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

Mitchells & Butlers plc  – Annual report – 24 September 2022

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. No adjustments have been made in the period.

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 comprising estimates of both fair maintainable turnover (FMT) and fair maintainable operating profit (FMOP); and estimated fair 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 estimated fair value. Where sites have been impacted by expansionary capital investment in the preceding twelve months, fair maintainable trade 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.

Accounting judgements

Revaluation of freehold and long leasehold properties

The revaluation methodology is determined, with advice from third-party valuers, incorporating management judgement where appropriate. 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 freehold and long leasehold licensed land and buildings.

At the prior period reporting date of 25 September 2021, judgement was applied to determine the most appropriate measure of site level fair maintainable trade. Given further periods of enforced closure, as a result of Covid-19, persisted throughout the majority of the first half of the financial year, the 52 week average trading performance to March 2020 was still considered to be the most appropriate measure of site level fair maintainable trade in the prior period.

The emergence of the Omicron variant of Covid-19 in November 2021 negatively impacted trade in the first half of the current financial period. As a result fair maintainable trade at 24 September 2022 has been determined by adjusting the prior period fair maintainable trade on the basis of turnover (FMT) and operating profit margin (FMOP) performance trends over the second half of the financial period. This adjustment is a matter of judgement that reflects the extent to which licensed property fair values are being impacted by performance over this period, as advised by third-party valuers.

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 fair maintainable trade, as the current period trading performance includes a period of closure. Fair maintainable trade has been determined by estimating both FMT and FMOP by reference to post-investment forecasts and turnover trends post opening.

Brand standard property multiples have been established by CBRE via third-party inspections of 20% of the freehold and long leasehold licensed property estate. Market conditions that resulted in Covid-19 multiple reductions in the prior period are no longer considered relevant by CBRE due to the strength of the property market. As a result the average multiple adopted has increased at 24 September 2022.

Further judgement is required where the property value derived purely from a multiple applied to the fair maintainable trade misrepresents the underlying asset value. In this instance, management apply a spot valuation.

Impairment review of short leasehold and unlicensed properties

For the short leasehold property impairment review, judgement has been applied to determine the most appropriate site level profit and cash flow forecasts based on the Group forecast for FY 2023 to FY 2025 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 attributable to a site on a consistent basis.

Significant accounting estimates

Revaluation of freehold and long leasehold properties

The application of the valuation methodology requires two significant estimates; the estimation of valuation multiples, which are determined via third-party inspections; and an estimate of fair maintainable trade, consisting of estimates of both fair maintainable turnover (FMT) and fair maintainable operating profit (FMOP). FMT and FMOP are determined at a site level by reference to both historic and future projected income levels. The valuers also make reference to market evidence of transaction prices for similar properties to support the multiples adopted. There is considered to be a significant risk that an adjustment to either of these assumptions could lead to a material change in the property valuation within the next year.

A sensitivity analysis of changes in valuation multiples and fair maintainable trade, in relation to the properties to which these estimates apply, is provided on page 136. The carrying value of properties to which these estimates apply is £4,036m (2021 £4,277m).

Other sources of estimation uncertainty

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 136. The carrying value of assets to which these estimates apply is £134m (2021 £146m).

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 £41m (2021 £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 £3,577m (2021 £3,806m), which are pledged as security for the securitisation debt and over which there are certain restrictions on title. Further details of the securitisation are provided in note 4.1.

Cost at 24 September 2022 includes £17m (2021 £14m) 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 24 September 2022, using information provided by CBRE, independent chartered surveyors. The valuation was carried out in accordance with the RICS Valuation – Global Standards 2022 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 rebuild in trade following reopening as a result of Covid-19, current cost inflationary pressures notably on labour and energy costs, as well as location, quality of the pub restaurant and recent market transactions in the sector. In the current period, CBRE have increased the property multiples by removing the deduction applied in the prior period for the expected impact of Covid-19. Property multiples have returned to pre-Covid levels, with some brand multiples exceeding the pre-Covid level, which is a reflection of the current demand in the freehold licensed property market.

Sensitivity analysis

Changes in the fair maintainable trade, or the multiple could materially impact the valuation of the freehold and long leasehold properties, and as such they are both considered to be significant estimates in the current period.

Fair maintainable trade

As noted in the accounting judgements above, fair maintainable trade in the prior period was determined by reference to the trading performance up to March 2020, the point of the first full lockdown following the emergence of Covid-19, in conjunction with the previous two years of trading performance. In the current period, site level fair maintainable trade has been adjusted to reflect more recent performance, by adjusting fair maintainable turnover (FMT) and fair maintainable operating profit (FMOP) with reference to both sales and profit margin trends over periods 7 to 12 of FY 2022 (13 March 2022 to 27 August 2022).

In the current period, fair maintainable trade has declined by 8% as a result of the combined impact of the FMT and FMOP adjustments made. Judgement has been applied to determine the adjustments to FMT and FMOP, by assessing the extent that current trading performance is considered to be impacting on freehold licensed property values. As a result, the valuation is sensitive to the view taken on the duration of the impact of high inflation on fair maintainable trade. Should the fair maintainable trade used as the basis in property valuations decline further in line with EBITDA trends over the second half of the reporting period, fair maintainable trade may decline by a further 8%. Assuming multiples remain stable, and without applying any further judgement on the resulting property valuation, this would generate an approximate £284m reduction in the 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 0.3, which is considered to be within the range of reasonably possible outcomes for future movements in multiples. It is estimated that a 0.3 change in the multiple would generate an approximate £115m movement in valuation.

Impairment review

Short leasehold and unlicensed properties (comprising land, buildings, 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 pre-tax cash flows, for years 1 to 3. These include steady growth in revenue and cost increases, notably across energy, labour and food, equivalent to c. 10% of the cost base in year 1, with an easing of inflationary pressure in years 2 and 3, as recent increases in energy prices are assumed to reduce, albeit they remain significantly ahead of historical levels. The forecast cash flows are discounted by applying a pre-tax discount rate of 9.65% (2021 9.60%) and a long-term growth rate of 2.0% from year 4 (2021 2.0%). The long-term growth rate is applied to the net cash flows and is based on up-to-date economic data points.

Sensitivity analysis

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

Forecast cash flows

The forecast pre-tax cash flows used in the value in use calculations are site level forecasts determined from the Group forecast for FY 2023 to FY 2025 that was in place at the balance sheet date. Management has determined a potential downside scenario to forecast trading as part of the going concern review discussed on pages 121 and 122. This would result in an increase of £2m to the impairment recognised.

Discount rate

The pre-tax discount rate applied to the forecast cash flows is derived from the Group’s post-tax weighted average cost of capital (WACC). The assumptions used in the calculation of the Group’s WACC are benchmarked to externally available data. A single discount rate is applied to all cash-generating units. Over the last two financial periods, the discount rate used in impairment reviews has moved by 0.1%. There is no material impact on the impairment charge to changes to the discount rate within a reasonable range.

Long-term growth rate

The long-term growth applied to the net cash flows in the value in use calculations is 2.0%. There is no reasonable scenario for the long-term growth rate under which further impairment occurs.

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 is £2,549m and £177m respectively (2021 £2,601m and £180m).

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 8.7 (2021 8.4).

Capital commitments