Why we invested in Patisserie Holdings

Patisserie Holdings (AIM:CAKE), is a UK branded café and casual dining group offering cakes, pastries, snacks, meals and hot and cold drinks from over 200 stores in the UK.

It currently operates under five different brands – Patisserie Valerie, Druckers – Vienna Patisserie, Philpotts, Baker & Spice and Flour Power City.

The largest and best-known brand, Patisserie Valerie, represented 75% of Group turnover and 80% of Group operating profit in the last reported 6 month period ending 31 March 2018.

For the last full year ending 30 September 2017, the Group had sales of £114m and pre-tax profit of £20.1m, having generated operating cash of a similar of a similar amount. In every practical sense, it therefore looked in great shape.

– Background

Patisserie Valerie was first opened in Frith Street in London’s Soho in 1926 by Belgian born Madam Valerie. 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 the Group’s Soho branch.

But enough of the romantic past!

– AIM admission

Patisserie Holdings PLC, the holding company of the Group, was admitted to AIM on 14 May 2014 at a share price of 170p.

£32m was raised by the company for the purpose of paying down senior debt (£21.9m) and shareholder loans (£10.9m). Total borrowings prior to admission were £33.2m.

£46.5m was also raised by selling shareholders of which Executive Chairman Luke Johnson received £23.6m, Chief Executive Paul May £5m and Finance Director Chris Marsh £1.45m.

These were the only Executive Directors with the Non-Executives:
Lee Ginsberg – former FD of Domino’s Pizza
James Horler – ex Frankie & Benny’s and La Tasca restaurants

The Board has the same composition today and, given the rapid expansion since IPO, seems to have needed bulking up!

At the time of Admission the Group had 138 stores.

The Executive Directors oversaw a period of growth from 8 stores in 2006, suggesting they initially had a fairly hands-on involvement from relatively humble beginnings.

The Group’s main bakery in Birmingham, its only freehold site, is also the head office.

All the stores are leased.

– Why we invested

Unless the valuation looks very compelling, we are generally reluctant IPO investors, preferring to see how new AIM arrivals develop in the public eye. Having had a good look, we first invested in CAKE in December 2016, attracted for the following principal reasons:

Growing sector
A business that is simple to understand, follow and monitor
Retail roll-out self-funded from internally generated cash flow
Attractive operating margins 16%+
Attractive Return on Equity 15%+
Highly cash generative
Growing dividend distribution – interim dividend was raised 20%
Strong net cash position and zero debt
Experienced senior management who had a material stake in the business, despite selling down at IPO
UK domiciled
Clean financial statements with an absence of adjustments

In summary, we invested in what we considered was a relatively simple, well-run, cash rich business, overseen by highly regarded sector specialists, operating in a very vibrant sector, that was easy to understand.

We like investing in companies where senior managers are large shareholders and have grown with the business. Luke Johnson and Paul May both come with excellent reputations in the sector and, despite selling down, retained material equity stakes.

We were slightly wary of Mr Johnson’s multiple directorships, but reassured that, with a 37% stake in a sizeable business he would hopefully be keeping a close eye on things.

– What has happened

On 10 October the Company announced that the board of directors of the had been notified of significant, and potentially fraudulent, accounting irregularities and therefore a potential material mis-statement of the Company’s accounts. This had significantly impacted the Company’s cash position and may lead to a material change in its overall financial position.

On 11 October they announced that, without an immediate injection of capital, there is no scope for the business to continue trading in its current form.
Chris Marsh, the Chief Financial Officer, has been suspended from his role and was subsequently arrested by police, although then released on bail.

– Recent Director option sales

In July 2018, Chief Executive Paul May and Finance Director Chris Marsh exercised options and immediately sold shares for a combined value of £5.26m. While they were both sizeable transactions, Mr May still held 4.54m shares, representing a sizeable stake with a value of approx. £20m.

Option exercises followed by share sales by senior managers are a regular part of the stock market and AIM and we are particularly wary if this results in the said managers having little or no stake afterwards. This was not the case here, although Finance Director Chris Marsh, who is considerably younger than Johnson and May, has only ever held a relatively small stake in this business.


– Cash flow was the real attraction

We aren’t big on earnings numbers or the mythical EBITDA so often quoted by analysts. Cash flow is our focus and the real appeal of CAKE to us.

In the 6-month period to 31 March 2018 claimed operating cash flow of £14.6m in the period, was up £2.9m or 25% (2017: £11.7m). There was nothing untoward on the balance sheet to suggest any unusual movements.

