Interactive Investor

Stockwatch: intrigue at this retailer prompts upgrade to ‘buy’ 

2nd December 2022 11:07

Edmond Jackson from interactive investor

This company has lost almost three-quarters of its value in 2022, but analyst Edmond Jackson thinks there’s a chance to dip your toe in if you’re happy with some risk.

Since plunging from around 250p last July on news it was writing down aspects of international expansion – Hotel Chocolat Group (LSE:HOTC) found support at around 130p and tested 170p earlier this month. 

I had felt the stock had been overvalued pretty much since its 2016 flotation – yet this mean-reversion intrigued me to examine Hotel Chocolat, concluding “hold” at 135p, but that the shares were worth watching.

While the products have no personal appeal, I respect they enjoy a cult following. Back in 2015, Thorntons had lost a reputation for quality yet was bought for £112 million by the Italian multinational Ferrero – and well-timed investors profited. 

Yesterday’s annual results to 26 June left the stock little changed at 147p which capitalises Hotel Chocolat near £200 million. The release seemed late, probably reflecting work on £30 million of one-off costs and adjusting items, also some restatements for 2021.  

A bit tiresomely, here is another company flagging adjusted EBITDA, up 43% near £41 million. I make the normalised operating profit near £17 million and net profit near £14 million, although the tax charge dropped to just £700k. The EBITDA margin was 18% and management targets 20% by the 2025 year. 

This still flags a decent-quality business so long as “luxury” demand is sustainable. A concern is what scope for expansion if there is a long recession, now that the refocus emphasises UK retailing and international wholesaling. 

I am wary of the company broker’s target for over £30 million profit in 2025. But if £20 million net is a realistic medium-term target, then on 137 million shares issued, earnings per share (EPS) is near 15p, hence a 10x forward price/earnings (PE) ratio. It is unclear quite when any dividend might be reinstated.    

Hotel Chocolat - financial summary

Year-end 27 Jun2016201720182019202020212022
Turnover (£ million)105116132136136167226
Operating margin (%)11.311.410.8-4.4-4.44.6-2.9
Operating profit (£m)11.913.214.3-6.0-6.07.7-6.6
Net profit (£m)8.810.010.97.5-6.53.7-9.4
EPS - reported (p)9.88.89.5-6.4-5.52.9-6.9
EPS - normalised (p)7.89.09.60.40.07.510.0
Operating cashflow/share (p)9.810.816.519.419.412.16.8
Capital expenditure/share (p)7.410.37.712.112.116.023.4
Free cashflow/share (p)2.40.58.87.37.3-3.9-16.6
Dividends per share (p)0.01.71.80.00.00.00.0
Covered by earnings (x)0.05.25.30.00.00.00.0
Return on total capital (%)31.930.727.0-5.8-5.89.113.9
Cash (£m)8.50.25.828.128.110.017.6
Net debt (£m)-1.60.0-5.818.918.929.5-10.9
Net assets (£m)31.239.643.388.163.065.898.4
Net assets per share (p)27.635.143.753.450.452.671.8
Source: company accounts

Conviction “value” is implied by two stakebuilders 

During September to October, Phoenix Asset Management – which runs for example Aurora Investment Trust ARR - raised its holding from 5% just over 13%. 

While that represents a modest £26 million exposure relative to some £1.5 billion equivalent, increasing to that size of holding is riskier than its initial buying – because such a stake gets harder to reverse in a relatively illiquid stock should things go awry.  

Implicitly, this fund manager has decided the potential reward outweighs additional market risk; that Hotel Chocolat’s refocus on the UK can pay off given its luxury brand.  

Quite similarly in November, Odey Asset Management’s special situations fund declared a 3.24% equity exposure via Contracts for Difference, or CFDs, then increased to 3.44%. CFDs can be risky instruments, where you need conviction to act. Quite what timescale may be involved is unclear, or whether the manager can roll the contract over, periodically. 

