Interactive Investor

Stockwatch: an exciting small-cap share in a sweet spot

2nd July 2021 10:14

Edmond Jackson from interactive investor

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Our stock picker takes a look at whether this small-cap retailer can keep the sweet treats coming for investors.

At around 330p after the latest annual results to 31 March, this AIM-listed franchiser of cream cake outlets Cake Box Holdings (LSE:CBOX) would initially appear a key beneficiary of the Covid era.

After floating three years ago at 108p, its stock jumped to over 125p, then traded in a sideways channel. It topped at 175p, but then in March 2020 saw a drop to 112p. It then embarked on a bull trend that accelerated from last September, and in the last 10 weeks has soared 26%. 

I have been positive on the company since drawing attention as a 'buy' in September 2018 at 163p – along a rationale of British weakness for cake as shown by popular fixation with the Bake Off shows.

Mind, the Hindu founders were also capitalising on demand for egg-free cake which is certainly a niche, but quite how many people nationally like relatively dry sponge with lots-of-cream (a typical critique on review sites). Lately, however, Cake Box has also capitalised on trends such as vegan and gluten-free. 

But if a published forecast of £4.8 million net profit this year is fair, implying earnings per share (EPS) around 13p, the price/earnings (PE) ratio reduces from 34x the latest annual outcome to 25x.

Such a rating could be justified if Cake Box genuinely has dialled into popular “free from” concepts, and I recall such food manufacturers supplying supermarkets enjoying high PE’s before eventually being acquired.  

Aside from marketing questions, bear in mind there are advantages and disadvantages with a franchising business model. In the near term, profit is helped by a low and flexible cost base, as evidenced by a gross margin close to 50% and operating margin near 21.5% in the latest accounts.

But since revenues reflect the sale of franchises and ingredients, than finished cakes, they will likely skew towards the early years of the chain’s roll-out.  

There looks a potential situation – perhaps a few years away though – where cake sales and customer reviews are going really well – yet the company’s growth rate is liable to slow if the pace of franchisees joining the bandwagon does.

Cake Box Holdings - financial summary          
year end 31 Mar   2016 2017 2018 2019 2020 2021
Turnover (£ million)   5.6 8.7 12.8 16.9 18.7 21.9
Operating profit (£m) 1.2 2 3.4 4.4 3.8 4.2
Operating margin (%) 21.7 22.9 26.3 26.3 20.3 19.4
Net profit (£m)   1.1 1.6 2.8 3.0 3.1 3.4
Reported earnings/share (p) 2.7 4.1 6.9 7.5 7.8 8.4
Normalised earnings/share (p) 2.7 4.1 6.9 8.7 7.8 9.6
PE ratio (x)             34.4
Operating cashflow/share (p) 5.4 1.5 8.0 7.9 8.3 13.0
Capital expenditure/share (p) 1.4 1.0 1.3 5.3 3.1 1.8
Free cashflow/share (p)            4.0            0.5 6.7 2.5 5.2 11.2
Dividend per share (p)       3.6 3.2 5.6
Covered by earnings (x)       2.1 2.4 1.7
Return on capital employed (%) 58.7 46.2 54.0 43.8 33.2 27.0
Return on equity (%) 526 116 78.4 53.2 38.8 30.6
Cash (£m)   0.2 0.5 2.5 3.1 3.7 5.2
Net debt (£m)   1.5 2 -0.9 -0.9 -2.1 -3.6
Net assets (£m)   0.4 2.4 4.7 6.6 9.5 11.1
Net assets per share (p) 1.0 6.0 11.7 16.6 23.7 27.8
Source: historic Company REFS and company accounts      

I have seen this so many times with smaller “roll-out” stocks which achieve a high rating until there is an approaching sense of market saturation. Then it drops. 

Having argued 'buy' for example last June and October, last April at 261p I moderated to a 'hold' stance and suggested buying dips, given the next two years still look promising for rolling out the Cake Box concept.