£2.7m of this cash was used to make income tax payments and £5m invested in capital expenditure, leaving free cash flows of £6.8m (2015: £4.9m). Of the £4.4m, £2.9m was invested in new stores and £1.5m in refurbishment of the existing estate or additional bakery or fleet facilities. Normalised Free Cash Flow for the 6 months, excluding new store investment, was therefore £7.7m.

The business is apparently well-funded with zero debt and claimed net cash at the end of the first half of £28.8m.

– Any clues in the cash flow?

Hindsight is a wonderful friend to the investor and, looking at things afresh, cash flow post IPO may have been a little too rosy, however, glorious cash is an attribute of a business such as this.

In the period prior to IPO, when the group was opening 15 sites per annum, capital expenditure represented approximately 58% of operating cash flow and 10% of turnover. For the period ending 30 Sept 2017, when the group opened 20 sites, cash flow represented 36% of operating cash flow and 7.6% of turnover.
Capital expenditure for the year ending September 2017 was in line with the prior year which may be viewed as mildly surprising given the ongoing maintenance requirements of a larger estate. However, allowing for lease expiries the net increase in the store estate was only 15.

Finance expenses of £36,000 in the period suggested the Group was using an overdraft facility on occasions.

– Low level of finance income

The single orange flag which may have suggested that something unusual was going on was the low level of Finance income for a business that claimed such significant cash reserves at its accounting period end.

Finance income for the year ending 30 Sept 2017 was only £44,000 whereas the Group stated period end cash was £21.5m.

However, rapidly growing businesses of this nature, which are collecting small amounts of cash on a daily basis and periodically paying out large sums to contractors can experience wide swings in cash flow, necessitating cash be available at short notice. Furthermore, deposit rates have been extremely low over the past few years.

– Wage inflation

We were concerned about the impact of wage inflation but the Group appeared to be taking this in its stride.

While inflation on food costs was high, management commented how they had benefited from a number of contract renegotiations, and in some cases switched suppliers to mitigate inflationary pressures. This, along with production efficiencies from investment in their bakeries helped them maintain a gross margin of just below 78%.

Management commented that ongoing labour inflation was built into budgets and is being absorbed as the group continues to grow.

– Too many pies….

At the time of AIM admission Luke Johnson was a Director or Partner in more than 50 companies and limited partnerships, including some high profile names. However, he was not a Director of many of Patisserie Holdings’ key operating subsidiaries, notably Stonebeach Limited, through which Patisserie Valerie trades, where Messrs May and Marsh were Directors.

Companies House currently lists him as Director and Partner in 33 companies and Partnerships although the list excludes Elegant Hotels PLC (see below), where he also a Director. Another list indicates he is a Director or Partner of 40 companies or LLPs.

Of significance, since June 2015 Mr Johnson has been Executive Chairman of Brighton Pier Group, which owns and trades Brighton Palace Pier, as well as twelve premium bars and six indoor mini golf sites. This business had a very active period this year.

In May 2017 he was also appointed Non-Executive Director of AIM listed, Elegant Hotels Group. However, the influential advisory firm ISS urged shareholders to oppose his election to the Group, on the grounds he is already on the boards of two other listed companies.

He stepped down from the Board of Arden Partners (AIM: ARDN), the AIM listed institutional stockbroker in May 2018.

He also has a controlled function in Risk Capital Partners LLP an FCA regulated firm.

Mr Johnson also has an interest in Gail’s Bakery (a trading name of Gail’s Ltd) and there was rumour of a combination of this business with CAKE. Gail’s Ltd is ultimately owned by Bread Holdings Ltd in which Luke Johnson’s Risk Capital Partners II LP and RCP Co-Investment LP have a combined controlling stake.
Surprisingly, financial statements have never been filed for either of these 2 LPs whose ultimate ownership seems to be hidden behind an extensive web of Limited Partnerships.

Mr Johnson also writes a regular column for the Sunday Times.

Paul May is involved with FD Chris Marsh in another business called Christian Lewis Performance and Classic cars, a company which appeared to be technically insolvent at 31 May 2017.

With due regard to current events, it now seems clear that Mr Johnson needs to have more focus in his business interests and extract himself from a number of executive and non-excutive roles….for his own financial well-being and that of his fellow shareholders!

 

We are absolutely staggered how a profitable, cash generative business of this nature could have collapsed so dramatically and suddenly. We will issue an update when we know more.