Description

Thorntons plc is a 100 year old manufacturer and retailer of chocolates in the UK.  With its eponymous brand, the company is the market leader of the inlaid boxed chocolate category with a 35% market share.  The company’s branded offerings are focused on the mass premium end of the market that it accesses through both the grocery channel and its own retail store base.  Thorntons has a market cap of £80 million ($135 million) and is trading at about 14x ttm earnings and under 0.6x ttm EV/Sales.

We believe the current valuation presents an opportunity to buy a strong brand, in a very resilient category that is significantly under earning its potential.  A confluence of factors has led to an under-appreciation of the changes underway at the company and consequently obscuring its intrinsic potential: the recent change of ego-driven and empire-building family management and governance to professional management and governance, the creation and execution of a polarizing strategy, a brand that has never resonated well with the London investing and analyst community given its roots are in the blue collar manufacturing belt of Northern England, and the difficult consumer environment that has plagued the UK since the Great Recession.

Thorntons was a family run company that went through several decades of being under managed.  Through the 90s, the company embarked on a reckless retail expansion binge which hammered profits and saddled the company with 25 year leases on stores that would never be profitable.  Beginning in 2000 the retail expansion stopped, but there was never a clearly articulated or executed strategy around product management, channel management or pricing.  In the mid to latter half of the past decade, Board and management changes started to take place and have resulted now in a clarified strategy and a plan with reasonable people in charge to re-focus the business and drive profit growth.  

We believe continued execution of the current strategy of focused channel management, with greater discipline on pricing architecture, SKU management, and cost control (elaborated below), can lead the company to generate earnings per share of between £0.15-£0.23.  Even at £0.23 in EPS, the company would be generating operating margins of under 10% which is not a stretch at all for a branded FMCG company.  We believe the stock is reasonably worth £2.40 to £4.00 or more.  At £4.00, it would be trading at an EV/Sales of about 1.5x on, arguably, sales that still had much potential after years of under-monetization.  Private market transactions for confectionary companies such as the recently announced acquisition of Russell Stover or Godiva a few years back have been in the range of 1.6-1.7x.  Notably, these valuations were reflective of earnings potential rather than current earnings.

Background & History

Thorntons was founded in 1911 as a confectioner of fine toffee and evolved over the years to a manufacturer of high quality chocolates particularly famous for its ganache and centers.  It was a family run company that was eventually passed on to the founder’s four grandchildren.  The Thornton family had a history of feuding and the company became a battleground for the grandchildren.  In 1988, after one of the grandchildren was ousted over disagreements about the future direction of the company, Thorntons was listed to raise funds for the construction of a chocolate factory.  The resulting significant new capacity put pressure on the company to aggressively grow which led to a frenzied expansion of the retail store base.  Stores increased from 177 at the IPO to 410 at its peak in 2000.  This expansionist strategy lacked discipline regarding the size, style, and location of the shops.  Moreover, lease terms were typically 25 years and landlord friendly as is common in the UK.  While sales tripled, pre-tax profits went from £7.5 million in 1988 (14.4% margin) to £5.5 million in 2000 (3.6% margin).  In the meantime, consumers had diversified their buying habits from solely the high street to also supermarkets where Thorntons historically had minimal presence. 

Leadership and strategy had been a mess for years.  After being a dysfunctional family run business, the company hired its first outside CEO, Roger Paffard, in 1996.  Paffard played an integral role in reckless expansion and upon departing was reported to profess an “ardent and unfathomable desire to spend more time raking leaves with family.”  In 2000, Peter Burdon became the new CEO and during his tenure things were mostly stable aside from the occasional profit warning.  At least, he recognized the overexpansion and thwarted new openings.  There was an MBO proposed in early 2004 which fell through, and John Thornton resigned from the BOD two months later which would effectively mark the end of family involvement with the company. 

Christopher Burnett became Chairman and then made a buyout offer at £1.85 in 2005.  Weak results during the 2005 holiday season led Burnett to revise his offer to £1.30, which was rejected.  Burnett resigned and John von Spreckelsen, considered a turnaround specialist, became Chairman.   Peter Burdon was resistant to the idea of selling to supermarkets and thus resigned after clashing with von Spreckelsen over distribution strategy. 

Mike Davies joined from Mars in 2006 to take over the CEO role and really pushed the business into the supermarket channel, something that was previously viewed as taboo at Thorntons.  However, he was overseen by a hands-on Chairman who had a retail background and was resistant to the idea of closing retail stores.  So while the FMCG business grew, the retail albatross largely remained.  There were additional missteps during this period such as SKU proliferation with an inconsistent offering across channels and cuts to investment in packaging driven by a “pile it high, sell it cheap” mentality.  After the Great Recession and under pressure from investors, Davies was replaced by Jonathan Hart as CEO in 2011 and John von Spreckelsen was  replaced by Paul Wilkinson as Chairman in 2013. 

Beginning in 2011 and for the first time in the company’s history, Thorntons finally has some semblance of strategy.  Importantly, the company is reducing the retail store footprint to 180-200 stores.  Finally there is both board/management support to close stores and the opportunity to do so thanks to maturing leases. 

