Can Hotel Chocolat bounce back after 75% drop?

Hotel Chocolat shares fell by 50% on Tuesday morning, after the upmarket chocolatier hit the market with a profit warning and said it would scale back its overseas expansion programme.

Shares in this former high flyer have now fallen by more than 75% since the start of 2022.

It’s a shocking reversal for investors. As recently as March, the company said that it had “a clear line of sight” to profitability in the US and Japan. While the core UK business appears to be performing more strongly, cost headwinds and restructuring costs are expected to lead to lower profits next year.

Hotel Chocolat’s market cap has dropped to c.£165m at the time of writing. That’s less than the £229m market cap achieved in the company’s 2016 IPO.

As shareholders or potential investors, I think we each need to decide whether this historically expensive stock now offers value.

At times like this it’s important not to anchor on past share prices. What’s happened before won’t necessarily happen again. Tuesday’s update suggests to me that Hotel Chocolat’s growth rate and cost structure are likely to be very different over the next few years. This will be reflected in its profits and valuation.

Let’s start with a look at the main points from Tuesday’s trading update.

FY22 trading: healthy

Hotel Chocolat’s underlying results for the year ended 26 June appear to be fairly healthy. Sales rose by 37% to £226m, ahead of the £215m consensus estimate shown by Stockopedia.

Full-year adjusted pre-tax profit is expected to be in line with market consensus, which is given as £22m (FY21: £10.1m).

The trouble starts with an admission that statutory profit for FY22 is “expected to be a loss”. This is due to impairment charges and costs arising from an ominous-sounding “internal business review”.

Overseas: exit costs

The majority of the extra costs that will be reported appear to relate to Hotel Chocolat’s near-total withdrawal from its international operations.

Japan: The company operates through a joint venture in Japan. This generated £5m of retail sales during the final six months of calendar 2021. Unfortunately, this loss-making business appears to have been built at a high price.

Hotel Chocolat loaned £23m to the JV between 2018 and 2022. According to Tuesday’s update, it’s now likely that these loans will be written off in full.

In mitigation, the company says its Japanese JV has suffered three consecutive years when peak sales (Valentine’s/White Day) have been impacted by Covid restrictions.

Going forward, funding will only be provided for essential working capital. However, the JV will be free to seek other sources of growth funding. This reads to me like Hotel Chocolat has decided to leave its Japanese partner to sink or swim. I suspect the former may be more likely.

USA: US sales totalled £2m during the six months ended 26 December 2021. The group had a small network of stores in the US, but these have now been closed (except one, which is due for closure).

As a result, Hotel Chocolat expects to report £3m of provisions relating to these store closures.

From FY23, US operations are expected to be online and wholesale only.

UK market “can be a lot bigger”

UK food brands seem to be a bit like UK rock bands. Only a few ever make it big abroad, especially in the USA. Perhaps Hotel Chocolat should have stayed focused on its home market, which continues to perform well.

Co-founder and CEO Angus Thirlwell now believes that the UK market “can be a lot bigger for us than we thought a year ago”.

The company now plans to focus on four core areas of growth over the next three years:

• VIP loyalty programme
• Digital growth
• Velvetiser hot chocolate system
• Velvetised chocolate cream alcohol drinks

All of these are identified as capex-light growth opportunities with market headroom to expand in the UK.

Mr Thirlwell suggests a number of reasons for investors to be confident of continued UK growth:

• Drinkable products have opened up “new incremental markets” and new sales channels.
• Online business is now three times larger than pre-pandemic (FY19)
• 71% of direct sales are now to VIP loyalty customers (FY21: 44%)
• UK stores are more profitable then pre-pandemic, due to higher sales densities and lower rents
• Unprompted brand awareness has risen from 17% in October 2020 to 23% in April 2021.
• The lifetime value of Velvetiser customers is “materially higher” than for non-Velvetiser customers.
• UK factory capacity increased from 210m pieces in FY19 to 380m pieces for FY23
• Ninefold increase in production capacity for vegan chocolate
• Lease signed for second UK distribution centre

Ahead of today’s update, I was cautiously optimistic about the outlook for Hotel Chocolat’s core UK business. My feeling was that even if profit margins came under pressure from rising costs, the company would be able to continue gaining market share and growing sales.

My view hasn’t really changed, but I think I underestimated the scale of the likely headwinds.

FY23 outlook: lower profits

Unfortunately, margin pressures for the year ahead seem likely to be worse than I expected. Hotel Chocolat’s guidance is for “lower profits in FY23, with the objective of higher profits thereafter”.

Management now has a strategic goal of achieving a 20% EBITDA margin in FY25. This compares to 15% in FY20 and 17% in FY21.

I think it’s possible that the company’s cost base may have become bloated as it expanded during the pandemic. CEO Thirlwell appears to acknowledge this:

"A year of exceptional sales growth following two years of reactionary tactics to the pandemic has left clear opportunities for us to proactively streamline overheads and improve gross margins.”

There’s no new profit guidance for FY23, but there is a useful breakdown of expected margin headwinds:

• Higher cacao prices and UK wages: -3% ongoing
• New warehouse capacity: -3% in FY23, falling to 0% in FY25
• General inflation: -3% in FY23
• Self-help measures: +3% in FY23

My arithmetic suggests that this means Hotel Chocolat expects to see a c.6% reduction in operating margins in FY23. To put this in context, operating margin in 2021 was 8.6%. Margins have peaked at 11% historically, but were already falling before the pandemic:

I think there’s a fairly wide range of uncertainty about the outlook for FY23, but I’d suggest that a 3% operating margin might be a reasonable estimate.

Balance sheet: Hotel Chocolat raised £40m in a placing in July 2021 to fund growth opportunities. Unfortunately, much of that cash now seems to have been used up.

The group had net cash of £53.8m at the end of 2021. By the end of February this had fallen to £27m. Tuesday’s update reported cash on hand of £17m and an undrawn £50m debt facility. I’m assuming this means net cash of £17m.

Although the business has clearly been cash flow negative this year, I don’t think the situation looks too concerning.The loan write-offs in Japan should be a non-cash item, while US store closure costs look manageable to me.

As long as Hotel Chocolat’s UK store estate remains cash flow positive, I don’t think there should be a liquidity problem.

However, I would suggest that Hotel Chocolat’s financial position is not as strong as it seemed six months ago.

FY23 profit estimate: Sales growth is expected to moderate in the short term.

Assuming sales are flat in FY23, then my estimate of a 3% operating margin would imply an operating profit of £6.8m. That’s nearly 45% lower than the £11.9m reported in 2016, the year of the IPO.

My view - fair value?

Based on a £165m market cap, an operating profit of £6.8m would give Hotel Chocolat an earnings yield (EBIT/EV) of 4.1%. That’s not outrageously expensive, in my view, but it’s well below the 6%-8% level I usually view as good value.

On a medium-term view, I think the shares could offer some value from current levels. But the market has now clearly lost confidence in the growth status of this business.

I don’t see any reason to rush in at this stage. I plan to wait for Hotel Chocolat’s full-year results in October. I’d like greater clarity on the group’s cash flow and current-year trading before taking a view on the stock.

Please let me know what you think in the comments below. Is Hotel Chocolat the next Thorntons, or can this former high flyer regain its lustre?