CAKE sold, HL bought

I have sold my holding in Patisserie Holdings at 335p realising a 15% gain, having only bought in December. I’ve changed my mind about this investment.

Basically I read this article by Phil Oakley of Sharepad. I think it’s pretty good reading for those thinking of investing in retail rollouts. The main thing I’ve drawn from it in relation to Patisserie is that there may be some quite firm limits to growth. This characteristic doesn’t really fit with my investing strategy.

Growth in a retail rollout mainly comes from adding new stores. While this can initially allow rapid expansion at high rates of return this sort of growth may be limited for two reasons. The first is that there are limits to the number of stores that can be added a year – as the size of the store network increases, adding a fixed number of stores a year results in a lower and lower growth rate. The second is that it becomes more and more difficult to find suitable locations for new stores, both where demand for the store is high and where it doesn’t cannibalise sales from existing stores.

Now Patisserie doesn’t actually do too badly on either of these points. It currently has about 184 stores and plans to add 20 a year. The growth rate in terms of number of stores is therefore currently about 11% and in 5 years would be 7%. It might also be able to grow its like for like sales, but rather unhelpfully management don’t provide such information and even suggest it is not what investors should be looking at. To me this communicates that management are not focussing on like for like growth i.e. they see it as a rollout play, and that consequently it will almost inevitably face slowing growth. While many businesses experience slowing growth rates as they mature I don’t like that for Patisserie this seems to have already started and is almost inevitably likely to continue.

On the potential for the total network, management suggest that there is capacity in the UK for at least another 250 stores. While this seems reasonable and does give quite a few years headroom I’m not so keen on investing where there is apparently a finite limit to growth that is not so far away. The prospect of international expansion seems a bit speculative at the moment and I’m not sure how well the brand would travel.

In my view these factors combined might have quite a bit impact on the value of the business I get from investing in Patisserie. While a 20 PE ratio might be a good price for investing in a business with the possibility of a reasonable rate of compound growth into the foreseeable future it would be a less good price for finite growth that is already slowing down.

Now I need to be careful not to overplay these points or be too absolute about them – there is still quite a bit of scope for growth and who knows what opportunities might arise in a few years time. There are also other things to like about Patisserie – it has very high ROCE and an apparently decent differentiated brand (but in a highly competitive retail market of course).

Overall I’m less sure that it fits well with my approach of hoping to hold great, consistently undervalued businesses for a long time without worrying about their valuations too much. It’s a close call but I believe there are better candidates out there. I’m going to keep an eye on it though to see how it pans out.

 

Hargreaves Lansdown: bought

With most of the proceeds I have made an initial investment into Hargreaves Lansdown, the investment services provider at £13.67. It is a business I have admired for a while and is now 1.9% of my portfolio. With the remaining cash I have topped up Dignity and Abcam (now 2.6% of the portfolio each).

Quality

Hargreaves provides a number of different investment services direct to individuals. It appears to be a very high quality business:

  • It appears to have a competitive advantage based on its brand, reputation, technology and customer service. It is a high price high service provider. This competitive advantage is demonstrated by its high and growing market share – it is the leading provider with about 38% of the market.
  • The business has really great economics – costs are pretty low and fixed and it is able to grow without too much capital investment so a large proportion of revenues turn to profit and a very large proportion of profit turns to cash. Most of its revenues are recurring from existing customers.
  • The numbers are consequently very impressive with exceptionally high margins, ROCE and FCF conversion. It has fairly consistently grown for a number of years.
  • It is in a market with secular growth and opportunities to grow through adding new products. Some of its fees relate to assets under management and so will rise and fall in line with the stock market. It is therefore cyclical to some extent.

Pricing

Momentum is good with results ahead of expectations released a couple of weeks ago and some share price rise since then. The medium long term share price chart looks very positive and the price is approaching the all time high of about £15 again. The valuation is quite high but I believe reasonable given the quality of business and likely growth. I would definitely be happy to add to this were the price to dip again.

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