Electra Private Equity — Innovating, restructuring and realising

Electra Private Equity is a London Stock Exchange-listed investment trust focused on PE investments. Since 1 October 2016, ELTA has distributed over £2.0bn to shareholders through ordinary dividends, special dividends and share buybacks. In 2016, the directors began reviewing the company’s strategy, considering options for the future of the company, other than retaining its diversified listed PE status.

On 4 October 2018, the board announced the outcome of its strategic review. The board concluded and recommended that it is in the best interests of shareholders to conduct a managed wind-down of the portfolio over a period of time, allowing optimisation of returns, the return of cash to shareholders and ultimately the winding up of the company.

The company is managed in-house. Neil Johnson is the executive chairman. Gavin Manson is the chief financial and operating officer. He works directly with the portfolio company CEOs to manage the assets. All ELTA’s administrative functions are outsourced.

G10 Capital (‘G10’) is its alternative investment fund manager or AIFM. G10 is authorised and regulated by the FCA. G10 is appointed as AIFM to ensure regulatory compliance.

The board considered that each of the remaining corporate investments represented an opportunity for value creation within an acceptable timeframe, typically up to seven years within the PE industry. The board concluded that reinvesting in a listed PE vehicle with a significant market discount to net asset value (NAV) was structurally inefficient. The very high concentration of the portfolio (three key investments: TGI Fridays, Hotter and Sentinel) means that a sale of an investment is more efficient, timely and the optimal option for the current shareholders, compared with building up the portfolio to become a more diversified listed PE vehicle.

ELTA believes that its three key companies have strong and effective management teams in place, improved product offerings and the determination to deliver value to shareholders consistent with the declared strategy. With significant structural improvements now implemented in each business, a return to 2019 levels of market activity should provide an opportunity for value realisation in excess of pre COVID-19 valuation levels.

The company highlighted in its annual report (to end-September 2020) that the pandemic and the resultant impact on equity market values has had the effect of reducing the combined valuation of the three larger investments by £58.4m from their valuations at end-September 2019. To mitigate that, during 2020, in the most challenging circumstances, the portfolio companies’ management teams and their employees have worked tirelessly to protect their businesses and put them in a strong position for future growth, as the UK and world economies recover and consumer demand returns.

On 4 October 2018, the board announced the outcome of the third phase of its strategic review. The board announced that it considered that each of the remaining corporate investments represented an opportunity for value creation within an acceptable timeframe, but had decided that the concentration of the portfolio and the structural inefficiency in reinvesting in a listed PE vehicle with a significant market discount to NAV made it inappropriate to seek to do this within the existing investment objective and policy of the company. The board concluded, and recommended, that it is in the best interests of shareholders to conduct a managed wind-down of the portfolio over a period of time, allowing optimisation of returns, the return of cash to shareholders and ultimately the winding up of the company.

ELTA’s investment objective is to follow a realisation strategy, which aims to crystallise value for shareholders, through balancing the timing of returning cash to shareholders with maximisation of value.

The company will not make any new investments but will continue to support its existing investments to the extent required in order to optimise returns. The company will retain sufficient cash to meet its obligations and to support its portfolio assets, with cash from realisations being invested in AAA-rated money market funds, pending utilisation or return to shareholders.

Gearing is permitted up to 40% of total assets, should it be appropriate to utilise gearing in order to optimise the balance between timing of returning cash to shareholders and maximisation of value.

Since 1 October 2016, the company has distributed £2.0bn to shareholders through ordinary dividends, special dividends and a share buyback.

In February 2020, ELTA supported the trustees of the Electra Private Equity employee benefit trust in acquiring 600,000 ordinary shares in ELTA at an average cost of £3.29 per share. The trust acquired these shares to hedge against any pay out under the Executive Share of Value Plan (SoVP). The SoVP is a long-term incentive plan for management, covering the period from October 2017 until the planned realisation of assets. The payout is directly linked to the shareholder value realised and the liability carried on the balance sheet is quantified under IFRS. As the payout, if any, will depend on the amount ultimately returned to shareholders (targeted by the ELTA board at approximately £6 per share), ELTA has hedged the potential cash payout by acquiring shares through the SoVP.

