A redacted and printable version of the pitch is here.
Churchill China (CHH) manufactures and sells ceramic tableware mainly to the Hospitality sector in the UK (42% 2019 sales), rest of Europe (36%), North America (11%), and RoW (11%). Churchill was founded in 1795 and has been owned by the Ropers family since 1922. The company used to serve in both Dining Out (which is hospitality) and Dining In (household/retail) end markets, about 50/50 split. In 1999, the management made a decision to cut down plants and headcount, in order to shift the focus to primarily the Dining Out division due to the high margin profile, growth opportunity, and the reliable customer/vendor network. It took the company nearly two decades to gradually change the end-market mix. This decision made 1999 the only year that booked a loss for the company.
Since the pandemic breakout in March, the stock price has fallen from £20 to £10. Currently trading at 13x 2019 earnings.
Why does this opportunity exist?
- Being a microcap in the UK certainly penalizes the company. With only one analyst coverage, the company is not so visible to investors. It is likely that the company is not properly valued.
- Exposure to the hospitality sector makes it an ugly investment. No one wants to touch stuff tied to this sector, especially considering that this company’s sales is mostly driven by eating out activities. I think the market is giving the company a sizeable discount due to this concern.
- The company’s long history itself is a durable moat that will strengthen itself as long as the company exists. The company’s strategic transition in selling more value-added products will benefit from this moat. I see margin expansion a very likely case.
- There’s very high switching and search costs for hospitality customers to switch suppliers; and existing competitors are not willing to compete with each other in a fragmented industry.
- Growth opportunity exists as the company has no presence in Asia; one comparable company has seen double digit growth in sales from South Korea, implying that demand exists in Asia.
- With 20%+ ROIC and a 20% CAGR of net income in the past 10 years, 13x P/E is too low. I expect the multiple to expand to 23x P/E in 2-3 years.
Why NOT to own this company
Before elaborating on my long theses, I wanted to present you some compelling bearish reasonings:
- We will see very limited amount of new restaurant installations that are focused on the sit-in dining experience. This will suppress Churchill’s sales growth.
- To preserve cash and due to the nearly non-existent sit-in activities, restaurants would not replace crockeries. Replacement sales make up a good portion of CHH’s sales.
- For customers that do open or have reopened, they are more inclined to use plastic or disposable utensils for hygienic consideration.
- Ceramic tableware is a segmented and old industry. With a fistful of clay, one can make countless of shapes, color and patterns. Due to this highly customisable nature, I don’t see how this industry can be consolidated as different companies serve different niche markets, so the growth by organically gaining market shares is very limited.
- EU exposure. Most of the revenue growth comes from the EU, which offset the flat UK sales, which has seen decline in LSD rates. And the strong growth from the EU segment depends a lot on the Anti-Dumping duties on cheap Chinese imports.
I think the depressed multiples we see are a result these bearish reasonings. However, most of these arguments are short-term focused that are not relevant to the business fundamentals. With respect to reason #5, the company will continue benefits from the protection because in 2019, the EU just renewed anti-dumping restriction to another 5 years. I believe there’s a good chance the stock can achieve my price target within 5 years.
Reason #3 would be a legitimate concern, but the company’s customers are mostly posh dining concepts, I can’t imagine a Michelin 3-star restaurant start serving meals on disposable plates. That might happen for deliveries, but for sit-ins, I don’t see how it’s going to happen.
For reason number #4, the growth can be achieved by expanding into different geographical zones and/or buying up design IPs, as Churchill did to Dudson. I would even argue that the pandemic has created a refreshed growth opportunity for the company. Sure, we will see many restaurants go bankrupt, but in the EU, bankruptcies mean more liquidation than restructuring. So, we will see more restaurant installations after the pandemic. More, there has been a pent-up demand for eating out, according to a survey. I think the new installations might actually accelerate due to the demand and that the COVID cases are much better managed in the EU than in the States. Of course, this is purely my conjecture, so I won’t factor this into my long investment theses.
In the short term, things are pretty ugly. But with £15m cash on hand with no debt, the company can get through this crisis with confidence. Also, since most of the costs are variable, the company is able to lower the cash cost for operations to below £1m a month. The biggest hit will be the first half of 2020 because the company has a £1.6m capex commitment to expand manufacturing and first-stage kiln firing capacity. The management expects these projects will be done in the first half of the year.
I think the company can end the year with profit AND a positive FCF.
I assume a 50% decline in sales, and gross margin contracts to 68%—the lowest level in two decades. SG&A will be £18m and D&A stays the same at £2.4m. That would imply an operating income of £2.67, or 7.9% margin—halved from 2019. The net income would be £2.1m factoring tax (that figure can be higher because you can defer tax payment to 2021 under the UK gov’s COVID support). As for FCF, I think the company can draw at least another £1m cash from its working capital like it did in the GFC. So, CFO will be £5.5m. Assuming an unrealistically high capex of £3m, we will still have £2.5m in FCF.
My revenue decline assumption is very conservative. The management comments in the annual report released in April that the company’s performance in the beginning of the year was ahead of schedule. I assume the “beginning of the year” means January and February. Using last year’s financials, that’d imply the company did £20m in those two months. A 50% decline from 2019’s £67.5m is $33.75m. I’m basically assuming that the company can only make £12.5m in the remaining ten month.
Historically, more sales come from second half of the year due to holidays. So, with this conservative assumption, the company can still profit and generate positive FCF. Even if the company ends in a loss, we still can get free cash flow out of the business. It underlines the resiliency of the business and that an existential crisis is out of the question.
