This premium brand’s growth story is melting away

Sales are expected to keep growing in the coming years, too, with market researcher Mintel forecasting a 13 per cent rise between 2022 and 2027. Unfortunately for confectionary makers, higher prices will need to do most of the work, as volume growth faces both tighter consumer wallets and a crackdown on the sale of unhealthy foods. New rules that restrict advertising and product placement of HFSS food and drinks (that is, those that are high in fat, salt or sugar) are a case in point. Although some larger players have responded by reformulating their products to avoid the HFSS label, life is getting tougher.

Another rising risk is consumers trading down from more expensive brands. It’s one Aim-traded premium chocolatier Hotel Chocolat (HOTC) knows well, having last month cited the impact of “ongoing weakness in consumer sentiment and continuing inflationary pressures” on its trading. It is now guiding for a loss this year and trailed that its sales and profits in 2024 are likely to be lower than current market expectations, news that sent the shares down by 17 per cent. 

The business model

While those shares are held by some of the biggest UK asset managers – including Phoenix, Abrdn, and Columbia Threadneedle – the business’s growth outlook is increasingly unappetising. Peel Hunt cut its target price from 175p to 100p following the latest update, and slashed its pre-tax profit forecasts for 2024 and 2025 by 78 per cent and 58 per cent, respectively. Explaining the downgrades, the broker's analysts noted “a realisation that there is more price elasticity in certain products than initially thought”.

The profit warning was the second in as many months, as the business works its way through a strategic transition and gets to grips with its new size after seeing a surge in its top-line in 2021 and 2022. Co-founder and chief executive Angus Thirlwell referred to “the growing pains of rapid growth and scaling £200m in revenues” in April, but the market seems tired of under-delivery. The shares are down by around a third in 2023 and are now shy of their 2016 initial public offering price of 148p.

Analysts at Liberum argue that the decline in the shares “more than bake in the latest round of [guidance] cuts”. The question is whether these cuts will be the last, a point the house broker acknowledged in noting the need for earnings momentum and operational delivery for a change of market heart.

This doesn’t mean there’s nothing to admire. Hotel Chocolat estimates its brand consideration grew by 13 per cent in the 30 months to March, helping to cement its ‘VIP’ customer base at 2.75mn. Forays into chocolate-adjacent products such as the Velvetiser hot chocolate machine have been a success. The core UK business, where sales were up by a quarter against pre-pandemic levels in the six months to December, has shown signs of improving like-for-like momentum.

The board's push for a bigger presence on the high street, meanwhile, shows bullishness: the company is aiming to add 50 stores within five years. Around 70 per cent of UK sales came from its 123 stores, with the average posting net revenues of over £1mn.

A downside of the reliance on physical retail, however, with the higher associated costs, is the resultant dent in profitability. Making progress with multi-channel selling has been a challenge as pandemic-era online buying habits have retrenched, chocolate eaters have returned to in-person shopping and marketing spending has been cut.  

The combined impact is seen in uninspiring operating margins, which last surpassed 11 per cent in 2018. This compares unfavourably with other (though much larger) chocolate producers such as Lindt maker Lindt & Spruengli (CH:LISN) and US giant Hershey (US:HSY).

Although this highlights the work to be done to boost profitability, an efficiency drive has faced obstacles. Along with labour cost headwinds, cocoa prices have spiked due to a global production shortfall, demand trends and poor weather in key growing regions in Africa. The margin pressure represents a headache Hotel Chocolat doesn't need. 

Management has a target of a 20 per cent cash profit margin for 2025, which not so long ago looked achievable. Doubts have now crept in. In its latest update, the company guided that this would only be “achieved towards the end of [that] year, with the full benefits being achieved through FY26”.

A sticky international retreat

Last summer, the market was taken aback by the company’s decision to scale back operations in the US and Japan. Management concluded that growth opportunities overseas weren't worth the risk or significant investment, at least for now. 

The current approach to international markets is now "low risk/low capex operating models". Hotel Chocolat has closed its stores and website and stopped selling direct-to-consumer in the US. Meanwhile, it booked over £22mn of loan impairments regarding its Japan joint venture, after being badly hit by Covid-19 restrictions. A new strategic partnership was inked there earlier this year. 

The pullback from the US, where Hotel Chocolat had been hit by supply chain issues, has been particularly damaging given the promise this offered to make the business more of a global name. The company had started to put the pieces in place across the Atlantic before retreating, but is now exploring opportunities again within online and wholesale channels. 

On one level, the retrenchment could be seen as a prudent move at a time of macroeconomic uncertainty. On another, by refocusing on the core UK operation, the potential for chunky overseas future growth has been stymied, and the business's horizons limited. While a bigger return in the future to the US is possible, it’s a worry that the business was so chastened on the first attempt. 

Balance sheet and valuation

At first glance, the balance sheet looks robust: excluding lease liabilities, Hotel Chocolat has no debt. But a closer inspection reveals that the business is burning through cash. From £54mn at the 2021 year-end, the cash position fell to £28mn a year later and to £19mn last month.

To Liberum, the shares offer long-term value when set against its discounted cash flow projections, and assumptions for capital returns and costs. An implied price of 176p – in line with Liberum’s target – offers lots of upside until you note that the target price was 300p as recently as May, and 620p in March 2022. Less optimistic City estimates mean the shares trade on 57 times consensus earnings for the 12 months to June 2024, which we do not think justifies talk of cheap valuations. 

Meanwhile, Peel Hunt concluded in its latest report that “what is required here is a series of solid prints” and “management resisting the temptation to run before it can walk”. Rebuilding shattered confidence, as is often the case in the stock market, can take time – and that’s assuming the challenge does not get tougher from here.

The hope for the Hotel Chocolat bulls is that 2023 will be as bad as it gets for the business, and that things will quickly turn a corner. While a turnaround for the shares is of course possible, the medium-term outlook tips us towards further pessimism. With weak margins and middling confidence in profitable growth, we see more reason for investors to occupy the bear camp.