Small Cap Value Report (Tue 6 Jun 2017) - RBG, COMP, JOUL

Good morning, it's Paul here!

Thanks to Graham for another very interesting report yesterday.

Hospitality & Retail sectors

I'm getting increasingly nervous about these sectors, mainly due to cost pressures. Until recently, I had assumed that companies would be able to mitigate cost pressures (e.g. by making efficiency savings, putting up prices, trimming staff rotas, etc). However, I'm starting to think that view might be wrong.

The shock profit warning from Revolution Bars (LON:RBG) (in which I hold a long position) a couple of weeks ago came completely out of the blue. To my knowledge, nobody had predicted that costs would spiral out of control. Some people were bearish on the stock, but for other reasons. Although, with hindsight the departure of 2 CFOs in rapid succession might have been a clue - I must be more sceptical about this in future, and ignore management reassurances. Apparently some other senior finance staff also left at the same time, to join a competitor. So it seems that financial controls slipped. I remain of the view that this should be fixable. Most importantly LFL sales are fine, and margins strong - that's what really matters.

So overall, I think RBG is probably (we can never be certain) now good value at 123p per share. However, that's a huge drop from the level of around 220p where it was just weeks ago - about a 45% drop. Clearly that focuses the mind, and I don't want to be exposed to any other similar situations.

For that reason, I've ditched most of my shares in other hospitality, or retail shares. In the case of Patisserie Holdings (LON:CAKE) I've had a couple of disappointing store visits, and feel the valuation is probably now high enough. It's managed to mitigate cost increases so far, but will that continue? Customer service standards slip if staffing is reduced. The figures look great for this company, but can it maintain such a high operating profit margin? I'm not sure it should try to - because if the operating margin is too high, then customers might become disillusioned with the poor value for money, and decline to visit in future.

I still hold some Fulham Shore (LON:FUL) - but in reduced size. I am concerned that its stores outside London are taking longer to mature than previously imagined. That, combined with a rapid roll out, and increasing staff costs, make this one probably higher risk than I previously thought - hence having cut back on my position size.

Tasty (LON:TAST) - have ditched this one completely, as I think it's a weak format, and with over-sized stores, hence another profit warning seems likely here.

Wage differentials seem to be the emerging problem for companies with a lot of lower paid staff. The problem is that Living Wage is not only pushing up wages at the bottom. It also seems to be triggering a domino effect, with supervisers & managers, plus Head Office staff also pushing for corresponding pay rises. Companies may not have budgeted for these knock-on effect wage rises.

Therefore I think there is a risk that there might be a wave of profit warnings from the hospitality & retail sectors. For that reason, I'm opening up some shorts on large cap retailers & hospitality companies, e.g. Marks and Spencer (LON:MKS) , Halfords (LON:HFD) , WH Smith (LON:SMWH) (although a lot of its profits come from its travel agency), and Whitbread (LON:WTB) .

Talking of profit warnings, one of my least favourite restaurant roll-outs issued another profit warning yesterday.

Comptoir (LON:COM)

Share price: 19.5p (down 13.3% today, after a heavy fall yesterday)
No. shares: 96.0m
Market cap: £18.7m

Trading update (profit warning) - this is a small chain (23 branches)  of Middle Eastern themed restaurants (glorified kebab shops, from what I can see).

I reviewed the figures in detail in my report here on 12 Apr 2017, explaining my reasons for considering this an unconvincing roll out, and best avoided. Good job too, as the share price is down 57% since then, less than 2 months ago.

What's gone wrong then?

The Directors confirm that, overall, the past two months have seen a continuation of the difficult trading it reported at the time of its prelims in April 2017. While the business saw improved sales figures over the Easter weekend and half term holidays, unfortunately much of this benefit was subsequently lost in the final two weeks of the month.

In May 2017 the Company also experienced an unexpected decline in like for like sales and profit at certain mature restaurants, particularly in retail-led locations and at its higher-spend restaurants, Levant and Kenza.

In addition, although the group as a whole is seeing a progression in sales, a number of the restaurants opened in 2016 remain behind expectations in terms of their anticipated maturity trading curve. 

That sounds pretty bad to me. It's not just new stores that are under-performing, it's existing ones too. In a very crowded marketplace for casual dining, with over-supply, this says to me that Comptoir just isn't cutting the mustard.

Cost pressures - as mentioned in the section above, this is a huge issue for this sector. Generally with this kind of thing, it's the weaker players who warn first, then others may well follow suit. Hence why I am now pretty bearish on hospitality and retailing sectors.

Like many of its peers in the sector, the Company is experiencing upward pressure on costs, including incremental wage costs and related taxes (apprenticeship levy), higher food and drink costs (driven by depreciation in sterling versus the Euro) and increases in rent and business rates.

Together with the softening in consumer spending, these factors have had a significant impact on restaurant profitability and visibility over short-term trading trends. The Company has taken steps to limit the increase in central overheads.