The company is a quality business that has grown its operating income at circa 20% CAGR in the past five years. Due to the nature of durable goods, the company has very low working capital requirements reflected in very little change in inventory levels. That makes this company a strong cash flow generator that has been compounding its FCF at 12% in the past five years. The only years the company ended up with negative cash flows are the ones the company made significant capex investment or inventory adjustments to reflect the transition into the hospitality end market.
Long History itself is a Moat
Being a 200+ year old company in this business is a significant advantage. If you think about it, a regular plate might last 5+ years before it gets replaced (not to mention that companies like Churchill usually have a five-year warranty in place); for high quality ceramics, they might last 10+ years. As the management mentioned, “a significant proportion of sales each year will be repeat or replacement sales to existing customers.” That means most of the sales are from customers that have been with the company for at least 5 years, and that they are willing to stay with Churchill. This advantage is impossible for new entrants to replicate because you can’t just fast forward the age of your business.
Being in the game for a long time also helps strengthen customer/vendor relationship. This relationship and Churchill’s strong distribution network are reflected in the company’s 80%+ gross margin. This margin profile will continue to improve because in 2019, the company vertically integrated a ceramic materials manufacturer, Furlong Mills, in Stoke-on-Trent, England. This acquisition provides more capacity and flexibility for the company to cut down feedstock costs. I think this acquisition also reflects the management’s prudent spending because the mill was acquired below its fair value.
The management is trying to focus on value added items. Because of the company’s history and its quality products, many chefs are drawn to Churchill. So, the company’s strategic shift benefits from CHH’s relationship with chefs, from whom the company can get an idea of the consumer tastes trend, and manufactured table tops that are designed to fit chefs’ cooking styles. This creates a positive feedback loop because the company can adjust its portfolio to attract more customers, and these customers add more data points of feedback, which adds more clarity to the company to see where the trend is going.
In short, this moat will strengthen itself as long as the company exists.
Strong Customer Captivity
A restaurant, especially higher end ones, bought lots of plates from CHH so that there’s a formality across plates to fit the ambient environment, if the restaurant is to get new tableware from a new supplier, the restaurant has to buy in bulk, which means it has to 1) spend more money upfront, and 2) have to get rid of existing tableware for the sake of consistency. For high quality suppliers like CHH, restaurants rely on the quality of the tableware so the switching and search costs will be high as restaurants are unwilling to experiment with new plates from another supplier. So, an existing restaurant is unlikely to switch plates suppliers unless it has very compelling reasons.
There’s only a limited number of new restaurants owned and installed by companies that have not have an existing tableware supplier. So, a new player might find it very hard to get into the business. And this is an old industry, which is unattractive for new players to get in.
The competition really comes from getting into the “shelf” of newly opened restaurants. And these new restaurants have to be operated under new companies because if an existing company is to open a new restaurant, it will likely to purchase from the same supplier. To gain new customers, Churchill will benefit from its brand equity and chef recommendations. Although the ceramic tableware is a fragmented industry with many players, the willingness to compete is low, especially for posh customers due to the high customer captivity. In fact, the management does not even identify peer competition as a risk. The risk comes from the distribution channel and the market dynamics.
So far, the company has no foothold in Asia. A comparable company, Portmeirion, has seen a 38% revenue growth from the South Korea market. That indicates a significant demand from Asia. I think the management should focus on that market rather than the North America. In fact, Churchill’s sales from the NA market stays at 11%, the same as in 12 years ago. Unlike the United States where dining out usually means fast-food or bustling sit-ins, dining out in Europe and some Asian countries is a slow process where consumers want to take time to get unique experience. To supply this experience, restaurant owners pay close attention to the ambient environment and the design and quality of the tableware. I think there’s demand in developed countries like South Korea, Japan, Singapore, etc.
However, it seems that the management is not so interested in this continent, probably due to the concern that cheap Chinese goods will depress their profit margin and growth, and also that the company is on the cusp of transitioning into a value-added focused supplier, entering Asia would distract the management. For modelling purpose, I will exclude potential growth from Asia.
Multiple Expansion is Very Likely
The company is trading at 13x PE, a multiple I believe is too low given the quality and growth of the business. Churchill has been growing its net income at 12% CAGR, and the quality of the earnings is good as it is very similar to CFO. Early investments in robotic manufacturing capability and kiln firing capacity have paid off. The ROIC in the past four years has been above 20%. The last time the company was trading at this multiple was during the GFC, when the company’s FCF took a hit to the negative zone. Now, that the company has completed its transition to the hospitality end market, and that significant infrastructure investments have done, I don’t think the company deserves <13x PE.
A German peer with single digit ROIC is trading at 27x PE, with that proxy and my own estimate, I think the business is worth at least 23x PE, implying a target price of £19, an upside of 80%. Note that before the virus, the stock was trading around £20s. If it takes the company three years to achieve £19, that’d imply an IRR of 22%, which is quite satisfactory given the UK equity risk premium is only 8.5%.
How Much Money Can I Lose?
The lowest price in this year was around £7. That was when the pandemic had just erupted in Europe, investors were very disturbed and were dumping hospitality related stocks at whatever price they can. So, even if there’s a second wave, I don’t think the stock can go below £7 as investors would be more rational with less fear involved. £7 represents a 34% downside.
The liquidation value of the company is £4.8 per share. So, even in the doomsday scenario, which is very unlikely to happen, I only lose about half of my investment.
So, a reasonable 34% downside vs 80% upside makes Churchill an attractive investment.
Risk factors are outlined above with bearish theses. However, there’s an execution risk. Since it’s a microcap in the UK, it’s very hard for US-based investors to buy. Interactive Broker does not have access to it; Charles Schwab has, but at $100 commission fee. I’m in the process of opening a UK-based brokerage. But if you are UK/EU based, this risk does not exist for you.
Stay-at-home restriction lifts
Interim reports in August
This writeup, which brings more attention to the company