Opportunity

We believe that despite its colorful history, Thorntons has a strong product and brand.  It’s a high quality product and according to our field conversations, UK consumers rank it among the top of any manufacturer globally in blind taste tests.  The brand has a strong heritage as “the blue collar man’s luxury treat” and is well recognized particularly outside of London.  Brand strength is illustrated by the fact that despite years of mismanagement, market shares and measures such as brand advocacy have remained strong.  Another testament to the strong brand with relevance is that Thorntons was able to go from being non-present in the grocery channel to now being the category captain in inlaid boxed chocolates.

Even under status quo, we think this is an attractive investment opportunity.  The company is finally in a position to shed the retail albatross, and channel mix alone should be enough to generate a decent investment return.  Given what current management inherited, their actions have been reasonable so far.  Importantly, they have moved to right size the retail store footprint from 364 to 260 stores currently, with a plan to get down to 180 in the next two years.  They have worked to clarify brand (and product) positioning and image and address product related channel conflicts.  There have also been cost and operational improvements such as being more systematic and controlled on store refit expenditure, outsourcing IT and distribution, and improving management reporting systems

We believe there is an even more attractive multi-year prize to be unleashed by stronger strategy and execution and would point to a few areas for potential opportunity.  Much of this relates to adopting an FMCG mindset and running Thorntons like a brand rather than a product/retailer.  Specifically, here are some of the potential areas of opportunity that management is addressing:

• Pricing & promotion strategy.   Our field work suggests Thorntons has been a leading culprit of the promotional activity seen in the UK boxed chocolate market.  Over the last 6 years, we estimate the company lost 700bp of gross margin through net price.  A survey of the company’s website will find 50% of products on promotion and large variance in price per pound (ie, $6/lb all the way to $40/lb).  Comparing to peers such as See’s Candies, Godiva, and Lindt, this is significantly more promotional activity.  Despite having a $22/lb median list price (similar to  See’s Candies), Thorntons median price post discounts and promotions is $16/lb.  Further, in the field we have heard of retailers using Thorntons “tactically” and that employees send “mixed messages” on things like promotions (ie, marketing team communicating a promotional policy but sales people then doing something different). 

• SKU management.  We have heard in the field that Thorntons has over 800 SKUs and refreshes 80% of them annually.  The company has indicated that SKUs are closer to 600.  Regardless, we believe this is far too many SKUs.  Based on our study of SKUs on peer websites, we believe Thorntons has about 2x as many SKUs as peers.  This does not take into account the fact that Thorntons will also use unique shippers for each retailer.  Vetted in the field, we believe there is a tremendous amount of waste caught up in design spend, purchasing power not being effectively leveraged, changeover time, and general complexity in the business. 

• Cost control and culture.  We think that there is a legacy of bloat.  In the field we have heard the company historically has been a sleepy organization that has lacked a culture of accountability.  Personnel expense is 28% of sales compared to confectionary peers and UK retailers at 10-20%.  Admittedly, this business has a more labor intensive manufacturing process than other confectioners (which would arguably translate to more pricing power) and also more seasonality than other retailers.  However, there are 265 management and G&A employees.  In the field we have heard of layers of management not adding value or profits.  We think that general complexity and a culture of complacency have likely led to a bloated cost structure (ie, different finance or HR guys for each channel). 

We believe that management understands the above points and is taking actions to address them.  Now, that management has initiated action on several fronts and has stabilized the organization, we believe management is going to become more aggressive with regards to the above points.  Management are committed to delivering an operating margin that is closer to 10% and some of that will be dependent on the intensity to which they execute on areas highlighted above.  In fact, very good execution can likely lead to margins that are in the low double digits – which would still be below levels seen by omni-channel chocolatiers such as See’s Candies and Lindt, let alone other branded food and beverage companies.

Valuation

As Thorntons continues to transitions away from own retail and toward wholesale, segment mix shift and just modest underlying improvement should increase margins from current c.4.5% to over 6.5%.  With low single digit revenue growth, we get FYE06/16 EPS of £0.15 and at 16x would lead to a stock price of £2.40, or more than a double from current levels. 

If better execution leads to margins of 9-10%, which is supported by benchmarking, field conversations, and commentary from management, EPS would be £0.23 and at 17-18x would be a £4.00 stock.

Thorntons could also be an acquisition target.  There have been bid rumors in the past and a large shareholder has publicly commented that the company “could be attractive to an overseas confectioner with limited UK presence.”  Private market transactions such as the buyouts of Godiva and Russell Stover or Hotel Chocolat’s capital raise have been done at valuations of 1.6-1.7x sales, even without inspiring margin performance.  This would imply a value of around £4.50 per share.  Shedding uneconomic retail stores is an important step to making this more attractive to buyers and that has precisely been a focus area over the last few years.

Management have been frequent buyers of stock.  CEO Jonathan Hart owns about 220,000 shares, CFO Michael Killick owns about 285,000 shares.  The Chairman Paul Wilkinson owns about 1.4 million shares.

Risks

This is a highly seasonal business with operating leverage so results can be quite lumpy

Stock could be a value trap in the case of weak execution

Catalyst