asset not been reclassified.

Disposals

Profits and losses on disposal of property, plant and equipment are calculated as the difference between the net sales proceeds and the carrying amount of the asset at the date of disposal.

Revaluation

The revaluation utilises valuation multiples, which are determined via third-party inspection of 20% of the sites such that all sites are individually valued approximately every five years; estimates of fair maintainable trade (FMT); and estimated resale value of tenant’s fixtures and fittings. Properties are valued as fully operational entities, to include fixtures and fittings but excluding stock and personal goodwill. The value of tenant’s fixtures and fittings is then removed from this valuation via reference to its associated resale value. Where sites have been impacted by expansionary capital investment in the preceding twelve months, FMT is taken as the post investment forecast, as the current period trading performance includes a period of closure.

Valuation multiples derived via third-party inspections determine brand standard multiples which are then used to value the remainder of the non-inspected estate via an extrapolation exercise, with the output of this exercise reviewed at a high level by the Directors and the third-party valuer.

Where the value of land and buildings derived purely from a multiple applied to the fair maintainable trade misrepresents the underlying asset value, for example, due to low levels of income or location characteristics, a spot valuation is applied.

Surpluses which arise from the revaluation exercise are included within other comprehensive income (in the revaluation reserve) unless they are reversing a revaluation deficit which has been recognised in the income statement previously; in which case an amount equal to a maximum of that recognised in the income statement previously is recognised in the income statement. Where the revaluation exercise gives rise to a deficit, this is reflected directly within the income statement, unless it is reversing a previous revaluation surplus against the same asset; in which case an amount equal to the maximum of the revaluation surplus is recognised within other comprehensive income (in the revaluation reserve).

Impairment

Short leaseholds, unlicensed properties and fixtures and fittings are reviewed on an outlet basis for impairment if events or changes in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognised whenever the carrying amount of an asset exceeds its recoverable amount. The recoverable amount is the higher of fair value less costs to sell or value in use. Any changes in outlet earnings or cash flows, the discount rate applied to those cash flows, or the estimate of sales proceeds could give rise to an additional impairment loss.

Where an impairment loss subsequently reverses, the carrying amount of the asset is increased to the revised estimate of its recoverable amount, but only so that the increased carrying amount does not exceed the carrying amount that would have been determined had no impairment loss been recognised for the asset in prior periods. A reversal of an impairment loss is recognised in the income statement immediately. An impairment reversal is only recognised where there is a change in the estimates used to determine recoverable amounts, not where it results from the passage of time.

Critical accounting judgements

Revaluation of freehold and long leasehold properties

The revaluation methodology is determined using management judgement, with advice from third-party valuers. The application of a valuation multiple to the fair maintainable trade of each site is considered the most appropriate method for the Group to determine the fair value of licensed land and buildings.

Where sites have been impacted by expansionary capital investment in the preceding twelve months, management judgement is used to determine the most appropriate source of site level FMT. The FMT is taken as the post investment forecast, as the current period trading performance includes a period of closure.

Due to the impact of Covid-19 in the current period, judgement has been applied to determine the most appropriate measure of site level FMT. Given the enforced closure of all sites on 20 March 2020, as well as subsequent local lockdowns, there was significant impact on FY 2020 trading profit for each site. FMT has therefore been determined by reference to the trading performance up to the point of closure, as well as the previous two years of trading performance. In addition, after application of a valuation multiple to provide a site valuation, an income shortfall deduction has been made to reduce this value by the difference between the FMT and the expected Covid-19 related reduction in profit for each site during FY 2021.

Impairment review of short leasehold and unlicensed property and tenant’s fixtures and fittings

For the short leasehold properties and tenant’s fixtures and fittings impairment review, judgement has been applied to determine the most appropriate forecast to use as a result of the impact of Covid-19 on site profitability and cash flows. Site level forecasts, including the allocation of directly attributable overhead costs, have been used that formed the basis of the overall Group forecast for FY 2021 that was in place at the balance sheet date. Management apply judgement when allocating overhead costs to site cash flows, with an overhead allocation being made only for those costs that can be directly attributed to a site on a consistent basis.

The forecast at the balance sheet date assumed that the Group would not be subject to enforcement of a prolonged national lockdown but would continue to trade at a materially lower level of sales due to selected regional lockdowns alongside other national restrictions, under the UK Government’s three tier alert system in England (and similar arrangements in Scotland, Wales, Northern Ireland and Germany). The forecast assumed reduced sales throughout FY 2021, building up to pre-Covid-19 levels of trade by the fourth quarter of FY 2021. In addition, the forecast also includes a reduction in VAT on non-alcohol sales to April 2021 and business rate relief to April 2021.

