Interactive Investor

Stockwatch: will consumer spending squeeze dampen appetite for this stock?

5th April 2022 11:29

Edmond Jackson from interactive investor

Although it’s headed by a restauranteur whizz, our companies analyst is concerned about this business’s balance sheet if stagflation bites.

Possibly showing investor complacency as higher household bills impact discretionary spend, shares in the £105 million restaurant group Fulham Shore (LSE:FUL) rose over 6% yesterday to 16.5p, after a 28 March year-end update cited customers returning to its restaurants in increasing numbers”. 

It reflected the fantastic quality and value of the Franco Manca pizzeria and The Real Greek outlets”, where both these brands have delivered strong performance despite government advice to work from home during the Covid Omicron variant. 

Consequently, and despite higher input costs, EBITDA for the March 2022 year will be ahead of market expectations for a reported £16.5 million, and for £9.5 million adjusted. While 10 new openings during the year have boosted the operating numbers, they are nonetheless a material advance on the £7.1 million and £7.8 million achieved respectively in the March 2019 year. 

After amortisation charges, however, and with interest charges taking around a quarter of operating profit, the six-year table shows a business yet to deliver substance at the bottom line. 

Mixed precedents as to pizzerias performance in a downturn 

Headed by restaurateur supremo David Page, who commercialised Pizza Express in the 1980s and 90s, Fulham Shore is an interesting current example of what to make of ‘trailing' numbers for businesses exposed to discretionary spending.  

A long-term bullish case for this stock involves sites becoming available at keener prices as retailers exit high streets, especially if there is any extent of recession.  

Yet I question whether this can offset a potential hit to demand, and also the impact of higher costs such as food input and fuel for transportation in a likely stagflation scenario.  

In the latest financial year, management was able to mitigate cost rises with small mark-ups on menus, generating better results than the board expected. Sharper price hikes could, however, put some customers off dining out. 

More positively, other people might trade down from pricier restaurants to the kind of distinctive artisan pizzerias that Fulham Shore offers. I recall from the early 1990s recession how Pizza Express proved a surprise winner. Similarly, in the aftermath of 2008 Brits who could afford it kept eating and drinking out, this being inherent to our culture.  

Yet a precedent exists of this share derating in 2017, from a circa 15p to 20p range in previous years, to 10p to 12p, until Covid triggered a brief lurch down below 5p. A trading downturn (see lower March 2018 profit in the table) was explained in terms of Brexit uncertainties weighing on consumer spending.  

Moreover, the challenges ahead look worse, especially for middle-income earners – the type possibly frequenting pizzerias – given a need to cut discretionary spending if mortgages and energy/fuel bills are to be paid. 

As the new tax year starts, council tax, national insurance, utility bills for energy, water and telecoms are all going up. 

Tax on share dividends is also going up by 1.25%, which may modestly affect older generationsspending habits. 

How significant is the David Page factor? 

I respect a case for holding a stock like this through difficult times, where the essential business concept is a winner and top management is the best available. 

David Page is a proven restaurateur over 40 years, who grew Pizza Express to over 300 outlets before it was sold to private equity in 2003 for £278 million. Fulham Shore will soon have 80 restaurants fully operational, with 21 further sites awaiting legal completion. 

One dilemma in assessing such roll-outs is guessing the extent of restaurants the UK can support. Plenty have closed since Covid, but the sector was bloated anyway – after cheap debt fuelled expansion and brought inexperienced managers into the trade. Even some high-profile operators such as Jamie Oliver became casualties. 

Yet if anyone has spurs to survive, it should be David Page. His track record in 'develop-and-sell’ includes the Clapham House restaurant group – sold in 2010 for £30 million – which owned concepts such as Gourmet Burger Kitchen, Bombay Bicycle Club and Tootsies. 

Aged 58, he then invested in Franco Manca, a south London artisan pizza operation founded in 2009, specialising in wood-fired and sourdough pizzas. Fulham Shore, Pages investment group, bought a majority stake in 2015 for £27.5 million.  

