100 Years; Still Going Strong?
As I mentioned on Friday, Thornton's are a bit of a strange company to analyse. Without trying to place too much faith in my predictive abilities, usually I find that one can sort of intuit what's wrong with a company when you first glance at its metrics and sector - cheap old school manufacturing company? Probably got a problematic pension plan. Retailer apparently cheap by every metric? Off-balance sheet liabilities, probably in the form of lease commitments, which make their position a lot more precarious than you might otherwise think. When I saw Thornton's, then, I expected to see the usual retailer story, something like HMV and Game. When I put the graph together, though, that immediately got called into question.
The key to the 'bull case' of a number of the companies I look at is that their profits are squeezed by the recession - and hence, should people get a bit more free with their cash, things will pick up again for them. One glance at that chart tells us that's just not the case - Thornton's profits have been in decline for a long time, it's been caused by a margin squeeze (revenue has continued to rise) and, surprisingly, the recession hasn't been that bad for them. They're still making money, which is more than can be said for many of our companies!
Indeed, it looks like they've been in decline for a long time. That surprises me. I wonder if there's ever been, or will ever again be a time consumers were so flush with cash than in the decade after the turn of the Millennium. I wouldn't particularly say they're being replaced by the internet, either - though maybe some people buy chocolates online. Their product is also apparently resilient, something that was driven home when I mentioned them on Twitter:
Thornton's focus on 'year-round gifting'.. bought for gift not consumption = value not in product but in other party knowing it's expensive?
That's the Buffett rationale for See's Candy's enduring value isn't it?
Yep, pure pricing power if viewed from that perspective.
A dash of economics
Traditional economics tends to categorise goods based on a number of principles - for instance, the law that as price rises, demand falls. As income falls, demand falls - for 'normal' goods. There are exceptions to these rules, but 'normal' as a term tends to categorise the goods which the vast majority of the companies I analyse provide - as they raise prices, fewer people purchase their goods. As incomes fall, as in the recession, fewer people purchase their goods.
It strikes me that Thornton's have a bizarre product demand curve - a strange, symbiotic relationship between price and sales. Since so much of Thornton's sales are made for someone else, there's the paradox that the chocolates being expensive is almost a selling point. You don't buy a box of Tesco Value chocolates for your boss or your girlfriend's parents! I'd argue it's not just the fact that the price implies they're good - it's the very fact that you're saying to someone that you're willing to spend a good deal of money on them.
I wonder if that very strange product profile makes them fundamentally different from the retailers I immediately associated them with. They're not getting pummelled by the internet, like Game or HMV were, and I think we're going to be giving chocolates as presents for a long time to come.
Times are changing
That's not to say they're standing still, though - quite the opposite. They say that their vertically integrated business model is risky - producing the chocolates and then selling them at their own stores - presumably because it's quite a narrow remit. In that vein, they've been seeing some substantial growth in sales to the supermarket and sales through their online business (does this question my dismissal of online competition above?). They also, curiously, say that as they close almost half of their stores over the next 3 years, they'll be replaced with franchised businesses - 'protecting contribution and customer goodwill'. Smaller units might be more feasible, with a better sales to cost ratio (their definition of 'franchise' seems to be small units in other stores - not my area of expertise) but I think it's probably a little hopeful to say that brand awareness and 'customer goodwill' will be maintained. There is surely a price to pay.
On top of that, included in their pretty weak interim report was a note commenting on the fact that part of their franchise sales reduction was due to 6 'significant franchises' held by Birthdays Ireland, which went into liquidation. I suspect their intention was to make the sales drop seem 'exceptional', with the liquidation seeming a one off. Unluckily for them, it just drilled home the problems with many of their self-identified franchise locations - they like card shops, for instance, and I suspect high footfall department stores are also good. I'm not particularly positive on the prospects of either of those sub sectors!
Not only does an investor have to worry about Thornton's and their own lease obligations inflating 'visible' debt figures, then, but one also has to worry about the state of their franchisees - something which you can't as easily gauge from the annual reports. There is one potentially saving light that I've been holding back, though; the fact is, profit figures aside, the group remains strongly cash generative. The impact of depreciation and amortisation in their figures serves to drag down apparent profitability while meaning cash flow remains strong - and, from the point of view of a business trying to downsize, it should be a continuing trend given that the group doesn't need to spend a lot on capex. The cash they do generate is mainly going towards restructuring the business in terms of ending leases and the like, but borrowings appear to be continuing to come down, too.
It seems too uncertain for me, but it's a more compelling investment case than I expected. I confess, try as I might, I still find myself biased against certain businesses; and Thornton's was one of them. Now I find myself tempted to really toy with the figures and see just how much the company - and the equity value - can take.