Electra Private Equity — The realisation strategy – further steps

ELTA’s investment objective remains 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 reported net asset value (NAV) increased 46% from £135.1m on 30 September 2020 (see our initiation note) to £196.9m on 31 March 2021 (see Exhibit 1). In this report we reiterate (unchanged) management scenarios and the impact of applying sector multiples to these scenarios.

ELTA’s board noted that the three operating businesses’ valuations as at 31 March 2021 reflected a high degree of judgement. Amid the pandemic, the resulting lockdowns and restrictions on the businesses, Fridays and Hotter, in particular, had to operate at below their average capacity. Meanwhile, they continue to undergo restructuring and are following reorientation plans put in place by new managements from 2019. The disruption to the historical earnings of the comparator companies historically used in ELTA’s internal valuation process have prompted the board to utilise published forward earnings multiples for sector peers within the consumer discretionary and industrial sectors.

Having received input from its auditors and other advisors, ELTA’s board is comfortable that the published valuations are a reasonable reflection of Fridays, as it emerges from COVID-19 lockdown, and Hotter, as it demonstrates early delivery of its new business model.

Both the Fridays and Hotter businesses have plans in place that aim to deliver long-term value creation. Fridays is a rejuvenated business with a sustainable growth strategy. It also has plans to win more market share in the casual dining market, as its recent performance indicates. Hotter has delivered on the early stages of its plan following the change in its operating model last year.

Exhibit 2 illustrates the considerable improvement in ELTA’s performance since November 2020 and its particular acceleration in 2021. In the last few months the company has been executing its realisation strategy and the increased NAV and narrowing discount reflect the value generated. Its 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 2 shows that ELTA’s price return was superior to UK equities over the past three and 10 years. Exhibit 3 demonstrates that ELTA’s NAV outperformed the CBOE UK All Companies and MSCI Europe indices over one year and shorter periods.

We have also included peer comparison in Exhibit 4, including Dunedin Enterprise and JPEL Private Equity, which are also in a realisation mode, and the peer average of 11 (including ELTA) London-quoted private equity closed-end funds of funds. Over one year, ELTA’s NAV returned 38.1%, outperforming peer group average of 26.0% and ranking third.

ELTA currently trades on a single-digit premium of 7.0%. This compares with the 15.4% discount of the peer group average and 18.4.% and 26.9% discounts for Dunedin Enterprise and JPEL Private Equity, respectively.

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 86 restaurants across the UK. Notwithstanding high brand awareness, the business has been newly renamed Fridays to reinforce the brand’s promise of its well-known ‘Friday Feeling’ experience. Fridays holds exclusive UK rights to use the brand under its agreement with its American parent, from which it was acquired by ELTA in 2014.

Fridays continues to please with confirmation of robust demand on reopening (like-for-like sales at its eight Scottish sites up 14% on 2019 since 26 April despite COVID-19 restrictions) and an undimmed implementation of strategic initiatives arising from the 2019 business review. Assuming a return to trading normality, management’s pro forma EBITDA projections based on demand at 2019 levels have been raised by 8% since December, thanks to the avoidance of previously anticipated ‘no deal’ Brexit costs. Indeed, the prospect of a favourable environment on pandemic fallout, notably pent-up demand and significantly less competition, supports confidence in management’s ‘best case’ scenario of 10% top-line growth, translating into a step change in profit compared with 2019. While trading inactivity drove net bank debt up by over 50% to £62m in the half to March 2021, finances remain strong (liquidity headroom of c £20m and bank facilities, expiring in 2022, will be extended prior to the demerger) and should not inhibit expansion, that is self-funding of the two current dine-in openings and a further seven (Fridays and the new 63rd+1st brand) planned over coming months.

The half to March 2021 saw the continuation of significant disruption as a result of COVID-19, with the loss of 75% of trading days (excluding the company’s ‘click & collect’ and delivery services) and restrictions in place for the rest of the period. In October, results were ‘encouraging’ after two months of profitable trading post reopening after the spring lockdown. The strength of Fridays’ underlying performance in 2020 is evident in its consistent outperformance of the UK restaurant market in terms of like-for-like sales (Exhibit 6). The renewed 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.

On reopening after the recent lockdown, the trading indications for Fridays again appear positive, with like-for-like sales at its eight sites in Scotland up 14% on 2019 in the three weeks since 26 April, despite not being permitted to sell alcohol and an 8pm curfew. It was also without the benefit of outside trading as there was no available space. In England and Wales, which reopened on 17 May, the initial three days saw trading at 76% of 2019 levels, showing the strength of demand and scope to fill capacity midweek.

Management is at pains to point out that it has not been deflected by the pandemic in terms of implementing measures to enhance the core Fridays offering and develop additional revenue streams. Initial key measures already effected include a new brand identity, namely the renaming from TGI Fridays to Fridays, and, as a nod to the chain’s heritage, the introduction of ‘Famous At Fridays’ (a focus on favourite dishes and classic cocktails) initially at 13 restaurants in larger cities and now being rolled out across the estate.

These have been complemented by further ambitious brand extensions via the company’s delivery and digital channels. Click and collect takeaway is now available at about half the sites in addition to home delivery through partners (Deliveroo and Just Eat) from all outlets and by an in-house Fridays team from one site, plus a broadening of the Fridays at Home offer, for example ‘Butcher’s Boxes’, DIY meal kits and ‘Cocktails at Home.’ ‘Jailbreak Chicken’ is a new delivery-only brand at almost a quarter of the sites, while an asset-light quick service restaurant proposition is under review. Digitalisation is being stepped up materially as a new gamification strategy, offering spontaneous rewards, is applied to the company’s guest loyalty programme, Stripes (management expects to increase its database from the current 683,000 app users).