Key sources of estimation uncertainty

Revaluation of freehold and long leasehold properties

The application of the valuation methodology requires two key sources of estimation uncertainty: the estimation of valuation multiples, which are determined via third-party inspections including consideration of a multiple reduction for the impact of Covid-19; and an estimate of fair maintainable trade, including reference to historic and future projected income levels.

In addition, in the current period, an income shortfall deduction has been made from the resulting valuation to estimate the impact on profit of the post-Covid-19 rebuild of trade in FY 2021.

The valuers also make reference to market evidence of transaction prices for similar properties. An adjustment to any of these assumptions could lead to a material change in the property valuation. At 26 September 2020 the spread of the Covid-19 virus and social distancing measures put in place in order to stem that spread, has disrupted activity in real estate markets for the hospitality sector, creating heightened valuation uncertainty for the Group’s valuers. As a result, the valuation report includes a clause which highlights a ‘material valuation uncertainty’. For the avoidance of doubt, this clause does not mean that the valuation cannot be relied upon. Rather, it has been included to ensure transparency and to provide further insight as to the market context under which the valuation opinion was prepared.

A sensitivity analysis of changes in valuation multiples, FMT and the income shortfall deduction, in relation to the properties to which these estimates apply, is provided on page 120. The carrying value of properties to which these estimates apply is £4,129m (2019 £4,343m).

Impairment review of short leasehold and unlicensed property and tenant’s fixtures and fittings

The impairment review requires three key sources of estimation uncertainty in calculating the value in use: the estimation of forecast cash flows for each site; the selection of an appropriate discount rate and the selection of an appropriate long-term growth rate. Both the discount rate and long-term growth rate are applied consistently to each cash-generating unit.

A sensitivity of changes in forecast cash flows, the discount rate and the long-term growth rate is provided on page 121. The carrying value of assets to which these estimates apply is £164m.

Property, plant and equipment

Property, plant and equipment can be analysed as follows:

a. Includes assets which are fully depreciated and have been removed from the fixed asset register.

Certain assets with a net book value of £39m (2019 £41m) owned by the Group are subject to a fixed charge in respect of liabilities held by the Mitchells & Butlers Executive Top-Up Scheme (MABETUS).

Included within property, plant and equipment are assets with a net book value of £3,685m (2019 £3,881m), which are pledged as security for the securitisation debt and over which there are certain restrictions on title.

Cost at 26 September 2020 includes £8m (2019 £7m) of assets in the course of construction.

Revaluation of freehold and long leasehold properties

The freehold and long leasehold properties have been valued at fair value, as at 26 September 2020, using information provided by CBRE, independent chartered surveyors. The valuation was carried out in accordance with the RICS Valuation – Global Standards 2020 which incorporate the International Valuation Standards and the RICS Valuation – Professional Standards UK (the ‘Red Book’) assuming each asset is sold as a fully operational trading entity. The fair value has been determined having regard to factors such as current and future projected income levels. As part of this, CBRE have taken into account the expected rebuild in trade following reopening as a result of Covid-19, as well as location, quality of the pub restaurant and recent market transactions in the sector. In the current period CBRE have therefore reduced the property multiples for the expected impact of Covid-19.

Sensitivity analysis

Changes in the FMT, the multiple or the income shortfall deduction could materially impact the valuation of the freehold and long leasehold properties.

FMT

The average movement in FMT of revalued properties over the last three financial periods is 1.4%. It is estimated that, given the multiplier effect, a 1.4% change in the FMT of the freehold or long leasehold properties would generate an approximate £52m movement in their valuation.

Multiples

Valuation multiples are determined at an individual brand level. Over the last three financial periods, the weighted average brand multiple has moved by an average of 0.2. It is estimated that a 0.2 change in the multiple would generate an approximate £88m movement in valuation.

Income shortfall deduction

The income shortfall deduction is calculated by comparing the site level FMT with the site level profit forecasts contained within the Group FY 2021 profit forecast. A downside profit forecast for FY 2021 existed at the balance sheet date which provides a sensitivity against this base position. This potential downside scenario of 11.2% reduction in profit, assumed a longer turnaround of profit back to pre-Covid-19 levels. Applying this downside scenario to the income shortfall calculation would result in an approximate £33m reduction in the valuation.

Impairment review

The fair value of tenant’s fixtures and fittings are removed from the valuation of freehold and long leasehold properties and are subsequently reviewed for impairment by comparing their recoverable amount to carrying values. Any resulting impairment relates to sites with poor trading performance, where the output of the calculation is insufficient to justify their current book value.

