Interactive Investor

Stockwatch: is this taste of luxury worth owning after share crash?

29th July 2022 10:29

Edmond Jackson from interactive investor

These shares are going cheap and seem to have bottomed out. Companies analyst Edmond Jackson gives his view on this yummy stock.

Has an overall 75% drop in this feted growth stock Hotel Chocolat Group (LSE:HOTC) created a buying opportunity? 

Early this year, Hotel Chocolat shares reached 520p on a whopping 80x forward earnings, but have since plunged – initially, as tighter monetary policy tempered growth stock ratings. Then came a 19 July update for the year to end-June that trashed much sense of leveraging a premium global brand. 

A subsequent update yesterday confirmed that a Japan joint venture is in a “civil rehabilitation” process seeking additional capital. Moreover, US shops are being closed albeit with wholesale and online sales retained. 

The “global macro climate” is blamed but this looks like another example of a British retailer finding international expansion tough. Also, it rather puts into question what appeal the company’s products have beyond British palates. 

Summary financial numbers since 2016 in no way justified anything like the premium rating that Hotel Chocolat enjoyed. So-called efficient pricing was based on hope. 

Operating margins have yet to climb above 11%, likely challenging in an inflationary environment. Yes, management has tried to leverage the brand, but capital expenditure has regularly compromised free cash flow and dividends are yet to be restored since 2018. Return on total capital and equity, have fallen from around 30% and may only be around 10% going forward. 

Near-term equilibrium for a stock with a sound UK business 

When a rating mean-reverts from frothy levels, it can overshoot on the downside, perhaps as fund managers seek to eradicate a blot from their portfolio books. Here, Aberdeen Investment Management has so far reduced its stake from 7% to below 5% as of 22 July. 

Showing how a near-term equilibrium may be reached, Hotel Chocolat is trading quite firmly around 135p, despite the “Japan Joint Venture” news announcement adding £6 million of leasing loans to be written off, alongside £23 million loaned to the Japanese venture, we now learn, in which Hotel had merely a 20% stake. 

This capitalises Hotel at £186 million and, with management’s profit guidance implying June 2023 earnings per share (EPS) possibly in a mid to high single-digit area, the stock would still be on a quite demanding 20x price/earnings (PE). 

Yet it is a well-established trait how stocks can trade on a high PE when the market is confident about recovery prospects. 

Unless a recession impacts luxury chocolate sales, and/or the business is hurt by higher costs, it could be vain hope to await a buying opportunity nearer 100p. 

Despite the international debacle, annual group revenue is indicated up 37% to £226 million, ahead of consensus for £212 million, and by 70% in 2019 pre-Covid.  

Latest annual profit is also in line with consensus, where a net £18 million implied normalised EPS of 13.7p.  

But exceptional costs of the Japanese financial write-offs and closing US stores mean a reported annual loss, management says. 

At least there was £17 million cash at end-June, plus a £50 million undrawn bank facility, after Hotel raised £40 million of new equity at 355p a year ago in order to “support growth investments”. 

The interim balance sheet at end-2021 had a satisfactory ratio of current assets 1.6x current liabilities; and for a company with undoubted brand value, intangibles constituted barely 4% of net assets. Property/plant/equipment was nearly half of net asset value (NAV). Hotel is therefore in a sound position to overcome its current challenges.  

I regard the crux for valuation as ongoing UK sales potential versus the question of costs. Management dangles a carrot merely of “transitional” costs, hence higher profits after the June 2023 year; but obviously we are in an inflationary environment.  