Nowadays he is chairman with a strategy role, though has also contributed for example in regard to restaurant design. 

Unlike Tim Martin, the boss of Wetherspoons, Page is sceptical about the benefits of Brexit, pointing out that it has raised import prices due to lower sterling and made it harder to recruit staff. 

The upshot for wages in the restaurant will therefore be interesting to see, if any upward squeeze adds to costs. 

The Fulham Shore - financial summary
Year end 28 Mar

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 29.3 40.4 54.7 64.0 68.6 40.3
Operating margin (%) 1.7 3.7 0.3 2.7 2.7 -11.8
Operating profit (£m) 0.5 1.5 0.1 1.8 1.8 -4.8
Net profit (£m) 0.1 0.9 -0.6 0.7 -1.2 -6.3
Reported earnings/share (p) 0.0 0.2 0.0 0.1 -0.2 -1.1
Normalised earnings/share (p) 0.1 0.2 0.1 0.2 -0.1 -1.0
Operating cashflow/share (p) 0.6 1.7 0.8 1.1 2.6 1.6
Capital expenditure/share (p) 1.2 2.1 1.8 0.6 1.3 0.3
Free cashflow/share (p) -0.6 -0.4 -1.0 0.5 1.3 1.3
Return on capital (%) 1.2 3.2 0.3 3.3 1.6 -4.3
Cash (£m) 0.2 0.3 0.4 1.8 2.1 12.3
Net Debt (£m) 3.3 5.9 12.0 9.4 77.7 74.6
Net assets per share (p) 6.4 6.8 6.6 6.8 6.8 5.7

Source: historic company REFS and company accounts

A hold’ if disposable income is not hit too hard  

Were it not for the consumer challenges ahead, I would regard Fulham Shore as a tuck-away based on Pages proven develop-and-sell formula. 

Be aware, however, that this stock listed in autumn 2014 and has essentially traded sideways, the business yet to show real financial substance. Its average trend in operating margin and return on capital employed is modest.

Say EPS near 0.5p is indeed achieved in the current year to March 2023, as per recent consensus, that implies a 33x PE.  

There is no dividend record – admittedly, that’s because profits are re-invested for expansion – and at 16.5p the stock is on 2.75x net asset value of 6p a share.  

63% of Septembers net asset value constituted intangibles, although you could say brand value matters for a restaurant group. 

My broad point is that the basic valuation criteria cannot withstand any material disappointment on trading. 

The stock derated 40% from 2017 on Brexit fears, yet many people now face the sharpest rise in cost of living since the 1970s. In 2017, the stock started falling from mid-year, yet the company took until that Septembers AGM statement to cite a trading slowdown primarily in London suburbs. We believe this is a sector-wide trading pattern and not unique to our brands.”  

Debt and leases also tilt me towards a cautious view 

Last Septembers interim balance sheet showed £75 million in such long-term liabilities and £12 million in short-term. Some 87% of these were leases, though there was still 229% overall gearing, which eased to 187% at the net level when deducting £16 million cash. 

If the group is to take advantage of sites becoming available at attractive prices, this cash is going to reduce. Meanwhile, a stagflation scenario could last two years or longer. 

Who knows how far interest rates will rise, but a £1.4 million first half-year net interest charge swiped 32% of post-exceptionals operating profit. 

I therefore find the balance sheet in a risky position to withstand any material downturn in trading. 

It is really a binary call according to how the economy pans out, given that interim net cash generated from operations was a respectable £15.6 million. But I take a significantly macroeconomic view on companies and am wary about what lies ahead. 

I would therefore avoid such a stock with fresh money, regarding it as a potential ‘buy’ maybe later this year or next. 

If consumer spending derates, then Fulham Shore is in my view a weak ‘hold’ which may be tantamount to ‘sell’, according to your risk preference. Given that capital protection should be a first priority when investing, I conclude: Sell

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

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