Short leasehold and unlicensed properties (comprising land and buildings and fixtures, fittings and equipment) which are not revalued to fair market value, are reviewed for impairment by comparing site recoverable amount to their carrying values. Any resulting impairment relates to sites with poor trading performance, where the output of the value in use calculations are insufficient to justify their current net book value.

Recoverable amount is determined as being the higher of fair value or value in use. Value in use calculations use forecast trading performance cash flows, which are discounted by applying a pre-tax discount rate of 9.9% (2019 7.7%) and a long-term growth rate of 0.0% (2019 0.0%).

Sensitivity analysis

Changes in forecast cash flows, the discount rate or the long-term growth rate could materially impact the impairment charge recognised for tenant’s fixtures and fittings, short leasehold and unlicensed properties.

Forecast cash flows

The forecast cash flows used in the value in use calculations are site level forecasts that form the overall Group profit forecast for FY 2021, in existence at the balance sheet date. Management have determined a potential downside scenario to this forecast which assumes a longer turnaround of profit back to pre-Covid-19 levels. The use of this downside forecast results in a reduction to EBITDA in FY 2021 of 11.2% against the FY 2021 base case forecast. This would result in an approximate £1m increase in the impairment recognised.

Discount rate

The discount rate applied in the value in use calculations is the Group WACC. Over the last three financial periods, the discount rate used in impairment reviews has moved by an average of 0.9%. It is estimated that a 0.9% increase in this rate would generate an additional £8m impairment charge. Similarly, it is estimated that a 0.9% decrease would reduce the impairment charge by £4m.

Long-term growth rate

Due to market uncertainty at the balance sheet date, mainly in relation to the ongoing Covid-19 pandemic, no long-term growth is included in the value in use calculations. However, should a long-term growth rate of 2.0% be applied, the impairment charge would reduce by £5m.

Current period valuations have been incorporated into the consolidated financial statements and the resulting revaluation adjustments have been taken to the revaluation reserve or Group income statement as appropriate. The impact of the revaluations/impairments described above is as follows:

The valuation techniques are consistent with the principles in IFRS 13 and use significant unobservable inputs such that the fair value measurement of each property within the portfolio has been classified as Level 3 in the fair value hierarchy.

The number of pubs included in the revaluation and the resulting valuation of these properties is reconciled to the total value of property, plant and equipment below.

a. The carrying value of freehold and long leasehold properties based on their historical cost (or deemed cost at transition to IFRS) is £2,601m and £181m respectively (2019 £2,657m and £190m).

The tables below show, by class of asset, the number of properties that have been valued within each FMT and multiple banding:

Movements in valuation multiples between financial periods are the result of changes in property market conditions. The average weighted multiple is 8.1 (2019 8.6).

Capital commitments

5.4 POST BALANCE SHEET EVENTS (extract)

UK Government Covid-19 announcements

On 31 October 2020, the UK Government announced a second national lockdown to be effective in England from 5 November 2020 to 2 December 2020. This resulted in mandatory closure of all of the Group’s trading sites in England on 5 November 2020. The impact of this has been included in the going concern assessment on pages 104 and 105.

However, the revaluation of freehold and long leasehold properties, the impairment review of property, plant and equipment and the impairment review of right-of-use assets were performed using known conditions at the balance sheet date. As such, the forecast profits for FY 2021 did not include the impact of a second national lockdown on forecast sales and the expected further reduction in trade rebuild.

The estimated impact of this is as follows.

Property, plant and equipment (note 3.1)

Revaluation of freehold and long leasehold properties

A revised site level forecast, that forms the basis of the FY 2021 Group forecast used in the going concern assessment, has been applied to determine a revised income shortfall for FY 2021.

The impact of this would have been a reduction in the value of freehold and long leasehold properties of £42m. This would constitute an additional impairment charge of £11m in the income statement and £31m revaluation loss in other comprehensive income.

Impairment review of tenant’s fixtures and fittings and short leasehold and unlicensed properties

A revised site level forecast, that forms the basis of the FY 2021 Group forecast used in the going concern assessment, has been applied to determine revised value in use calculations.

The impact of this would have been an additional impairment charge of £1m.

Leases (note 3.2)

Impairment review of right-of-use assets

A revised site level forecast, that forms the basis of the FY 2021 Group forecast used in the going concern assessment, has been applied to determine revised value in use calculations.

The impact of this would have been an additional impairment charge of £2m.