2020 has thus far been a busy year for the global PE industry. The S&P Global Market Intelligence November 2020 PE EMEA report highlights that the global financial crisis was ‘painful for everybody’, and the asset class began changing and adding value creation teams, moving away from the focus on leveraged buyouts. This crisis has prompted PE operators to do operational restructuring, in comparison with the Global Financial Crisis (GFC), which was more to do with financial restructuring. Businesses backed by PE firms have access to capital and skills. Firms focused on the operational aspects of their portfolio companies were able to put these attributes n action, navigating their portfolio companies through the pandemic.

A substantial part of the c US$7.8tn of money printed globally in 2020 (source: Atlantic Council think tank at 1 December 2020) to fight the coronavirus-triggered economic crisis went into PE investments, including those in Europe. Globally, the amount of 'dry powder' in the PE industry looking for transactions was estimated at $1.5tn (source: Funds Europe at August 2020). Buyout funds had $853bn in dry powder as of the third quarter, according to Ernst & Young’s third-quarter report on private equity trends (published October 2020). We believe, this substantial amount of capital will support valuations. The report shows that despite a noticeable decline of over 40% year-on-year in the number of PE deals in 2020 year-to-date and aggregated capital falling back to pre-2015 levels, the average fund size has climbed to a new record level of US$476m. Limited partners’ (LPs’) appetite for European assets continues to be high, with the US$119bn capital raised year-to-date (Exhibit 2), exceeding the numbers of the previous three years, with the average fund size rocketing to US$714m (Exhibit 3). This implies aggregation of capital in the hands of fewer, but larger, PE players.

With technology and healthcare dominating the European PE landscape, both the consumer discretionary and industrials sectors demonstrated decent activity as well. Exhibit 4 illustrates higher entry volumes across five of the top six EMEA sectors (except healthcare).

Exhibit 5 shows that exit volumes primarily were affected in the sectors most hit by the pandemic, lockdowns and resulting business disruptions, including industrials, consumer discretionary and financials. Nevertheless, exits in both the industrials and consumer discretionary sectors continued in Q320, albeit at about half of Q319 volumes. The consumer discretionary and industrials sectors recorded about 20 and 30 transactions, respectively, in Q320.

During Q320 in EMEA the UK dominated in terms of the number and volume of both entry and exit transactions. The close to 300 entry deals in the UK with c €8bn value in 2020, beat Q3 2019 valuation at €6.5bn of a similar number of deals. Despite UK exit numbers and volumes shrinking, Q320 still saw over 30 exits valued at €4bn in total, compared to over 60 exits at €7bn in Q319.

We used the S&P Global Market Intelligence Q3 2020 report for EMEA to illustrate the current valuations landscape in Europe, including the UK. As there is a wide range of exit multiples, from 6.4x to 36.8x (Exhibit 6), we have used the sector median for exits in EMEA of 12.3x as the average multiple. The consumer discretionary (83% of ELTA’s portfolio NAV) and industrials (8%) sectors, where ELTA’s portfolio is concentrated (see the current portfolio section), had very similar Q320 exit multiples of 11.1x and 11.4x, respectively. M&A EMEA multiples were 10.5x for both sectors in Q320.

ELTA’s portfolio had a valuation of £128.6m at 30 September 2020 (FY19: £192.4m).

Following the high volume of realisations between October 2016 and December 2020 (see Exhibits 7 and 8), ELTA’s portfolio consists of buyout, secondaries and other investments.

The buyout portfolio category consists of direct equity investments in five private companies (2019: seven) with an aggregate value of £127.2m as at 30 September 2020 (FY19: £189.9 million). These include the three key ELTA investments – Fridays, Hotter and Sentinel – which together represent 97.0% (FY19: 98.0%) of the total value of the buyout category. The other two companies are Special Product Company (escrow) and Adjustoform. There are no co-investments in the portfolio as at 30 September 2020 and no assets are classified as held for sale (FY19: £10.6m).

ELTA’s liquid resources stand at £5.6m (FY19: £17.3m) or c 4.1% of NAV reported as at end-September (£135.3m), held in money market funds.

The change in portfolio movement and valuation during the four years up to FY20 is presented in Exhibit 8.

