Hotel Chocolat Group ($HOTC.L)
Turnaround idea - Premium products, no debt and owner-operator at a compelling valuation
“Making people happy through chocolate”
Hotel Chocolat Group (HOTC), founded by CEO Angus Thirlwell and Development Director Peter Harris, started out as a digital and subscriptions business in the 90s selling chocolate. Today HOTC is a vertically integrated premium producer with roughly 130 shops, cafes, restaurants, outlets in the United Kingdom, which bring north of £1M in revenue per store, a wide and innovative product range and an active subscriber base of 2,75 million people. New products such as the Velvetiser (Hot chocolate machine) and a new rigorous, profit-driven strategy have made HOTC an interesting idea on the backdrop of a recent halving of the share price.
HOTC IPO’d in 2016 on the London stock exchange and has a £163 MM market cap as of 22-07-2023. The active founders (Thirlwell, Harris) still hold 27% of the company a piece. The company has been debt-free since 2018. In 2022 sales consisted of 48.4% from UK stores, 46.5% from digital sales and the rest from international sales. From the IPO up until Covid HOTC showed healthy organic growth with revenue growth of 14.2% CAGR and 18.4% CAGR for EBITDA. In the light of the pandemic HOTC’s increasingly subscription-driven approach proved invaluable, which is reflected in the stubborn stock price during the period and exiting into a post-pandemic rush, which is to be credited mostly to unsustainable margins and led to a sharp plunge.
Why did HOTC go from £5.40 to £1.40 in under a year?
High inflation and difficulties in keeping personnel have been key issues for almost all UK companies, but most of all a failed international launch is the scapegoat in HOTC’s instance. In 2018 the company started opening stores in Japan and in 2019 in the US. The expansion was out of control and built on a fragile base which in 2022 led to the company announcing the shutting down of all stores in Japan. At this point these stores generated 3% (!) of revenue and the write-off of the international assets (among other minor things) resulted in a 45% (!) drop in the stock price. However, HOTC still had 200,000 subscribers in Japan, so through a Joint Venture they are now capitalising on that market with a more conservative and safe approach. All stores and online sales remain closed in the US for now, with a possible shift from B2B to B2C coming in the future. The expansion in 2018 was rushed and partly unjustified because I still see some runway in the UK for HOTC, as do they when forecasting 50 new UK stores in 3-5 years.
As a product of the uncontrolled and rapid post Covid expansion both operating and net margins took a tumble as inventories and overhead costs rose to unsustainable levels. The margins for FY2023 will also be low due to the construction of a new distribution centre, which in turn will prove to greatly increase operating capabilities in the mid-term. Margins are also heavily weakened due to the current high levels on inflation.
Outlook
The short-term outlook for HOTC is quite shaky. The company stated that it will streamline operations and focus on the most profitable aspects of its business, which is to say that growth will be stunted in the short-term for a better chance for organic and sustainable growth in the mid-term. They call it a “once in a decade simplification plan” and target 20%+ EBITDA margins pre IFRS16 by FY25, which is very optimistic. The margins should therefore see a return to previous levels once the restructuring is underway and the UK gets a hold on inflation, with a target of around 4%.
The business continues to operate as usual and demand is growing, with a 7% L4L increase in store sales for the first half of 2023. The shift towards an increasingly subscription-based business is also a good sign as customer retention and the stickiness of revenues improve. The VIP loyalty program had 2.8 million subscribers at the end of FY2022 and the customer base continues to grow at a steady rate with 14% YoY growth in customer frequency. Innovation is also key for growth, as their hot chocolate machine, the Velvetiser, accounts for 5.5% of sales while being sold in only 45% of stores. The store economics are also great, as a store takes less than a year on average to turn profits with revenues over a million.
Through the Japan JV HOTC has a 20% exposure to the 20 or so stores that are to be opened, which is a sound and low-risk plan to capitalise on the existing customer base. The strategy regarding the US market is still under evaluation, but we could very well see a similar approach once the Japan JV is up and running.
The company is positioning itself to minimise risk and focus solely on their strengths, while learning from past mistakes an applying lessons into the coming expansion. I do not see any substantial disruptors in the chocolate business in the UK, and once the above mentioned weak points are addressed as outlined by management, the company is set to capitalise. However, their future seems to depend more on their environment than the company itself, but if and when she UK capital markets take a turn for the better HOTC should be well positioned as a well managed, debt light company with plenty of growth drivers. However, in the short-term, I see that the share price could still fall when the markets react to the weak FY2023 results and does not account as much for the restructuring happening.
*Rough* valuation
Assumptions:
A 10% drop in revenues for FY2023 and 8% growth after that
14% EBITDA margins for FY23 & FY24, 16-18-20% for FY25-26-27
165 UK stores by FY2027 with 5% L4L growth for old stores and 7% for new
Enterprise multiple of 8,00x which is fair/optimistic, previous multiples were overvaluations
No debt, £50M credit-line undrawn
3% share dilution
The company expects between 4 and 7 million PBT for FY2023. The company is well financed with a net-cash position of £15M. Assuming all of the above and not taking international sales into account I land at a 5-y annualised CAGR of 23%, which would be fantastic, but this scenario is very idealistic and the valuation is very simplified. Goes to show that if the macroeconomic environment is to turn favourable, HOTC can see significant growth and provide great value for investors.
Conclusion
The business is experiencing mostly temporary problems and is affected by low discretionary spending in the UK. As a company it is healthy, has incentivised management and has a clear path for the coming years. The products are quality and in high demand, stores are found at top locations, and new store openings will accelerate growth further. For FY2023 growth should not be a concern, but how well management has completed the changes it set out to do. At the moment I do not hold a position in HOTC, but will be monitoring it for the future.
NOTE: This does not in any way constitute investment advice and is for educational purposes only. This is not a BUY or SELL recommendation, this is my own opinion. Any investment decisions should not be based on Smart Micro Caps articles. I encourage all readers to do their own due diligence and contact authorised professionals for advice.
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