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Wed 27th Sep 2017 - Analyst predicts winners and losers as margins erode
Analyst – private companies now at an increased risk of failure: City analyst Tim Barrett has argued that current weak like-for-like sales increases in the sector do not allow margins to be protected, meaning an increased risk of failure for some private companies. Barrett, who works for Numis, said: “Industry like-for-likes remain flat and insufficient to cover cost growth: Peach Tracker data for August was disappointing (total market 0.2%) the third consecutive month of deceleration and suggesting that price increases are proving ineffective at stimulating sales. The weakness was most pronounced in pub restaurants (-1.2%) and within greater London (-1.6%) while the regions are holding up better (0.8%). Nonetheless this sales performance is below the level needed to offset costs: for the listed companies this leaves earnings risk on the downside and for private players/independents increases risk of failure. Food cost inflation exceeding expectations at 8%, adding to margin pressure: In the last three months, food cost inflation has accelerated from 2% to 8%, as agricultural harvests and foreign exchange pressures combine to drive up the cost of dairy and meat. In the next 12m many companies will see the benefits from pre-referendum hedging roll off and RPI-linked contracts inflate, exposing companies to further headwinds. For most operators an 8% increase is equivalent to some 250bp of gross margin. Revised cost model suggests margin-neutral like-for-like sales may be over 5%: Cost of goods inflation of 5%-10% will compound the existing headwinds faced on labour (NLW) and business rates. The conventional wisdom is that 3-4% like-for-like sales growth will be required to be margin neutral next year; our worst case estimates suggest this could actually be closer to 5-6%. In either case, current industry like-for-like sales growth would be insufficient. Weaker undercapitalised players may exit, to the benefit of listed companies: The listed players generally have freehold assets giving a more resilient margin structure and lower operational gearing than leasehold operators. In contrast, our analysis suggests that fixed charge cover would be uncomfortably low for a number of smaller private operators (evident in Handmade Burger Co falling into administration). As the number of exits picks up and supply growth fades, the larger companies’ pricing power should improve, increasing their ability to mitigate cost increases. This would be an encouraging sign of cyclical recovery and a potential buy signal for the listed groups albeit some time away. Selected valuation opportunities on NAV/yield but generally cautious: since the start of the year the sector has derated from a P/E of 12.1x to 10.3x, reflecting negative earnings momentum and increased awareness of sector headwinds. Value investors will look for NAV support and Ei Group’s valuation (0.6x) is compelling in our view. The average dividend yield in the sector is now 4.3% although the latter provided little ST support during the 2009 downturn. Even if valuations are now undemanding, recent datapoints leave forecast risk on the downside. This makes it too early to buy the sector with conviction with the exception of self-help situations such as EIGE and RTN. We see further downside in managed pub operators given their operational gearing – of these players only JDW comes close to protecting margins (like-for-like +6% last six weeks) with M&B +0.3% and GNK -2.4% in latest quarterly reports.”

Hotel Chocolat – there is scope to add cafes at many of our larger stores: Hotel Chocolat has expanded the number of shops with cafes it operates to 15 – and sees scope for many more. The company reported turnover up 12% to £105.2m in the year to 2 July. Profit before tax was up 115% to £8.8m. Of the potential for adding cafes, the company stated: “In the summer (we) completed our first retrofit of a cafe into an existing store, at Milton Keynes. If this test proves successful we see scope to add cafes in many of our larger locations. Adding a cafe adds more reasons to visit, whilst deepening the customer experience. By keeping the operation simple, this can be achieved without significant additional operating costs and with modest additional capital expenditure. Since the end of the financial period we have opened two stores in Beverley and Clarks Village, a designer outlet in Street, and at the time of writing have signed leases on a further six, all of which we expect to be trading before Christmas 2017.” Angus Thirlwell, co-founder and chief executive of Hotel Chocolat, said: “Our existing stores continued to perform very well and we opened twelve new stores in the year, of which eight were in the Shop+cafe format. We will continue to open both pure chocolate shops and Shop+cafe formats to best match the opportunity in each location. We opened Shop+cafes in Worcester, London Euston Station, London Covent Garden, Cheshire Oaks Designer outlet, Bury St Edmunds, Chelmsford, Glasgow Buchanan Street, and our second store in Belfast. Through modular design techniques we are now able to open a Shop+cafe for the same capital expenditure as a Shop-only store previously. The results from this format have given us confidence to test it in smaller catchments, which if successful has the potential to materially increase the number of new sites in the UK. I am pleased to report another year of growth and good results. The Hotel Chocolat brand has continued to strengthen and we have made excellent progress with our three strategic priorities of investing further in our British chocolate manufacturing operations, growing our store estate and developing our digital offering. All our channels are growing. In retail, the new Shop+cafe format is proving popular, our new website has improved conversion on mobile devices and since the year-end, we have signed six new wholesale accounts that will make it easier for consumers to buy Hotel Chocolat products. Given the encouraging performance of our retail and internet channels, along with the pipeline of opportunities ahead of us, we are confident of further growth. This of course depends on the availability of suitable sites. We have further improved our Christmas ranges and this year will be our biggest ever seasonal offering.” The company said it benefited from increased consumer interest in ‘experiences’. It stated: “Experiences are becoming increasingly popular as a new luxury and consumers are seeking to go beyond the purely transactional, but only with brands they love. We are well positioned to grow with this trend. “Chocolate Lock-Ins” were launched in the year, attracting ticketed customers in small groups into our stores after closing time for some tutored tasting and nocturnal private shopping. The customer feedback has been extremely positive. It also enables our School of Chocolate graduates to show off their knowledge and converse with other real chocolate enthusiasts. We intend to continue developing the range of experiences we can offer, showcasing the brand obsession with making the best chocolate on the planet from farm to finished product and aspire to turn customers into advocates.”

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