Interactive Investor

Stockwatch: capital growth and good yield trigger upgrade to buy

Having previously made a big profit on this share following a well-timed sale, analyst Edmond Jackson thinks it’s time to buy back into this interesting small-cap business.

9th April 2024 11:19

by Edmond Jackson from interactive investor

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Upgrade to buy with a series of colourful arrows pointing upwards

As AIM-listed cream cakes retail-franchiser Cake Box Holdings Ordinary Shares (LSE:CBOX) issues a rather better-than-expected trading update, comes news from BDO that UK business output has grown for the second consecutive month to its highest level in two years. Meanwhile, Deloitte says corporate sentiment has risen for a third consecutive quarter.

Perhaps we need to move on from the “Mars bar index” – whose price has accurately tracked the value of the pound since the Second World War – to consider the “cream cake index” as a measure of macro developments.

Meanwhile, and assuming a fair trading scenario continues, at around 165p this share offers a 5.6% yield with 1.3x earnings cover, and most likely better cover in terms of free cash flow. Not only does a retail operation tend to be inherently cash generative (it’s why the likes of Sainsbury (J) (LSE:SBRY) tends to be regarded as reliable for yield), a franchise set-up enhances this further.

Given the company is 225 stores into a UK-wide roll-out of 400, unless consumer spending takes a dive, it looks positioned to deliver capital growth with decent yield.

I would not opt for a focused position - Cake Box looks an example of one of several interesting small-caps an investor might use as supplementary to core holdings within a diversified portfolio.

Founded by Hindus, Cake Box occupies the “free from” food retail space; in this instance, from egg. This can mean a lot of cream to offset relatively dry sponge, although Trustpilot reviews have improved, this having previously been a complaint. Opinion does divide over the cakes’ sweetness. It is a tricky product for me to judge given I would never want to eat it, but I respect financial delivery as the ultimate test.

Continued momentum in the second half to 31 March

The share price was already rising when interim results were reported last November, and this has persisted with the help of further new store openings (20 for the financial year as a whole), positive sales growth and higher online sales with new products launched.

This has resulted in around 9% annual revenue growth to near £35 million, with 4% like-for-like growth at the shop level as franchises roll out. The holding company makes money providing ingredients to franchisees and on revenue sharing – hence its published revenues will always be comparatively lower than a regular retailer.

Operating margins are thus relatively higher, the table shows over 20% until post-Covid cost inflation cut it to 16%. Management now says material cost inflation “continues to stabilise”.

I would therefore not raise profit expectations too high given we know from our own shopping that prices have inflated but are not coming down. Also, if central banks leave inflation at 3% or so, in eagerness to cut interest rates, businesses can only go so far exacting efficiencies to compensate.

The overall message is adjusted annual profits slightly ahead of expectations.

Cake Box Holdings - financial summary
Year-end 31 Mar

Turnover (£ million)5.68.712.816.918.721.933.034.8
Operating profit (£m)
Operating margin (%)21.722.926.326.320.319.423.716.0
Net profit (£m)
Reported earnings/share (p)
Normalised earnings/share (p)
Operating cashflow/share (p)
Capital expenditure/share (p)
Free cashflow/share (p)               4.0     
Dividend per share (p)
Covered by earnings (x)
Return on capital employed (%)58.746.254.043.833.
Return on equity (%)52611678.453.238.830.843.324.5
Cash (£m)
Net debt (£m)1.52-0.9-0.9-2.1-4.0-2.6-3.7
Net assets (£m)
Net assets per share (p)

Source: company accounts.

What might be fair value?

Cake Box listed at 108p in June 2018, a decade after founding. I rated the shares a speculative “buy” at 164p that September and again at 170p in June 2019. They had a great run to 400p by November 2021 but that July at around 330p I questioned for how long a high price/earnings (PE) multiple of 25x could last. I suggested “locking in some gains for prudent risk management”.

A savage correction ensued: in early 2022, down over 20% after accounting inconsistencies were identified; then in August a 40% slump after a “significantly more challenging” trading context was experienced. Input cost inflation had compromised margins and sales slipped, albeit less than 3% and during a heat-wave.

Investors were cautious to back recovery prospects amid a cost-of-living crisis. Yet the shares bottomed at 108p in November 2022 and have since been in a steady overall uptrend.

At around 165p, the forward PE multiple is around 13x relative to possibly 11% earnings per share growth this financial year, without upgrading 2025 prospects. Market value is nearly four times net asset value, although a relatively robust yield above 5% should limit downside. Last September’s interim balance sheet had £7.1 million cash relative to a circa 8.8p per share dividend in respect of the March 2024 year, costing £3.5 million.

It seems unlikely any other dedicated retailer of egg-free cake will materialise and try to muscle-in here. My concern had been that supermarkets would copy the product for their shelves. Cake Box did start to introduce kiosks in supermarkets - the last I saw was 35 - but there is no update. The marketing pitch is anyway around creating indulgences for a special event rather than one or two uniform supermarket products.

Encouragingly, the company says: “The demand for new stores remains strong among the group’s existing franchisee base as well as new enquiries from prospective franchisees.”

That appears to offer plenty of mileage unless the brand somehow sabotages itself. Even if growth prospects slow a few years ahead, if the operation is well run it should throw off material cash. With the PE in low teens, it is not as if (like in 2021) there is risk of a drop back with the shares going “ex” the growth hopes.

It therefore looks to me as if Cake Box can regain 200p and build steadily over 250p on the basis of achieving earnings per share (EPS) of 20p. Again, the business model is attractive in the sense of not requiring dilution.

In terms of stock market risk, the traders have been and gone – using this share as a momentum play during Covid lockdowns. Sentiment seems altogether more cautious which should be good for patient investors.

The financial summary table above shows dividend growth has been consistent from 2019 after flotation, even if there was a 2020 Covid disruption.

Indulgent cakes are not my sense of eating, and so many campaigns tell us not to overdose on refined sugar and saturated fat. But are people generally taking any notice? Even if they do, perhaps they still want to indulge, especially at celebrations, hence are also prepared to pay a premium for what they want.

On one occasion in a dentist’s chair, the medic told me while she inspected and relayed what not to eat: “Tests on rats show they eat measurably until given a mix of sugar and fat. Then they gorge.”

Assuming people do not change, it therefore seems fair to consider Cake Box shares as one means to achieve a benchmark 5% dividend income.

Australian investor appears over the disclosure threshold

In terms of institutional share trading, the only significant change lately has been River Capital Pty of Australia, going over the 3% disclosure threshold last 1 December, to own 4.6%, which on 23 February rose to 5.8%. This position is worth less than £4 million but is interesting how Cake Box has got on to an international investor’s radar for small-caps. I imagine this manager sees a medium to long-term, attractive risk/reward profile based on the yield currently over 5% and scope to nearly double the franchised estate.

As a patient situation: Buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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