Yet the advance to 330p does significantly look to involve enthusiasm for small-caps in a bull market, the chart’s uptrend seems to reflect current risk appetite as well as a good story. 

If the wider market was to dive say on inflation proving more stubborn and translating into wage increases, than “transient” claims suggest, risk preference in equities could alter radically.  

Doing well despite Covid’s early impact on last financial year 

Annual revenue rose 17% to £21 million, with record franchise sales were achieved despite outlets’ closure for the first six weeks of the pandemic. There were 24 store openings during the year, taking the total to 157 at end-March and “we have a record number of holding deposits for new franchises…underpinning our confidence in opening 18-24 stores this financial year”. Nine have already opened. 

“Kiosks” in shopping centres and supermarkets are also going ahead “together with online delivery through third party platforms as well as our own delivery platform”. The revenue model needs clarifying here as a shift to more directly-owned revenues – if that is happening - could mitigate my concern about those from new franchisees slowing. 

Pre-tax profit is up 12% to £4.2 million, although management presents an adjusted number of £4.7 million - up 25% - after a £486k provision for a website data breach (a £175k equivalent fine via its data service provider also professional fees involved). 

While you could question aspects of control at a smaller plc, data breaches seem a feature even of big business nowadays. It does appear a one-off not the start of a chronic gap between reported and normalised profit for example at acquisitive companies, where advisory fees and share-based payments are lumped with the cost of goodwill/intangibles.  

Reported net profit just shy of £3.4 million compares with £3.6 million expected hence may be seen as a modest “beat” when normalised. Similarly, normalised EPS is 10% ahead of forecast. Net cash from operations soared 55% to £5.2 million supporting a 38% rise in cash at bank to £5.1 million, also a £128k debt repayment and a 26% rise in dividends with over £2 million paid out.  

Mind how it is easier for smaller companies to achieve this when the going is good and from a low arithmetic base. 

Also, how Cake Box has quite supported growth during its last financial year by way of a circa £50k each, lending facility to 16 franchisees who had difficulty obtaining loans during Covid. This appears to have been funded comfortably out of cash flow given near-term debt of £168k remains stable and £1.3 million longer-term debt is down by 9%.  

AXA Investment Managers now own 5.7%  

Beware reading too much into institutional stake changes, which can happen for reasons other than a company-specific view – such as a shift in overall risk preference, or insurance companies funding their liabilities. 

But last April I noted how AXA Investment Managers had trimmed its stake from nearly 8% to 5%, as if shrewd risk management, given it is only possible to lock in gains on a chunky small-cap stake when strong demand exists. Well, on 21 May, AXA bought another 0.7% of the equity so at least no longer appears a seller. 

Mind how sentiment is likely to focus on profit dynamics  

Possibly for a few years yet, Cake Box should deliver exciting growth – a sweet spot, serving the nation’s sweet tooth. Despite obesity now an epidemic and Britain the fattest nation in Europe, warnings to people about diabetes seem to fall on deaf ears. I therefore find an outright “sell” stance premature.   

Marketing-wise, my concern remains as to the national extent of demand for cake that is free from egg or gluten or dairy-free – but genuine demand for such options should offer franchisees a secure future. Time will tell as to any saturation point. 

But this stock is chiefly about perception of earnings growth and should that falter, net assets are sub-28p a share. Assuming the dividend rises towards 7p a share, the yield would be only 2%. There is no prop. Pay-outs need to substantially increase otherwise once considered “ex-growth” the stock will de-rate to a price that exacts a yield enough to counter selling by growth-oriented investors.  

​A case to lock in some gains

Within an overall 'hold' stance I therefore suggest holders consider locking in some gains for prudent risk management.

Both the current bullish sentiment to small-caps may change, and Cake Box has yet to show its business model is long-term durable – at least for the kind of growth rates, small-cap investors tend to expect. If your risk appetite is sufficient, then Hold.  

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

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