The sale of the Special Product Company (SPC) business in December 2019 for £8.6m and the £1.6m sale of a debt asset accounted for the bulk of £12m realisations during FY20. ELTA’s remaining interest in SPC is a share of an escrow account deposit and is classified in the ‘other investments’ category (£1.0m, Exhibit 7).

ELTA performs portfolio company valuations in compliance with the International Private Equity Valuation (IPEV) Guidelines. ELTA uses historical earnings figure (as a proxy for maintainable earnings) and a public market multiple for similar companies, with a consistent discount applied to reflect scale and other differentiating factors.

The reduction in market multiples as a result of COVID-19 led to a reduction of approximately £61.8m (34.8%) in the March 2020 valuation of ELTA’s three larger investments (TGI Fridays, Hotter Shoes and Sentinel). Given the material disruption to the trading results of these three portfolio companies in the six months prior to the September year end, the determination of earnings required more judgement in the September 2020 valuations than in previous few years.

The September 2020 ELTA’s valuation of the three largest investments of £123.3m (Exhibit 9) is broadly unchanged from March 2020 other than reflecting the utilisation and allowance for cash during the pandemic. As the businesses emerge from the pandemic, ELTA would target a market led recovery of value lost in March 2020 in addition to substantial value created by business improvements and market share opportunities.

Other portfolio core assets of £3.9m (or 3% NAV) and non-core assets of £1.4m (or 1% NAV) consist of four investments: a small trading company owned 100%, a property leasehold investment, a minority holding in a trading company and an escrow account in relation to the sale of SPC in December 2019. ELTA deems all four values to be reasonable and expects to realise these investments during 2021.

Edison reviewed the portfolio companies and used their pro forma forecast, peers and sector multiples to provide valuation scenarios. A description of the scenarios and the potential upside of the three key portfolio companies as assessed by Edison are discussed in the Appendix on page 12. The base case is the current NAV at 30 September 2020, and thus includes the negative NAV impact from the economic crisis triggered by COVID-19.

In December 2014 ELTA invested £99m of equity in the buyout of TGI Fridays, the UK franchise of the eponymous American-styled restaurant chain. At the time of ELTA’s investment, it operated from 66 (now 67) UK restaurants in a range of locations, including city centres, shopping centres and retail parks. The business offered a differentiated product, with a wide demographic appeal, in the growing casual dining market. In 2019 ELTA appointed the new management team, who restructured the business. The intention is to grow through improved customer proposition, market share gains, additional sales and brand extensions.

In February 2011, ELTA acquired Sentinel Performance Solutions for £43m in an all equity financed secondary buyout. In April 2011 ELTA’s investment was reduced to £15.7m by a subsequent debt and equity refinancing. Based in Runcorn, Sentinel supplies water treatment products to improve the performance and efficiency of residential heating and hot water systems. It has a strong track record in new product development. In 2019 ELTA appointed the new management team, who continue to grow and develop the business. Sentinel has developed a market-leading position in the UK and is building a market presence in other European countries as well as the US and China.

In January 2014 ELTA invested £84m in the buyout of Hotter Shoes. Hotter was then Britain’s largest shoe manufacturer (see ELTA’s FY14 annual report), selling over two million pairs of shoes each year in the UK and internationally in stores, via catalogues and online. Its customers comprise those whose age, health or lifestyle require more cushioned and supportive footwear. Hotter more than doubled its sales in the four years prior to ELTA’s investment as a result of its UK store opening programme and its entry into the US market. Furthermore, the company benefits from a strong brand and favourable demographic trends. The new management team took over in 2019 to restructure the company, and bring in new skills and technologies to facilitate growth. This growth trend will be continued with new product development, digitalisation and technology enhancements and opportunities in international markets.

Exhibit 10 illustrates the considerable improvement in ELTA’s performance over the past month as the company confirmed the engagement of Stifel Nicolaus Europe in the sale of Hotter (most likely a trade sale), on 13 November 2020. We believe this reflects the market’s confidence in the success of ELTA’s realisation strategy and its execution. Performance during 2020 suffered materially, as the market discounted the hospitality industry and restaurants’ shares in Q1, after the pandemic hit and lockdown was imposed in the UK.

