Description

Executive Summary

Patisserie Holdings (CAKE:GB) is a high quality bakery/café business with excellent returns on capital  employed (30%+ post-tax), fantastic unit economics (payback period for a new store is 23 months), a long growth runway (opening ~20 stores per year on a current base of 193 units, mgt has identified over 200 additional locations), and multiple call options. It is run by a highly incentivized and experienced chairman that led his last publicly traded restaurant concept to over 10x upside in 6 years. The company is underfollowed as a small-cap UK company with no bulge bracket coverage. I believe shares are conservatively worth 481 GBP/share (4.81p), ~30% higher than the current market price.

Business Description

Patisserie Holdings is a UK-based business positioned across both the café and casual dining markets. The main concept (144/193 stores) is the original Patisserie Valerie brand. The other brands were strategic acquisitions, are small in size, and are neither actively being grown nor crucial to the story.

~50% of sales are cakes and the company has carried many of the same recipes since the original store was founded in 1926. Core to the groups’ operations is a hub and spoke model whereby their 7 central bakeries deliver high quality handmade pastries, slices, and cakes to surrounding stores. All pastries are produced in-house and delivered daily to stores. The group’s current hubs are capable of serving up to another ~100 stores. Coffee is another ~10% of sales. The remaining ~40% of sales are sandwiches and other drinks/snacks. There is a consistent theme across the brands of quality but still good value (an affordable treat).

Stores have a broad demographic, an all-day trading format from breakfast through to dinner, a takeaway offering, and an affordable proposition with an average spend per head of approximately £9. Typical hours are 7am to 7pm. 15% of revenue is generated after 5pm. Unlike most other coffee shops and casual dining restaurants, Patisserie Valerie offers table service (comprises ~65% of sales). The majority of stores are on high streets (75%) but they have also succeeded in retail parks (2%), shopping centers (8%), train stations (7%) and concessions stores in larger retailers (8%). Because of the cakes and coffee concentration, gross margins are an astounding ~78% and EBITDA margins ~22%.

The store model is formulaic and now well established. Each new Patisserie Valerie store takes ~4 weeks to fit out with a typical capital expenditure of just 250K GBP. This is significantly lower than most restaurants, which reflects both a simple design but also the fact that each business operates without a full-service kitchen (since stores are supplied by the central bakeries and only need small kitchens for some food items). New stores are profitable within the first month and the payback on invested capital is 23 months. At the time of IPO, the company (with help from an outside party) identified over 250 additional new Patisserie Valerie store sites based on their ability to meet existing payback criteria and EBITDA generation consistent with new stores. The company has been very disciplined (I would say overly conservative) about opening ~20 stores per year, so even accounting for store growth since the company went public, there is over 10 years of growth left at the current 20 stores/year pace.

Unit Economics of a New Patisserie Valerie Store

Ownership History/Situational Overview

Patisserie Holdings started as a single “Patisserie Valerie” store on Frith Street in Soho, London, back in 1926. It was founded by Belgian-born Madame Valerie who came to London to introduce fine continental patisserie to the English. During the Second World War the Frith Street premises were bombed by the Luftwaffe and Madam Valerie subsequently set up shop around the corner in Old Compton Street where her legacy continues to this day in their Soho branch. In 1987, the business was acquired by the Scalzo family which grew the concept to 8 stores in London. The stores were run well and held onto their historical roots, but it was still a very small and somewhat “sleepy” business under family control.

The big change happened in 2006 when the group was acquired by Risk Capital Partners, led by Luke Oliver Johnson. Luke Johnson is a well-known and successful serial entrepreneur in the UK. In 1993, Johnson took control of PizzaExpress with partners and subsequently became Chairman. He grew PizzaExpress from 12 owned restaurants to over 150, and the share price from 40p to over 900p. He has a long history of other successful growth stories, which I won’t fully flesh out here, but can easily be read by visiting his Wikipedia page or elsewhere online. Johnson also is an author and wrote a business column for the Sunday London Times as “The Maverick” from 1998 to 2006. He is also an Oxford graduate. I recommend reading his book which is a compilation of many of his Sunday columns to better understand his business mentality.