That sounds horrible. The danger for investors is that we forget about operational gearing - i.e. businesses which have mostly fixed, or semi-fixed costs, can see profitability absolutely collapse once they encounter softer sales combined with higher costs. Previously profitable businesses can quickly turn loss-making once operational gearing goes into reverse.

Roll-out - when trading goes backwards, it's usually sensible to stop opening more new sites. However, for now anyway, Comptoir is pressing on (maybe they had already signed these leases, I don't know?);

The Directors believe the Comptoir brand continues to have a strong appeal to consumers and landlords and there remains considerable potential for expansion in the UK.

The Company still expects to open 3 more restaurants before the end of 2017 - Comptoir Reading, Comptoir Oxford and Shawa Oxford - together with a first international franchise operation in the Netherlands with HMS Host.

Sale & leaseback - this suggests they're getting strapped for cash, and I would be interested to find out the terms of this deal. It will increase costs significantly of course, as rent will be paid, whereas before the site was owned.

Lastly, the Directors confirm that they expect to raise £2.7m (gross) from the sale and leaseback of the freehold of its central processing unit (CPU) in North London. The net proceeds will be used to fund the remaining new openings for 2017 and strengthen the Group's working capital position. A further announcement on the sale and leaseback will be made in due course.

My opinion - I think this looks very wobbly indeed.

If a roll out isn't working, then you should stop opening new sites immediately, and sort out the existing ones. Shop leases are not a problem if you trade profitability from them. However, if you begin to trade at a loss from any sites, then the leases suddenly become a potentially very serious issue. It can be difficult to impossible to exit from problem leases. French Connection (LON:FCCN) is a great example of that - absolutely haemorrhaging cash from its retail division, yet locked into loss-making sites due to lease commitments spanning years in some cases. Typically retail leases are 15 years at the point of signing. So get it wrong, and you have a massive headache which can pull down the whole company.

It's tempting to bottom fish on a share which has fallen heavily, but I'm steering well clear. My view is that this format doesn't look particularly viable for a roll out. By my reckoning, it could struggle to survive the next recession. Therefore, why get involved?

There have been far too many restaurants opening in recent years, and I think this sector is poised for a major shake-out, due to over-capacity combining with weaker consumer demand, and multiple cost pressures. Weaker formats such as this one are likely to be the casualties in an economic downturn, in my view. That then leaves more business for the stronger players.

Note that Stockopedia computers also dislike this share, categorising it as a "Sucker Stock", and with a dismal StockRank of 11.

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Joules (LON:JOUL)

Share price: 300.5p (up 5.4% today)
No. shares: 87.5m
Market cap: £263.8m

Pre-close trading update - this company is a "premium British lifestyle brand" - selling mostly clothing by the looks of it, in shops and online. I've never bought anything from them, because I wouldn't pay £55 for 2 polo shirts from Joules - I buy them for £4 each from Primark instead. Also I don't have a beard.

Today's statement is very good. It relates to the financial year that's recently completed - 52 weeks to 28 May 2017. Nice prompt reporting today then, which indicates good financial controls are probably in place.

Key points;

• Revenues up 19.6% to £157.0m
• Strong profits in H1 and over Xmas continued in H2
• 11 net new stores opened in the year
• Stronger gross margin, for various reasons
• Good cost discipline
• Profit before tax will be "comfortably ahead of its previous expectations" - which probably means something like 5-10% above, at a guess. Why can't they just give a range of percentages, instead of using coded wording?
• Confident outlook comments - robust order book for wholesale, and new store openings planned.

Valuation - at first I thought this share looked too pricey. However, the latest broker forecasts (issued today) show EPS forecast for 05/2017 being increased from 8.2p to 9.1p - that's a PER of 33 times - i.e. expensive.

However, the same broker hasn't changed its 05/2018 forecast, leaving it at 13.4p. Given that the company seems to be humming along nicely, then I'd say there might be scope for a beat on that 13.4p forecast. If we up that to 15p, then the PER drops to about 20 - which looks fine, maybe even good value if out-performance, and sales growth continue.

The Thomson Reuters data for consensus earnings, shown on Stockopedia, is likely to rise shortly, given this strong update.

My opinion - this seems to be another growth company which initially looks expensive, but then goes on to out-perform against expectations. It therefore seems to be growing into the valuation, with the stock market correctly predicting out-performance on profitability.

I like it. My main reservation is that of fashion risk - i.e. this company has a very distinctive style of clothing, which may seem classic at the moment, but could in future possibly become naff. If that happens, then the company would have to reinvent its look pdq, or suffer the consequences.

Personally I prefer fashion companies which have a broader based appeal, and don't rely on a very specific style. However, for now anyway, Joules seems to be trading very well, and looks a really good growth company. So well worth a closer look, in my opinion. Having had a terrific run, I wonder whether people might be tempted to profit-take? Especially if the market as a whole goes wobbly, as it inevitably will at some point.

Good performance seems to be largely baked into the price, given that it only rose about 5% today on this strong update.