This is very relevant right now, because I have just noted that chocolate manufacturer and retailer, Thorntons (THT: 82.5p), has not only issued two upbeat trading statements in the past month, but the company's chairman has also made a major share purchase. In fact, Paul Wilkinson has bought 200,000 shares in his company at 78.5p to take his holding to 1.2m shares, or 1.76 per cent of the issued share capital. That is even more significant given that Thornton's shares are at a two-year high, having risen eight-fold since the start of last year. Having researched the company in quite some detail, it is clear to me that Mr Wilkinson's purchase is based on firm foundations. It is also one that we can profit from by riding on his coattails.
Improving operational performance
Thorntons' third-quarter trading statement for the 14 weeks to 20 April was truly eye-catching. The period includes Valentine's Day, Mother's Day and Easter, so demand for the company's lines is always likely to be good at this time of year. But it's worth noting that commercial sales rose 10 per cent to £27.4m, accounting for 45 per cent of sales in the period. This is the first time that commercial sales have exceeded those from Thorntons' retail shops and is a strong indicator of the direction the business is heading in the future. That's because the problem the company has experienced in the past is that its retail operations have proved a drag on overall profitability due to the cost of running an estate of over 300 stores. Thorntons also has a further 187 franchises.
In order to address this issue, Thorntons has been closing underperforming stores - 22 have been closed in the first nine months of the financial year to the end of June 2013 - and a further 18 are earmarked for closure by the end of June. Around 40 shops will be closed in the year to June 2014, to slim down the retail estate to around 250 units. It is a sensible strategy because profits on the retail side have been under pressure for some time. In fact, analysts at Investec Securities estimate that the retails division's reported cash profits will have fallen by more than half from £13.3m three years ago to around £6.5m in the financial year to the end of June. In contrast, cash profits on commercial sales have been rising sharply, up from £19.2m in 2010 to well over £24m in the current financial year.
It only makes sense to focus on the segments of the business that are producing the growth, and to reduce exposure to operations holding back performance, especially as there is strong demand for the company's products. According to market research group Nielsen, Thorntons' market share increased from 11.7 per cent to 12.2 per cent in the 12 months the end of March 2013, and its share of the inlaid boxed chocolate market rose from 32.9 per cent to 35.6 per cent in the same period. Sales of Thorntons' Easter speciality range surged by over 23 per cent, and the company's market share in the Easter market rose from 4 per cent to 4.7 per cent.
Brand awareness
The change in Thorntons' business model to increasingly focus on commercial product sales and slim down its retail operations may be perceived as damaging to its brand. However, this model has not stopped global brands such as Haagen-Das from selling the majority of its volumes through supermarkets while maintaining brand awareness through a high street presence. And discounting of the product through supermarkets in targeted promotional activity has hardly dampened profitability of the ice cream maker over the long run, as the company's impressive financial results testify.
A high street presence also enables Thorntons to test new product lines out before they are sold to a much larger customer group through commercial outlets. If the trails are unsuccessful, the lines can simply be withdrawn without the company ending up with substantial unsold inventory. However, if customer take-up is positive through Thorntons' stores, then this is a good bargaining tool when it comes to negotiating with supermarkets. The retail outlet also enables customers to experience the company's products by making small purchases.
Earnings upgrades
With costs being reduced by shrinking the poorly-performing retail estate, there is scope for profits to rise markedly if gross margins can be improved as Thorntons replaces lost retail sales with more profitable commercial sales. And this is exactly what the company reported in an upbeat trading update a couple of weeks ago.
In fact, post the trading update, analyst Bethany Hocking at Investec upgraded her pre-tax profit estimate for the financial year to June 2013 by 50 per cent from £3m to £4.5m to produce EPS of 4.8p. This estimate represents a five-fold increase on the £0.85m of underlying profits made in the prior financial year, and is based on sales of £223.2m for the 12-month period, up from £221.6m previously forecast. Thorntons reported sales of £217m in the 12 months to June 2012, so it is clear that higher-margin incremental sales - all of which are being generated by commercial, private label and international sales - are strongly benefiting the bottom line.
Analysts Philip Drogan and Jean Roche at broking house Panmure Gordon are even more bullish, having upgraded their profit estimates from £3m to £5.7m for the financial year to June 2013. On that basis, EPS of 6.3p is expected. Moreover, Panmure notes that "with a quarter still to go, there is scope for these numbers to move ahead further, although it should be remembered that the fourth quarter is much less important trading period". For the financial year to June 2014, Panmure is expecting pre-tax profits to rise further to £7.4m to produce EPS of 8.3p.
That means that Thorntons' shares are currently trading on 10 times Panmure's earnings estimates for the 2013-14 financial year. Interestingly, the broker is advising clients that "June 2014 estimates still have upside...because we believe that Thorntons can drive sales through a number of channels and that profits will further benefit from a reduced costs base. Historic levels of profitability are within reach." In the 2007-08 financial year, Thorntons' pre-tax profits peaked out at £8.5m on sales of £208m to produce EPS of 9p.
Chart break-out beckons
Interestingly, Thorntons' share price has formed an ascending triangle formation and is now strongly pressurising the 83p level at which the shares peaked at on 18 March. I believe a break-out is imminent and one with no overhead resistance until around 105p, the former high dating back to January 2011. Even at this level the shares would still only be rated on 12 times 2013-14 earnings estimates and with the real prospect of more upgrades to come.
The combination of substantial director share buying, scope for further upgrades in a pre-close trading statement in early July ahead of full-year results on 12 September, and strong sales momentum in commercial sales channels, makes the shares a compelling buy on a bid-offer spread of 79p to 82.5p. My two-month price target is 105p, which if achieved will provide a 27 per cent return.
MORE FROM SIMON THOMPSON ONLINE...
I have written five other articles in the past week, all of which are on my homepage and include the following companies or sector trades:
KBC Advanced Technologies ('Fuelled for growth', 6 May 2013)
Communisis ('Buy the triple top break-out', 7 May 2013)
Global Energy Development ('A share priced for a sharp re-rating', 8 May 2013)
Spark Ventures, Greenko ('Awaiting another spark for a re-rating', 9 May 2013)
Treatt ('A real treat', 13 May 2013)