Today, Johnson is the chairman of Patisserie Holdings. He personally owns 38.6% of the company, which at current market values is ~140M GBP. While it is hard to know for sure, I estimate this is a bit more than 50% of his net worth—so this is a very meaningful bet. He is paid only 60K/year as the executive chairman of the company, so his interests are very much aligned with shareholders. The current CEO and CFO also joined alongside Luke Johnson in 2006. The CEO, Paul May, also has strong entrepreneurial roots having founded and sold “Cash a Cheque” after growing it from one to 60 stores in four years.

Johnson and May have helped grow the company from eight sites in Central London in 2006 to 193 at the end of 1H 2017. Risk Capital Partners’ original stated reasons for investing in the company were:

• “a well established brand with strong customer loyalty”

• “Opportunity for a national chain of café bakeries”

• “Build Patisserie Valerie to be the market leading patisserie brand

Under Johnson’s control, the company has made four small acquisitions and has grown the flagship (and original) brand, Patisserie Valerie. Patisserie Valerie is still the main driving force behind growth as it is 144/193 units and the only meaningful grower.

Patisserie Holdings IPO’d in May 2014 and raised £33m of new money (at 170p per share) to pay down all existing debt and to finance the acquisitions post 2006. 

Keys to the Thesis

• Excellent unit economics leads to great returns on capital employed

• I have already laid out the 23 month payback on new stores. Below I show the company’s impressive ~38% ROCE pre-tax and 30%+ post-tax returns on capital employed at the group level.

• The excellent returns are a function of both very high margins and good capital turnover:

• Substantial growth opportunity

• Great unit economics and returns on capital employed are extremely valuable when you have a long growth runway. Patisserie Holdings is only at 193 units as of 1H 2017.

• At the time of IPO, the company identified 250 additional site locations. Since then, the company has had success opening up in formats other than high streets, so it is conceivable that the ultimate TAM has increased. Regardless, there are easily over 200 more locations available, which at ~20 new stores/year, provides unit growth for the next decade.

• Over the next few years, you get HSD % top-line growth just from unit openings.

• Relatively low risk business and execution risk

• "I was attracted to fast-food restaurants because they were so easy to understand. A restaurant chain that succeeded in one region had an excellent chance of duplicating its success in another." – Peter Lynch

• Patisserie Holdings may not be a fast-food restaurant, but the same concept applies. It has fantastic unit economics and a long runway for growth. Now, the challenge is to just continue executing, methodically opening up ~20 stores per year while constantly becoming more efficient. As far as growth stories come, this is relatively low risk.

• There is no tech or obsolescence risk. There will always be a market for cakes and coffee. The store formats are formulaic at this point and many of the recipes have been around since 1926.

• The company is being very disciplined in rolling out new stores

• They have consistently opened about 20 stores/year with a couple of closures as leases come up for renewal.

• Store expansion is being funded entirely from internally generated cash flow. The company has a net cash position.

• The company is the largest regional player in their cakes niche and mostly competes against mom and pops

• The key to their excellent returns is their hub and spoke model whereby their 7 bakeries delivery fresh items to their stores on a daily basis. This keeps their product fresh, but also reduces the need for a large expensive kitchen and considerable labor each day.

• The company’s brand is also a key advantage as many of the recipes have stayed the same since 1926.

• Patisserie Holdings has an A+ management team as both the chairman, Luke Johnson, and the CEO, Paul May, have significant experience taking small concepts and successfully multiplying the unit count.

• In 1993, Luke Johnson took control of PizzaExpress with partners and subsequently became Chairman. He grew the business from 12 owned restaurants to over 150, and the share price went from 40p to over 900p. He sold out in 1999.