This “event-driven” fund pursues takeover arbitrage and special situation equity longs; an approach that nearly doubled the fund’s value over two years from launching in October 2019. It is down over 10% this year, however, so rather needs to rescue performance. While it only has assets of around £80 million, it invests globally, with UK bonds representing 18% and UK equity just over 3% of the fund.  

So, unless this manager has lost objectivity as a Hotel Chocaholic, it is interesting that he has alighted on the stock – indeed, leveraged near £7 million exposure via a CFD.  

UK revenue up 35%, but what further scope to develop? 

The active customer database is up 15% to two million, its overall frequency up 14%. It offers some reassurance, a leg is not going to fall off the group as international operations scale down to purely wholesale in the US, and a potential licensing model in Japan albeit after a full impairment of the recent joint venture. 

While international sales more than doubled, it was only near £13 million, or 5% of total. The intent is for a “capex-light, risk-contained, global wholesale model”, but I would tend to write down the real prospect of UK sales and whether Hotel Chocolat will ultimately get acquired like Thorntons? 

Retailing concepts can sustain a growth stock rating for so long as roll-out beckons, but growth inevitably slows, investors lose interest and the company gets taken off-market – growth being revitalised by integration with another sales network. 

Normally, I would say all that is likely to take say three years here, but the stake-building implies two institutions judge it is possible sooner.  

Weak sterling empowers the likes of Ferrero and, if Hotel Chocolat has a firm future, then an opening offer around 250p a share could work for an acquirer and have to be taken seriously. Although I don’t want to over-egg this speculation. 

“A range of possible outcomes” for June 2023 year 

A third of the way through the current year, retail trading is said to be “in line” with last year – a polite term for “flat” while online and wholesale sales are “softer” but not quantified. 

This implies some downside risk as the UK recession tightens, with added uncertainty as tax rises take effect. Christmas period trading will perhaps be even more significant than the update mid-January which cited a 37% revenue advance against 63% in the 2020 year. 

Yet employment levels remain high, recessions can prompt more (self) treating, and high-quality chocolate is nowadays rated almost as a health food. “Luxury” spending is going to see some fall, but the company appears already to have guided its broker for around £8 million net profit this year, i.e. is in the market.  

Hopes are high for the “Velvetiser” in-home hot chocolate system, claimed to deliver a barista grade drink and which costs over £100 to get started, although quite how many (doubtless high-margin) chocolate powder refills will get sold is unclear. Reviews rate the Velvetiser highly but find it works with any cocoa type powder. One domestic machine seems unlikely to re-rate revenue, so the broad question remains about the durability for premium chocolate sales.

Potentially more to net asset value than the balance sheet 

Within £89 million net assets last June, there were just £2 million intangibles yet £69 million property/plant/equipment. This reflects organic development rather than acquisitions generating goodwill, but I think brand value genuinely exists, hence true net asset value per share is likely greater than 72p, accounted for.  

I begin to think that buyers around the 125p low were getting it fully asset-backed. 

Financial liabilities are chiefly £54.5 million leases and there is also a credit facility with £32 million unutilised. The balance sheet cites near £18 million cash but the release “£9 million cash on hand”.  

Inventories have risen 34% to £43 million but, as a percentage of turnover, have eased from 19.5% to 19.0%. Longevity of the chocolate is a concern if a serious recession hits sales, so mind the write-down risk. 

Scope to upgrade from 'hold' to 'buy' 

My purpose is to update from July, and a sustained modest price rise implies that on current insights the stock’s technical position is sound. 

Upgrading would depart from my base-case, which acknowledges that we are still at an early stage in a downturn and that it is sensible to let bad news manifest in company updates. The general aim is to buy nearer “trough earnings”. 

Yet a £540 million recommended offer has been made for sausage skin maker Devro DVO from a European group. Devro traded on a modest rating, but the move implies overseas industry at least, is not waiting.  

A compromise would thus be a small, knowingly risky, starter position in Hotel Chocolat. Buy. 

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

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