MORAM - Hotel Chocolat : A turnaround idea in the consumer discretionary sector
Sunday 9th April 2023
Today, we are sending a mini-thesis on a company that I've been familiar with since I arrived in London in 2019. The company is called Hotel Chocolat LON:HOTC, and it is a chain that sells chocolate-related products targeting a premium clientele. Since its stock market debut back in 2016, this company has always traded at demanding multiples (high growth and good margins to support it), but over the past 12 months, due to a series of circumstances discussed in the article, its share price has fallen by up to 75%. In today's article, we analyze the events that have triggered this decline and assess to what extent it is justified. We also perform a simple valuation of the company using our conservative scenario and share several thoughts on the company and the macro discretionary consumer spending sector.
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What is Hotel Chocolat LON:HOTC ?
Hotel Chocolat is a British vertically integrated premium chocolate producer, manufacturing their range of chocolate products from their factory based in Huntingdon, Cambridge. The company produces a broad range of chocolate-based products, from regular bars to hot chocolates, and other related products. They sell their products online, wholesale and through their stores mainly in the UK. They also produce a small quantity of their own cocoa on their 140-acre cocoa plantation in Saint Lucia, where they also happen to run a boutique 14 room hotel. Hotel Chocolat made its IPO on the London Stock Exchange in 2016 and trades at a market cap of around £250 MM as of today. From 2016 to 2019, revenues grew at a 13.3% CAGR, with EBITDA growing at almost 19% CAGR (grew at a much higher rate post-COVID, but the margins were not sustainable, so we believe that this data is the most indicative in a normalized environment).
Hotel Chocolat is an example of successful entrepreneurship history. Angus Thirlwell (CEO) and Peter Harris (Development Director) founded Hotel Chocolat selling chocolates online in 1993. They both maintain 27.1% of shares each. They opened the first shop in North London in 2004. And since then, the company has grown to have 126 shops, cafés, restaurants, outlets, and factory stores. The group also has a chocolate thematic hotel in Saint Lucia. For 2022, 48.4% of sales came from UK own stores, 46.5% were digital sales and the rest were international.
The business model is as simple as designing and manufacturing semi-luxury chocolate products for later distributing directly both online and physical shops. Hotel Chocolat offers boxed chocolates, semi-luxury gifts, and chocolate slabs for anniversaries, birthdays, or other special celebrations. Targeting premium customers and with an increasingly subscription-based model, the average revenues for every store is more than one million per year.
Could Hotel Chocolat LON:HOTC current share price represent an attractive opportunity?
We have known Hotel Chocolat since 2019 and have been intermittently monitoring it since then. It is a company that, logically, suffered during the pandemic but experienced enormous growth in 2021 (online), trading at an all-time high in October 2021. Since then, the share price has fallen 66% (with a nearly 75% drop in the summer of 2022) for several reasons, including high inflation in the UK and difficulties in retaining staff, as well as the fiasco of their international expansion. When a company on our watchlist experiences such a significant decline, we resume our analysis where we left off last time and try to understand if this drop is justified. If you've been following our analyses, in recent months we have been focusing on consumer discretionary (you can see various analyses of companies in this sector on our website). To do this, we will first attempt to understand what caused the decline:
Write off of international assets: The company started their international expansion in 2018, opening stores in Japan, and in 2019 the United States. This expansion was not under control, so the company was forced to take a step back, shutting down the Japanese stores in 2022 and putting in stand by the US expansion. The business in Japan suffered a £22.4 million impairment in 2022 (fiscal year ended in June). Hotel Chocolat crashed 45% following this announcement while Japanese sales were just 3% of total revenues. We believe the market has gone too far overreacting to the failure in the international expansion.
We did not understand the strong store opening in the US and Japan, as we think they can continue growing more in the UK and Ireland and, in the mid-term, in closer countries in Europe. After the failure in these markets, the company has taken a different approach to international expansion, closing all US stores and online selling, and opening new shops in Japan through a Joint Venture (to take advantage of its 200k subscriptors in Japan).
Lower margins: Following an uncontrolled post-Covid expansion, the company struggled to manage the excessive growth in overhead costs and inventories, which had a highly detrimental effect on their margins. Related to the inventory problems Hotel Chocolat is facing, when visiting their stores we were surprised by the continuous offers and discounts. In our view, to consider themselves an accessible luxury company, we think that discounts should not be so often. For 2023, the margins will also assume a 300 bps worsening due to the construction of a second distribution center, which will substantially increase the operating capacity of the business.
Additionally, Hotel Chocolat (as well as the rest of the industry in the UK) is having significant issues retaining staff. Recently, Hotel Chocolat has launched a program for all the employees. The options will be exercisable at £0.001 and there were 218,028 outstanding at FY22. Although we understand that in such a situation it is difficult to retain talent, we think it is too loose and the incentives are not that aligned. The share based payments are expected to be £2.5MMin 2023 (company is currently trading at £1.8). If the share price continues to decline, the dilution could be huge, making the company unattractive. The option plan remuneration for directors is much more ambitious with a LTIP that has a minimum threshold price at a share price £4.72 with full vesting at £12.00.
Bad perspectives in the short term: Hotel Chocolat has decided to stop the growth for 2023 and focus on the margins, having tighter inventory management, distributing directly from their Distribution Centers and cutting in costs like online marketing. The lower inflation should also help to return the margins back to pre-Covid levels (we are not talking about 1% inflation, but real inflation in the UK is 16% (source Trueinflation), we think as a base scenario around 4-5%). If the market focuses on 2023 results and does not reflect on the cost management and store openings, we would not be surprised at all by further drops in price.