• See the below video where Luke Johnson explains how he opportunistically bought Pizza Express and grew profits 20-fold. It is a great 4 minute watch. There are many parallels with Patisserie Holdings. I summarize some of the highlights below the link but it is worth a watch:

• http://www.telegraph.co.uk/finance/businessclub/10466344/Luke-Johnson-how-we-grew-Pizza-Express-profits-20-fold.html

• Johnson is asked by the panelist to explain his success with Pizza Express. He describes why it was so attractive, but almost all of the takeaways also apply to Patisserie Holdings. Johnson says “If you want a perfect biz formula, Pizza Express might be it…”

• Incredibly high gross margin

• Incredibly quick to cook, skill required to cook is much less in a normal restaurant

• The amount of space the kitchen takes up is less than normal

• Lower labor costs, less property used back of house so more for front of house

• Has broad appeal from children to couples

• “All we had to do was replicate it. The business had stalled because of the recession and the family fell out. We just expanded it. That is how we grew it 10-fold through the 90’s and profits 20-fold.”

• I am not going to predict 10x upside for Patisserie Holdings, but I think the playbook with Patisserie Holdings is very similar: take great unit economics and replicate it in various geographies.

• Johnson was not a one hit wonder by any means though. After selling out of Pizza Express, Johnson started Signature Restaurants, which owned The Ivy, J.Sheekeyand Le Caprice, as well as the Belgo chain, selling the business in 2005. 

• In 2000 he started the Strada restaurant concept from scratch and took the chain to 30 units, selling the business in 2006.

• The total proceeds from these two disposals were in excess of £90 million.

• Luke founded Integrated Dental Holdings with partners in 1996 and grew it to become the largest UK chain of dental surgeries with over 500 dentists. This was sold in 2006 for over £100 million.

• Paul May, Patisserie Holdings CEO

• May founded and sold Cash a Cheque, having grown it from one to 60 stores in four years.

• The bottom line

• This is an A+ management team that is serious about shareholder value and has a tremendous amount of experience.

• Multiple call options

• Acquisition of the group

• Panera was recently bought by JAB for 15x fwd EBITDA and 34x fwd EPS. Patisserie Holdings trades for ~12.5x Sept 2018 EBITDA and ~20.5x fwd EPS. I think Luke Johnson realizes the tremendous value in the chain today but will eventually look to realize fair value.

• I think the most likely outcome is that Johnson further develops Patisserie Valerie, acquires another concept (bringing me to my next point), and then later sells the business several years down the road. Johnson said in an interview that he “left too much on the table” at Pizza Express and I do not think he will make the same mistake with Patisserie Holdings.

• Acquisitions by the group

• I think Luke Johnson wants to acquire another concept and roll it into Patisserie Holdings. They have made many small acquisitions so far, but would love to make a large acquisition if they can find the right opportunity. They have a net cash position and could easily take on a couple turns of leverage. Normally, I would consider a potential large acquisition without much visibility an investment negative, but with this management team, I see it as a significant positive. I would love to invest alongside Luke Johnson and a new turnaround concept.

• Franchising growth

• The group has not done any franchising yet, but Johnson has said in interviews dating back to as early as 2014 that the company has turned down offers to franchise the brand overseas due to a concern about quality control.

• http://www.telegraph.co.uk/finance/newsbysector/retailandconsumer/10700271/Sunday-interview-Patisserie-Valeries-Luke-Johnson.html

• I think this highlights the upside optionality in this security. While Johnson is an excellent manager and very incentivized alongside shareholders, he is certainly not in a hurry. I think investors just looking at the headline multiple are missing the many ways that this company could dramatically increase profits.

• Wholesale growth opportunities

• The company’s latest results for their 1H of 2017 ended March 31, 2017.

• In April, the company started a pilot program with 12 Sainsbury’s stores. Patisserie Valerie introduced a temporary pop up patisserie counter in these stores which enabled loyal customers to buy their cakes while shopping for other items in the store.