A new cocktail led bar and restaurant brand, 63rd + 1st, is being launched in Cobham, Surrey. Although visibly different from Fridays (typically c 40% smaller at 4,000 sq ft, and a focus on adults with the bar at its heart), the aim is still to cater for guest affection for the original brand. Importantly, it also meets changing market trends, notably the growing appeal of local/community all-day venues reflective of the popularity of boutique hotel and members’ club environments. The Cobham site (previously Carluccio’s) will have 96 covers with outdoor dining for a further 20. Deemed by management as ‘a huge opportunity to drive further growth’, 63rd + 1st is intended to be expanded across the UK with four further sites by early 2022.

Despite the successful rollout of vaccines, it remains challenging to predict when trading normality will resume. Therefore, we support management’s approach of using 2019 sales levels as a base for a pro forma assessment of potential annual profitability. On management’s base assumption of zero like-for-like top-line growth, EBITDA (pre-IFRS 16 as in 2019) is expected to grow by 28% to £32.7m (see Exhibit 7), an increase of £2.3m on the December 2020 projection, which reflected potential costs, predominantly food, in the case of a ‘no deal’ Brexit. This absolute rise of £7.1m from £25.6m in 2019 derives in part from net openings in 2019, that is 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 £12m rise in pro forma sales despite assumed flat like-for-like assumptions. The bulk of the projected EBITDA gain is due to changes in the cost base, including labour efficiency cost savings (already implemented) and other fixed implemented cost savings (mainly rent reductions). Net bank debt of £62m at March 2021, up from September’s balance of £39m (after adjusting for delayed creditor payments), reflects cash burn during protracted trading inactivity in the first half of the financial year. Management reiterates its commitment to expansion (it has medium-term development plans for about five net new sites per year). While these should still be funded from its operations, given their cash generative nature, it is also looking at capital-light quick-service (drive-in) restaurants.

Management’s confidence in this zero like-for-like growth scenario appears well justified. First, market conditions 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. The COVID-19 led reduction in supply and competition (widely estimated to be at least 20%) yields a more benign trading environment, complemented by the growing availability of properties at ever lower rents, as confirmed by restaurant operators. 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. These are supplemented by the addition of permanent outside trading space, the size of four restaurants, at sites in the south of England.

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 60% on 2019 demand levels, according to management’s EBITDA projections (see Exhibit 7).

These growth scenarios take 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 NAV of Fridays at £146.2m at March 2021 suggests an EV/EBITDA multiple of 6.4x on pro forma zero life-for-like growth on 2019 (see Exhibit 8). On a similar basis, that is pre-COVID-19 reported results, its closest listed competition, Loungers and Fulham Shore, trade on significantly higher multiples (17x and 13x, respectively). For Restaurant Group we have used the mid-point of its ‘illustrative’ and wide-ranging (£110m to £125m) EBITDA ‘capability’ on 2019 sales levels, hence some potential downside.

Given its comprehensive restructuring ahead of its September 2020 IPO, 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, the blended average of 14x EV/EBITDA for four of its peers is more than twice that of Fridays on management’s pro forma zero like-for-like growth trading assumptions (the multiple falls to 5x on management’s ‘best-case’ 10% growth).

Hotter specialises in the design and manufacture of stylish comfort footwear (with 1.6m pairs manufactured in 2019, 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.

Hotter’s reshaping as a digital ‘direct to consumer’ business looks to be paying off, with 30% online sales growth in the seven months from October 2020, albeit boosted by restrictions on retail because of COVID-19. With its targeted operating model now in place (68% of revenue from direct channels in that period following 2020’s retail de-risking with the closure of 70% of the UK estate), management is actively addressing opportunities in terms of both its core customers (product needs beyond comfort and fit) and a broader offering, for example menswear and safety shoes according to industry requirements. An improved digital marketing, personalisation and loyalty scheme, facilitated by a new app in Q121, is allowing enhanced management of a loyal customer base (four million, with 100,000 added annually) with long-term scope to market all manner of products and services related to footwear and customer profiles. The shops will be restyled as Technology Centres in Q221. International expansion is expected to capitalise on Hotter’s successful US operation, possibly with a partner (or even a disposal), and address new markets in the Far East.

With Hotter’s financial period under review marred by COVID-19 restrictions, it is more meaningful to look at the performance of direct channel sales, which are key to the new operating model. Exhibit 10 shows this to have been very encouraging, with double-digit percent year-on-year sales growth for the majority of the period since March 2020 lockdown and a marked acceleration in Q420.

Taking management’s reasonable approach of using FY20 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 the performance in 2020 (see Exhibit 10). Indeed, with trading in the seven months from October up by 30% year-on-year (+44% from digital partnerships), 20% growth may be closer to the mark, even if flattered by COVID-19 retail constraints. The assumption of flat sales at the retained stores may be cautious, given their selection as optimum sites and planned conversion into Technology Centres in 2021. It is also encouraging, in terms of profit, that EBITDA for the seven months from October 2020 exceeded management’s pro forma EBITDA of £5.4m for FY20 (the year to January 2020) by 8%. Management has cut its estimate of EBITDA sensitivity to a 10% fall in retail revenue to just £0.2m (£0.5m indicated in December 2020) thanks to enhanced cost control.

Management’s valuation of Hotter of £19.2m at March 2021 (more than trebling from £5.8m at September 2020) suggests an EV/EBITDA multiple of 4.3x pro forma 10% direct channel sales growth on FY20, assuming management forecasts. Notwithstanding residual retail exposure and the risk of executing planned business enhancements, such a rating appears unduly low. Favourable macro trends, for example 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.