Post-Covid growth was excessive for company possibilities, and the international strategy was proven wrong. The company has reacted to the setbacks and changed their strategy to reverse the situation. The wage increase has also started to be controlled, with a decrease on the wage expenditure on 1H23 vs 1H22. We are confident that margins can return to 17-18% for 2024 onwards, a bit below the company expectations of +20% for the 2024-2025 period.
Reasons to believe in a turnaround LON:HOTC
The strength of demand continues to be tangible, with a 7% increase in sales in the stores on a like-for-like basis for 1H23, with a new record for Christmas campaign sales. The total decrease in revenues comes from the decrease in online sales. On the one hand, intended by the company to control the inventories and the margins and on the other by an after Covid willingness to buy at stores recovery. And also for the international strategy change. The UK is one of the largest chocolate consumer countries. The chocolate industry is expected to grow at moderate paces, mainly driven by increases in prices. We do not expect any disruptive force in the market that could impact Hotel Chocolat.
Following the company's strengths, the company has shown their ability to produce innovative products such as the Velvetiser (a hot chocolate machine), now present in around 890,000 households in the UK, which accounts for 5.6% of retail sales being only present in 40% of stores. So, we are not worried about the temporary growth decrease as we think they can rapidly accelerate it back.
Also, their VIP program is a very valuable asset, and we must take into consideration the steady revenue stream that it represents for Hotel Chocolat. Currently, It had at December 2022, 2.75 million active subscribers. This is 23,000 subscribers per store. The unit economics of the stores is also fantastic, being the time to make a shop opening profitable in less than one year with revenues above a million.
In January 2023, they relaunched their business in Japan with a 20% share in a JV, with brand royalty revenues. 21 stores will initially be established in Japan. They have opted for this new strategy to take advantage of their 200,000 subscriptors with a more conservative approach. Of course, this can give a larger upside and we celebrate the lower risk involved. In the US, they intend to change their strategy from B2B to B2C, as their margins were very low. However, the company will make their strategy more clear in the following months. Despite this, it is true that we have some reservations about international expansion in such distant, diverse, and complex markets (Consequently, we do not take into consideration any revenue from international when making our valuation)
We believe that, fundamentally, this investment is more dependent on the macroeconomic situation in the UK than on the company itself (since we believe that what depends on the company will go well). We think that although 2023 may be a transition year with likely poor results, margins should recover by 2024. It is a company offering premium products, with no debt, and well-managed, and its valuation (discussed in the next section) could be attractive. Therefore, we believe it makes sense to keep it on our radar.
LON:HOTC Financials & Quick valuation
*During Covid some shops were temporarily closed . ** Net Income negative for the asset impairment
The first half of 2023 continued to be negatively impacted by the above-mentioned problems. A second distribution center has been commissioned to accommodate the larger sales. This will represent a cost headwind of around 300 bps in 2023, to be normalized in 2024 onwards. Therefore, the full year 2023 will still be affected by the previous year's dynamics, the company expects a profit before taxes between 4 and 7 million.
Hotel Chocolat continues to be well capitalized with a net cash position of £15.4 and with a £50 million credit line undrawn.
Making a quick valuation, taking the following assumptions:
Revenues of £210 million for 2023, with a 10% growth in 2024 and 2025.
5% on a like-for-like basis (even this year has been 7%) +5% from new openings.
EBITDA margin of 17.5 and 18% for 2024 and 2025, respectively. The company expects this margin to be +20% for these years and beyond.
Profit after tax margin of 10 and 11% (similar to pre-Covid levels).
Share dilution of 3% per annum.
With a 10x EV/EBITDA multiple, we come with a target share price of £2.73 and £3 for 2024 and 2025, respectively, implying a 51% and 66% upside on the stock price as of today. (Note: Very simplified, EV/EBITDA multiple pre-covid was double than applied here, so no WACC & other methods applied. If we make the full thesis, we will delve deeper into it)
Before the sharp decrease in price, Hotel Chocolat was trading at a much higher multiple. This was due to the recognition of the company's quality and their related growth. Nevertheless, in our view, it was overvalued. And that is the reason we had not talked about It until today (Not taking into account the recent months, during which we have been following the company but have prioritized publishing analyses of other companies)
Conclusion about Hotel Chocolat LON:HOTC
We were originally attracted to Hotel Chocolat because we consider the product to be high quality and the location of the stores is extremely good. However, the valuation had been always very demanding. We thought that after Covid we would have an opportunity but online sales skyrocketed. In addition, the VIP Me plan has been successful in increasing the retention of customers, increasing 14% YoY (2022 vs 2021) the frequency of active customers.
At the moment, we understand that given the poor expectations for discretionary consumer spending in the UK (the entire sector is greatly affected), as well as their international failure and incentive plan, investors have fled towards other options. However, we believe that this is a healthy company that is doing well, its management owns more than half of the company, and product demand is still high. 2023 is a key year to show whether they can pivot their strategy mainly to achieve operating efficiency, and when analyzing their results, we should focus on it and not on growth. We effectively think that the problems are temporary, and once overcome in 2023, we believe that the top-line growth can continue to grow organically at mid-single-digits and the opening of new stores could drive this growth to double-digit (they have recently announced that they expect around 50 new stores in the next three to five years, with the first wave planned for this Autumn). We think that great opportunities arise from moments like these, and although we do not currently hold a position, we are monitoring it closely in case we consider that an opportunity arises (specifically if the stock reaches the 150-160p area).