Exhibit 10 demonstrates that prior to the change to the realisation strategy, ELTA’s NAV total return was superior to UK and European equities. Exhibit 11 demonstrates that ELTA’s NAV outperformed the CBOE UK All Companies and MSCI Europe indices by 85.8% and 43.5%, respectively, over 10 years on a total return basis.

Over the last three years, ELTA’s shares have traded at an average discount to NAV of c 39%, reflecting the realisation strategy and high uncertainty around the remaining investments until 2019, when the management of all three investments was changed. In 2020 the discount has been volatile, coinciding with the March stock market correction in response to the pandemic. Subsequently, however, the discount has narrowed relatively quickly and remained stable around the 50% level until November. The discount has narrowed further recently after the company confirmed the engagement of Stifel Nicolaus Europe in the sale of Hotter on 13 November 2020. Currently, the shares trade at a discount of c 22%.

There are no management charges as fund management is conducted in house. The only costs are the operating costs of ELTA, disclosed as a percentage of NAV. The maximum aggregate fee for non-executive directors, including the chairman, are limited by the company's articles of association to £750,000 pa. The ongoing charge ratio (OCR) at end September 2020 was 1.8% of NAV. The OCR is calculated as annualised ongoing charges over average undiluted NAV in the year.

A special dividend for FY20 of 31.0p per share was paid on 24 January 2020 for the aggregate amount of £12m.

Given the board’s intention to target the end of 2021 for completion of ELTA’s realisation strategy, the board has elected not to declare further dividends for the year ended 30 September 2020. It is the board’s intention to distribute the proceeds of asset realisations in 2021, the timing and quantum of which will be dependent on the realisation processes.

Although ELTA’s winding up mode makes it difficult to identify comparable listed PE companies, we have collated a set of potential peers (Exhibit 13). The table reflects ELTA’s chosen realisation strategy. It is the second smallest fund of the 11 peers. The three smallest funds also include Dunedin Enterprise and JPEL Private Equity, which are also in a realisation mode. ELTA’s ongoing charge is third highest and it trades at the widest discount among the peers. ELTA’s 11th performance ranking over one-, three- and five-year periods emphasises the change in the investment objective and strategy, which began to be followed through in 2016 and was formally adopted in October 2018.

ELTA’s board consists of six directors, three of whom are independent from the investment manager.

Neil Johnson has been executive chairman since 1 March 2018. He has been on the board since 12 May 2016, when he was appointed non-executive chairman and director. Gavin Manson is an executive director and chief financial and operating officer. He joined the company in 2016, was appointed as a director on 23 March 2017 and is a director of the company’s portfolio companies. Stephen Welker was appointed a director on 18 July 2019, and has been a non-executive director of TGI Fridays, an ELTA portfolio company, since 2017. Stephen Welker is a representative of Sherborne, ELTA’s largest shareholder.

Paul Goodson, who was appointed as a director on 26 May 2016, is chairman of the valuations committee and a member of the audit and risk, nomination and remuneration committees. David Lis was appointed as a director on 26 May 2016. He is chairman of the remuneration committee, the senior independent director since March 2018 and a member of the nominations, audit and risk and valuations committees. Linda Wilding was appointed a director on 1 December 2016. She is chair of the audit and risk committee and a member of the remuneration, nomination and valuations committees.

Born of the eponymous original casual dining bar and grill in 60s New York, TGI Fridays offers authentic American food, an innovative cocktail list and a high level of service at its 85 restaurants across the UK. Notwithstanding high brand awareness since its successful introduction in 1986 under different ownership (Whitbread), the business has been newly renamed Fridays to reinforce the brand’s promise of a renowned social experience, ‘In Here, It’s Always Friday.’ This is just one of a series of significant initiatives led by the new management team to enhance the core offering and develop additional revenue streams.

Fridays holds exclusive UK rights to use the brand under its agreement with its American parent from whom it was acquired by ELTA in 2014.

In spite of the pandemic, 2020 has seen widespread implementation of measures arising from a comprehensive business review at the start of the period and the appointment as CEO of Robert Cook. He joined from Virgin Active, ‘the world’s leading health club’, where he was credited with rapid and successful extension of an already iconic brand. This followed almost 30 years in hospitality, notably as CEO of Malmaison Hotels and Du Vin, where he created the standalone restaurant concept Smoak Bar and Grill, and then as CEO of De Vere group’s Village Hotels and COO of Macdonald Hotels. Robert Cook is backed by a considerably strengthened management team.