Hotel Chocolat - financial summary
Year-end 27 Jun 2016 2017 2018 2019 2020 2021
Turnover (£ million) 105 116 132 136 136 165
Operating margin (%) 11.3 11.4 10.8 -4.4 -4.4 5.8
Operating profit (£m) 11.9 13.2 14.3 -6.0 -6.0 9.5
Net profit (£m) 8.8 10.0 10.9 7.5 -6.5 5.7
EPS - reported (p) 9.8 8.8 9.5 -6.4 -5.5 4.5
EPS - normalised (p) 7.8 9.0 9.6 0.4 0.0 7.5
Operating cashflow/share (p) 9.8 10.8 16.5 19.4 19.4 12.1
Capital expenditure/share (p) 7.4 10.3 7.7 12.1 12.1 16.0
Free cashflow/share (p) 2.4 0.5 8.8 7.3 7.3 -3.9
Dividends per share (p) 0.0 1.7 1.8 0.0 0.0 0.0
Covered by earnings (x) 0.0 5.2 5.3 0.0 0.0 0.0
Return on total capital (%) 31.9 30.7 27.0 -5.8 -5.8 9.1
Cash (£m) 8.5 0.2 5.8 28.1 28.1 10.0
Net debt (£m) -1.6 0.0 -5.8 18.9 18.9 29.5
Net assets (£m) 31.2 39.6 43.3 88.1 88.1 96.5
Net assets per share (p) 27.6 35.1 43.7 53.4 53.4 56.9
Source: historic Company REFS and company accounts

Calling this stock is as much about marketing as valuation 

Hotel has not been on my radar until now because it always appeared over-valued. Management timed the 2016 flotation well, but also got lucky, as excess monetary expansion boosted growth plays to silly levels and helped last year’s capital-raise at low dilution.  

But the situation is now interesting to follow. If management addresses its challenges well enough then a worthwhile business exists – possibly to become a takeover target. Seven years ago, Ferrero bought Thorntons for £112 million. 

I am in no way surprised to see Hotel mean-revert below its 148p flotation price; and mind how the current equilibrium may chiefly reflect enough buyers’ belief that a plunge to 130p appeared too far. 

A key issue – applying generally to “luxury” products – is whether a recession follows, deep enough even to cause affluent people to change behaviour. 

Take your view as to whether premium chocolate sales can stay relatively firm, because enough people still want their treats, or could require discounting to maintain sales.  

Personally, I find nothing special about Hotel Chocolat products, being satisfied with an occasional piece of Morrisons The Best, 85% dark chocolate – which has an improved recipe. And while some rave about HTC’s “Velvetiser” hot chocolate machine (and its doubtless high-margin refills) I am content with Green & Black’s organic cocoa.  

Much of this relates to habit; and in fairness there are Hotel Chocolat addicts likely to continue splashing out for premium gifts at Christmas, Valentines’ and Mothers’ Day, unless say, the quality of chocolate declines – as consumers used to complain about Thorntons, one reason its performance deteriorated as a listed company. 

“VIP loyalty” customers now account for 71% of UK direct-to-consumer sales, up from 44% in the June 2021 year. Innovations such as Velvetiser and Velvetised Cream (with liqueur) have won a cult following – check out the online reviews

Online sales are also up three-fold since June 2019 and perhaps such a transition could cut retail outlets thereby costs.  

So, there are useful prospects to work with, so long as an inevitable UK downturn does not crimp spending on treats. 

Might new auditors challenge aspects of accounting? 

Accounting is possibly low risk, but it’s still worth noting how in March there was a change of the auditors who had served from 2012. With a 27 June financial year-end, they will be working on the current audit.  

Mind, this company declared a very confident outlook with its March interims. Then, after a wheel or two came off, there was the proverbial “internal review”. That begs questions as to controls, hence the chance a new broom uncovers something else. 

Given my conclusion is anyway not to chase this stock for now, I find it prudent to await full audited accounts. 

Will director buying further support the stock? 

Again, a possibility rather than probability – as they already own 54% of the equity – but there are regular examples where substantive owners buy to prop the rest of what they own. 

I would be careful assuming “skin in the game” is reliable to mitigate losing money in stocks. French Connection (now privately-owned) and also Ted Baker (LSE:TED) had founders with big shareholdings and exercising influence in some form or other – but overall marketing success or failure was most significant. 

If you reckon Hotel Chocolat tastes so good, its corporate financial future is assured, buy its equity now. I think pricing is currently fair, hence prefer a waiting game and more evidence. Hold. 

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

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