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Hotel Chocolat leaves sour taste in investors’ mouths


Hotel Chocolat [AIM:HOTC], the UK AIM-listed purveyor of posh confectionary, has had a troubled time on the stock market in 2022. Its shares have collapsed, falling 73% year to date. A former market darling, Hotel Chocolat achieved a premium rating after its IPO in 2016 and received the backing of well-respected funds such as Baillie Gifford and Threadneedle asset management, which helped to drive the shares up 150% in the five years post-IPO.

However, since the beginning of the year the tide has turned against the chocolate maker as rising costs and a botched expansion to the US has wiped out profits for the current financial year and will likely create a financial drag in 2023. In the company’s latest trading update, Hotel Chocolat expected to make an underlying profit before tax of GBP22m for 2022, however the costs related to closures of US stores will result in a statutory loss for the period.

To add more bad news to the situation, further to the announcement in July, on 12th September, Hotel Chocolat announced its move to cease trading through their direct to consumer (DTC) website that fulfils orders across the US.

Despite the doom and gloom this week, long term value-focused investors, Phoenix Asset Management upped their position in Hotel Chocolat to over 10% of the traded equity, after an initial investment at the end of July. Phoenix’s investment strategy typically revolves around buying great companies at deep discounts when short term issues present themselves. Should this move prompt investors to take a closer look at Hotel Chocolat?

What’s tasting good at Hotel Chocolat?

Despite the general economic malaise, Hotel Chocolat’s sales in the UK are doing particularly well. In the full-year results to June 2022, UK revenue grew 35% against 2021 and 68% when compared to pre-pandemic levels in 2019. This helped group revenue to GBP226m in 2022, up from GBP165m the previous year.

Positive revenue growth in the UK has been aided by the company’s progress in brand building, where brand awareness has risen from 17% in 2020 to 23% in 2021, and the uplift in repeat purchasing through conversion of customers to loyalty programmes – VIP loyalty customers now account for 71% of UK direct-to-consumer sales by value (FY21 44%).

The company has also benefitted from some good fortune, related to Covid-19, where significant cost savings have been made across UK high street retail locations as occupancy costs are reduced because of the challenges presented to companies during the pandemic.

The American palate

Recent news of a withdrawal from North America has certainly been damaging for Hotel Chocolat’s growth prospects. Until recently, the US had been established as the next frontier for Hotel Chocolat, with the company investing in multiple store fitouts, supply chain presence and marketing.

Upon delivery of the news, analyst Peel Hunt said the plans: “come as a surprise to many, and a disappointment, as these were obviously the first real steps to demonstrate that [Hotel Chocolat] was able to become a global brand”. Whilst the closure of US retail locations is clearly disappointing for investors, it could also be a sign of management prudence, as a quick decision to pull out of an underperforming market, with a potential economic slowdown on the horizon, may eventually prove to be the right decision.

Not so sweet

Hotel Chocolat certainly has a premium brand and price tag for its products, however, since listing in 2016, its profitability has been rather lacklustre. Measured in EBITDA, peak margins for the company were 18.3%, which might seem reasonable. However, looking at the most reliable measure of profitability – Operating profit (EBIT), the business has struggled to produce operating margins in excess of 11%.

This could be due to Hotel Chocolat’s relative immaturity as a brand relative to many confectionary brands that have been known for decades. However, Hotel Chocolat’s go-to-market model is highly weighted to its retail store locations across the UK, which have high operating costs.

Contrast Hotel Chocolat’s 11% margins to that of American confectionary superpower The Hershey’s Company, which has an operating margin of 23%, one can see that selling confectionary through traditional wholesale channels is more profitable.

Hotel Chocolat is attempting to improve margins through e-commerce sales, wholesaling through selected retail partnerships and building scale in manufacturing and supply chain operations, however the business has some way to go to become a high-quality profit machine similar to the likes of Hershey’s.

In summary, there is much to like about Hotel Chocolat’s business, which has grown revenues significantly throughout the last couple of years. The shares are deeply discounted, and the co-founders remain holders of over 50% of the equity – one could argue this has led to prudent decisions with the withdrawal from the US market.

However, trading conditions are unlikely to get better over the short term for Hotel Chocolat, with reduced disposable income from consumers, and cost inflation likely to weigh on profitability. Given the lacklustre profit margins seen by the business in prior years, the current risk/reward dynamic for the shares looks unfavourable.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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