Initial key measures already effected in support of That Fridays Feeling include:

These have been complemented by further ambitious brand extensions:

‘There were too many restaurant businesses with owners and managers convinced they could swim like Mark Spitz, but which were actually being kept afloat by some badly made rubber rings and various leaky flotation devices,’ according to David Page, chairman of Fulham Shore in October 2020.

Structural difficulties have long bedevilled the UK restaurant market as a result of excess capacity, frequency of ‘me too’ product, rising costs and narrow margins. Economic and political uncertainty following the result of the EU referendum in 2016 only made matters worse as the erosion of consumer confidence led to increasing vacant retail space being rented out to restaurant operators on historically cheap debt. As shown in Exhibit 15 below, like-for-like UK restaurant sales according to industry monitor Coffer Peach Tracker barely progressed in the two years before COVID-19, with apparent strength in the first half of 2019 against a weak comparative (exceptional weather – ‘Beast from the East’ and heatwaves – and the football World Cup). Such stagnation in sales and inflationary pressures (notably, business rates, the National Living Wage and food imports thanks to sterling weakness) have proved an especially sorry mix for restaurant groups, which were already highly indebted. High-profile chains entering administration or credit agreements in 2018 and 2019 included Jamie’s Italian, Carluccio’s, Gaucho and Gourmet Burger Kitchen.

Persistent pressures on restaurant groups were of course accentuated seismically by the advent of COVID-19 in early 2020 and government-imposed restrictions on hospitality. While the current year began positively with UK restaurant sales up 2.5% (see Exhibit 16) in January, if admittedly against a subdued comparative, the initial effects of the developing pandemic were felt in February, culminating in national lockdown on 20 March.

With the Coffer Peach Business Tracker inactive for like-for-like data between April and August we refer to UKHospitality’s monitoring of Q2 and Q3 turnover across the entire hospitality market (restaurants, pubs, bars, hotels, attractions and other hospitality venues) in Exhibit 17. Predictably, there was a virtual elimination of sales (down 87%) in Q2 and a near halving in Q3 despite a phased reopening from 4 July and the government’s Eat Out to Help Out scheme in August, which is reported here to have driven a 13% y-o-y rise in like-for-like sales for UK restaurants. A further qualification is that because of continued site closures in July and August (respectively two-thirds and one-third of outlets trading pre-COVID-19), in absolute terms the restaurant sector’s total sales were down 60% and 11% respectively in those two months. The renewed significant downturns in September and October highlight the boost from the government’s campaign to eat out in August as well as the introduction of the 10pm curfew from 24 September and tougher regional (tier) restrictions from 15 October. The impact of England’s second lockdown (four weeks from 5 November) is self-evident, as is that, for example, of the placing thereafter of over 40% of its population in areas subject to Tier 3 (Very High) rules, where restaurants must stay closed except for delivery and takeaway services (to be reviewed periodically).

There is a grim irony that a severely depleted restaurant sector (estimated up to c 30% contraction) and a fragile property market as a consequence of COVID-19 offer significant opportunity for those groups that survive. To date high-profile casualties include Carluccio’s, Café Rouge, Ask, Zizzi, Byron, Frankie & Benny’s and Yo! Sushi (all recently in administration), with further to follow, given continued punitive conditions and weakened finances, such as business interruption loans and delayed creditor payments. In addition to this paring of competition, restaurant operators confirm a growing availability of properties at ever lower rents.

Before 2016 there was opportunity for strong growth as demand was rising faster than supply.

Therefore, in assessing Fridays’ underlying performance in 2020 it is more useful to look at its like-for-like sales relative to the restaurant market. Exhibit 19 shows that encouragingly Fridays has consistently outperformed since the end of the spring lockdown. We are heartened also that net bank debt appears to remain in check, with September’s balance of £39m (after adjusting for delayed creditor payments) on a par with that at December 2019, ie pre COVID-19 (£30m at March 2020). Management reiterates that its medium-term development plans for about five net new sites per year should still be funded from its operations, given their cash generative nature.

