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OPINION

A rating too sweet?

A rating too sweet?
December 10, 2013
A rating too sweet?
IC TIP: Sell at 143p

True, I subsequently placed a stop loss of 78p on the holding in the summer ('Trading plays', 23 July 2013), a level that was briefly breached, but only by a whisker, before the price resumed its upwards move in dramatic fashion following upbeat full-year results in mid-September and a subsequent trading update in October.

So, with medium- and longer-term holders still invested, and the shares now well above the target prices of analysts at Panmure Gordon (116p) and Investec (124p), I am revisiting the investment case to decide whether the best of the gains have been made.

Earnings upgrade story

The key driver in Thorntons' rerating has been an earnings upgrade story. Back in May when I initiated coverage, and following a bumper third-quarter trading update from the company, 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 represented a five-fold increase on the £0.85m of underlying profits made in the prior financial year, and was based on sales of £223m for the 12-month period. Thorntons reported sales of £217m in the 12 months to June 2012, so it was clear that higher-margin incremental sales - all of which are being generated by commercial, private label and international sales - were having a major impact on the bottom line.

Analysts Philip Drogan and Jean Roche at broking house Panmure Gordon were even more bullish at the time, having upgraded their profit estimates from £3m to £5.7m for the financial year to June 2013 to produce EPS of 6.3p. In the event, Thorntons reported underlying pre-tax profits of £5.6m, right at the top end of the range, on sales of £221m. Operating profit margin increased to 3.3 per cent, up sharply from 1.3 per cent the previous year and, buoyed by a five-fold rise in cash generated from operations of £8.3m, net debt was reduced by £1.6m to £27.5m at the end of June.

According to analysts this strong earnings momentum is set to continue: for the financial year to June 2014, both Panmure and Investec expect pre-tax profits to rise further to £7.2m to produce EPS of 7.87p and 7.6p, respectively. The analysts differ for the following year when Panmure expects EPS to rise to 12.2p, but Investec predicts 10.2p. Therefore, with the shares riding a four-year high, they are rated on a forward PE ratio of 18 for the current financial year to end-June 2014, falling to between 12 to 14 the year after.

 

Earnings upgrades needed to drive share price

In my opinion, the current valuation now factors in the earnings recovery story. Both Investec and Panmure left their estimates unchanged after the first-quarter update for the 14-week trading period to 5 October. So for the share price momentum to continue, then we need further earnings upgrades to drive it. We will not have long to wait to find out because the company is due to release a second quarter trading update in mid-January for the all-important Christmas sales period.

It's fair to assume that we can expect a continuation of the positive trend in this part of the business given Thorntons had a strong order book in its 'fast moving consumer goods' (FMCG) division entering the second quarter. In the last quarter, the segment delivered double digit sales growth and, for the first time ever, accounted for more than half of total sales. It's also fair to assume that this stellar growth will more than offset the weak showing from the lower margin struggling retail operation.

To address this, Thorntons has cut the number of stores by 10 per cent to 288 units in the past 12 months including a further eight closures in the three months to end-September. Around 40 shops will be closed in the year to June and the aim is to slim the estate down to a profitable and sustainable portfolio of between 180 to 200 stores within the next two to three years. In order to achieve this goal a further 20 to 25 store refurbishments are planned during the course of the current financial year.

It's a sensible strategy because profits on the retail side have been under pressure for some time and it 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' share of the boxed chocolate market increased from 11.7 per cent to 11.9 per cent in the 12 months to the end of June 2013, and its share of the inlaid boxed chocolate market rose from 33.1 per cent to 35.2 per cent in the same period. Consumer demand is clearly not the issue, it's a case of generating the best margin from the most appropriate channel to the market to capitalise on this.

So with costs being reduced by shrinking the poorly performing retail estate, there is scope for profits to rise faster than analysts predict as Thorntons replaces lost retail sales with more profitable commercial sales. I still believe the company can do this, but equally I also feel that at 143p, valuing Thorntons' equity at almost £100m, so do most other investors now.

In the circumstances, I would be inclined to bank these hefty profits and look for a better re-entry point next year to capitalise on what remains an earnings upgrade story. If nothing else, it surely pays to top slice your holdings to crystallise some of the huge gains.

Finally, due to unprecedented demand, my new book, Stock Picking for Profit, has sold out and is being reprinted for delivery the week commencing Monday, 6 January 2014. As a special promotion to IC readers, the first 100 pre-orders for the book placed online with YPD Books and quoting offer code ICOFFER will receive complimentary postage and packaging. The book can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213. The book is only being sold through YPDBooks and no other source. It is priced at £14.99, plus £2.75 postage and packaging. Telephone orders will continue to incur the £2.75 charge.

 

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