• Sainsbury’s is the 2nd largest chain of supermarkets in the UK. It has over 600 supermarkets and an additional 600+ convenience stores.

• They announced recently that the collaboration “has proven to be so popular that we are introducing our pop up patisserie counters into another 6 stores.”

• https://www.patisserie-valerie.co.uk/press.aspx/2017/6/26/119/Patisserie-Valerie-Comes-To-Another-Six-Sainsburys-Stores

• This expansion with Sainsbury’s is an exciting development that should be incremental to sales and is hopefully in its early innings.

• Price increases

• Patisserie Valerie has not raised prices in 5 years. Costa raised coffee prices this year. With Patisserie’s incredibly high gross margins, they do not need to push price, but I think they certainly could and they are due.

• Underfollowed:

• No bulge bracket coverage. No perfect comparable company. Small-cap with an even smaller float due to Johnson’s large ownership %. The company does not hold conference calls and only reports twice per year (FYE in September, next report out in November). Zero write-ups on VIC, SZ, seekingalpha, etc.

Valuation

There are many ways I could approach valuation for this asset, but I’ll keep it very simple as I do not think this idea requires any elaborate exercise to highlight the exciting opportunity in this name.

Let’s ignore franchising opportunities, any material impact from Sainsbury’s expansion, price increases, and any potential accretive acquisitions. Let’s just assume that in a base case, the business continues on its steady state of growth by opening 18 stores per year at good returns on capital, has 1.0% comps at Patisserie Valerie stores, has no gross margin improvements, and modestly levers SG&A 30 bps/year as it takes advantage of an underutilized logistics network over the next 100 stores. In this very modest scenario I am calling the “base” case, I get to 17.61 in EPS (.17p) in 2018, representing 12.7% EPS growth y/y on a 10.7% top-line increase. Note, the company does not report official comps, but stores mature very quickly, so a sales/average store metric is essentially equivalent.

In this simple scenario, what should Patisserie Holdings trade for? While there is no perfect comparable company, a collection of 8 growing restaurant peers with average rev growth of 3% and EPS growth of 6.6% trade for an average of 23.8x fwd P/E and a median of 24.8x. Let’s split the difference and call it 24x. This is roughly in-line with someone like TXRH, a fast-growing owned restaurant concept. 24x 2018 EPS of 17.61 would result in a 422.6 target price (4.2p) or 16.1% upside. That is reasonable upside on what I would describe as very conservative assumptions.

In the bear case below, I assume slightly slower openings, flat comps, flat GM, flat SG&A margin, and a 20x fwd EPS multiple. Note, through unit growth, EPS growth is still 9% in the bear case. In the bull case, I assume 20 stores open/year, Patisserie Valerie comps are 2.0%, GM increases 20 bps, and SG&A levers 30 bps. In this scenario, you get 17% EPS growth. Finally, the “uber-bull” case assumes Panera’s recent take-out multiple (34x fwd EPS) on my bull case assumptions. The table below summarizes these assumptions. My probability-weighted assumptions result in a ~30% risk-adjusted return:

It is worth noting that I do not actually think the company will be acquired at 34x in the next 12 months. I also do not think a 2018 EPS framework necessarily is the most fair valuation framework for a company that can grow units at very high returns for the next decade and has many untapped growth opportunities I am not giving them credit for. This is just an exercise to show that at the current price, you are buying into a high quality business led by a very capable management team at a bargain price even using fairly conservative assumptions. I am happy holding this high quality business compounding EPS at a LDD to high teens pace while I wait for either a multiple rerating or this management team to create further value.

Risks

• General consumer slowdown in the U.K.

• Rise in labor costs

• Patisserie Valerie comps stagnate

• Food quality/supply issues

   

Catalyst

Catalysts

• Sainsbury’s upside

• Management makes an accretive acquisition

• The company is bought by a larger strategic or PE buyer