While even with the promising news of the development of vaccines, it remains extremely challenging to predict when trading normality will resume, we support management’s approach of using 2019 sales levels as a base for a pro forma assessment of potential annual profitability. On their base assumption of zero like-for-like top-line growth, EBITDA (pre IFRS 16 as in 2019) is seen to grow by almost 20% to £30.4m (see Exhibit 20. This absolute rise of £4.8m derives in part (£1.8m) from net openings in 2019, ie a full year contribution rather than part year from five stores opened during 2019 less three removed (one closed in 2019 and two in 2020), which explains the stated £8.9m rise in pro forma sales despite assumed flat like-for-likes. The bulk (£3m) of the projected EBITDA gain reflects changes in the cost base, ie labour efficiency cost savings (already implemented) of £3.9m and other fixed implemented cost savings (mainly rent reductions) of £2.6m, partly offset by a ‘no deal’ Brexit risk of £4m (predominantly food costs).

Management confidence in this zero like-for-like growth scenario appears well justified. First, market conditions, as already explained, were already difficult in 2019 owing to chronic overcapacity in the sector, significant cost pressures, particularly owing to labour costs, and consumer uncertainty on the eve of Brexit. COVID-19 led reduction in supply and competition of up to 30% yields a more benign trading environment. Secondly, there is the expected benefit of Fridays’ own wide-ranging brand extension initiatives, already largely implemented and bearing early fruit in recent sustained market outperformance.

Consequently, on resumption of trading normality it is not unreasonable to foresee annual like-for-like sales growth rates of up to 10%, which with margin gain could drive a rise in EBITDA of over 50% on 2019 demand levels, according to management (see Exhibit 20).

Of course, this takes no account of Fridays’ site expansion plans (typically five openings per year, which is 6% of the current estate). The noted availability of attractive sites at ever cheaper prices provides assurance that this may be achieved satisfactorily.

Assuming 2020 to be a trading aberration and using pre IFRS 16 numbers for easier peer comparison, management’s valuation of Fridays at £106.6m at September 2020 suggests an EV/EBITDA multiple of under 5x pro forma zero life-for-like growth on 2019 (see Exhibit 20). On a similar basis, ie pre-COVID-19 reported results, its closest listed competition, Loungers and Fulham Shore, trade on significantly higher multiples (13x and 8x, respectively). While Restaurant Group’s rating is close to that of Fridays, it may reflect company-specific issues, notably indebtedness, continued restructuring and exposure to businesses that management does not term as ‘growth.’ Also we have used the mid-point of their ‘illustrative’ and wide-ranging (£110m to £125m) EBITDA ‘capability’ on 2019 sales levels, hence some potential downside. In the absence of reported results, given its recent listing, we admit a caveat about our computed rating for Various Eateries. Even so, its very listing amid the pandemic endorses the opportunity for well-funded hospitality businesses. In summary, a blended average of 10x EV/EBITDA for its four peers is twice that of Fridays on apparently cautious trading assumptions (the multiple falls to under 3x on management’s best-case 10% growth).

Established in 1959, Hotter specialises in the design and manufacture of stylish comfort footwear (1.6m pairs last year making it the UK’s largest shoe manufacturer). It is renowned for its product quality and innovation as well as customer service, epitomised by its pioneering digital Footprint 3D fit technology, use of BASF’s Infinergy foam inserts and over 40 width and size combinations via its Comfort Lab. The current target market is females over 55 with specific fit and comfort needs; while this is a favourable demographic, the company aims to broaden significantly its proposition. Sales are primarily through digital direct channels with a limited retail exposure (c 20 stores). Hotter’s customer database exceeds four million, with one million active shoppers. 20% of sales are international, predominantly in the US, where it has a profitable and scalable operation.

A silver lining of the pandemic is its acceleration of the digitisation strategy, which was already firmly in progress under the leadership of Ian Watson and his new management team. Most notably this has involved retail de-risking with the recent closure of over 70% of the UK estate as a result of a company voluntary arrangement (CVA). Although retail development had driven growth (sales doubled between 2010 and 2014), the subsequent consumer downturn and operational complexities, eg inventory management and head office costs, prompted a renewed strategic focus on the core customers in UK direct business, already the major profit centre.

With its targeted operating model now effectively in place (over 85% of revenue from direct channels), Hotter should now be able to focus on identified opportunities, which include:

With Hotter’s financial year under review ending before COVID-19 and the current period marred by the halt in production and retail in March and subsequent restrictions, it is more meaningful to look at the performance of direct channel sales, which is key to the new operating model. Exhibit 23 shows this to have been very encouraging with double-digit percent year-on-year sales growth for the majority of the period since March lockdown and a marked acceleration of late.

This complements our analysis in Exhibit 24 of the impact of the removal of the bulk of the retail estate (August 2020 CVA), which prompted the step-change in significance of direct channel business (from 48% to 68% of adjusted FY20 revenue) and the elimination of retail losses and a portion of central costs.

Taking management’s reasonable approach of using FY19 sales levels as a base for a pro forma assessment of potential annual profitability, we look at its various revenue growth assumptions from direct channels. The base case of 10% growth fits well with performance in 2020, as discussed (see Exhibit 25). Indeed, trading in October and November suggests 20% may be closer to the mark.

The assumption of flat sales at the retained stores may be cautious, given their selection as optimum sites and planned conversion into Technology Centres next year. Management estimates that a 10% fall in retail revenue could depress EBITDA by £0.5m.

Management’s valuation of Hotter at £5.8m at September 2020 suggests an EV/EBITDA multiple of 3x pro forma 10% direct channel sales growth on FY20. Notwithstanding residual retail exposure and risk of executing planned business enhancements, such a rating appears unduly low. Favourable macro trends, eg a growing older population with increasing disposable incomes, a coherent strategy (largely in place) and proven management are grounds for optimism, while the joker in the pack may be Hotter’s database, providing direct access to valuable customers and the opportunity to add related products and services.

Sentinel is a leading provider of products and services to clean and protect the water in heating systems from the effects of corrosion and limescale. Thanks to a longstanding reputation for innovation and product development, Sentinel is endorsed internationally by principal boiler OEMs and merchants who ensure availability of the company’s product alongside that of OEMs. With a sales presence in key EU and US markets, it addresses both commercial and residential custom, eg respectively major corporates such as Travelodge and McDonald’s and a 40% share of UK social housing providers (management estimate).

Launched in the UK by Grace Dearborn in 1988 and subsequently a subsidiary of multinational General Electric, Sentinel operated independently from 2005 until mid-2019 when ELTA obtained management control despite being the majority shareholder since 2011.

The relative maturity of the UK market means that growth will be driven internationally. ELTA’s 2019 review on taking control found that Sentinel had mistakenly targeted UK growth through the development of high-tech products that were not accepted by the plumbing and heating industry, which remains comparatively low tech. A new management team under David Barrett, initiating significant efficiencies in H219, led a renewed focus on core products in the UK, less mature export markets such as France and Italy (already over 50% of sales in FY20) and new territories. To this end there is encouragement in Sentinel’s previous strong international growth in 2017/18 thanks to new products, primarily next-generation filters tailored for country-specific requirements. Evidently, China offers considerable potential, given the appeal of foreign brands to upscale consumers and the endorsement of Sentinel by OEMs, particularly Vaillant. Other replicable markets with low penetration include eastern Europe. In addition, in the UK management sees continued scope for market share gains and benefits of innovation both in existing ranges and in development of renewables-focused chemical products.

The step-change in FY20 profit was an early endorsement of new management’s focus on profitable organic and new product growth as well as efficiencies. This was also reflected, as planned, in a further marked shift in revenue towards export markets (53% against 49%), which comfortably made up for domestic weakness with a 16% gain.

This profit momentum borne of operational measures was maintained in H121 (EBITDA more than doubled) despite COVID-19, which contributed to revenue down 18% y-o-y (the international share is not disclosed).

Encouragingly, early indications of key winter trading (annual profit is sharply H2-biased) suggest a resilience to COVID-19 restrictions in both the UK and Continental Europe and bolster management optimism that recent EBITDA improvement will be sustained, albeit tempered by the impact of COVID-19. We are therefore showing in Exhibit 28 the potential current full-year outcome (management estimate), assuming only a maintained year-on-year financial performance in H2, which is arguably cautious.

While the prospective EV/EBITDA multiple may be fair, given market pressures, there may well be scope for profit to surprise, as explained.