Description

***OVERVIEW***

• Cake Box PLC ("CBOX") is a UK based franchisor of specialist cake shops founded in 2008
• 214 franchise stores and 27 kiosks
• Strong franchisee & customer value proposition
• 20%+ pa growth, 20%+ ROEs, FCF generating
• 7% FCF yield, 5% dividend yield and strong growth prospects
• Good visibility on near-term growth (deposits on 44 new stores, demonstrable white space, professionalising organisation)
• Owner-led and increasingly professional management team with material skin in the game
• Net cash balance sheet with de minimis financial leverage  
• 52 week range: 116-180p / share
• See 250p+ / share as doable over next couple years as near term roll-outs successfuly executed
• See 330p+ / share as doable over next five years as longer term growth plans materialise 

***Company***

Overview

Founded in 2008, CBOX is a franchisor of celebration cake stores. As of Sep-23 it has a portfolio of 214 franchise stores and 27 kiosks that sell CBOX’s signature egg-free cakes. The outlets are mainly in London, Coventry and Bradford. Stores tend to be off-high street, garnering cheaper rent. Kiosks are in supermarkets and malls.

The revenue model is simple. CBOX manufactures cake sponge at one of their three sites and then ships it, along with other ingredients, to franchisee stores. Shipping is done with CBOX owned vehicles on a weekly basis. In return, franchisee stores pay CBOX for the inventory received. CBOX will also charge franchisees a one-time fee for setting-up their store. There is also a percentage commission on any sales made by store operators through the CBOX website. There is no other fee charged to franchisees at the moment (e.g. no marketing levy as would be common in other franchise models).

CBOX cakes are egg-free but still use fresh cream and sponge. The original target customer doesn't eat eggs, typically for religious (e.g. Hindus, Sikhs) or dietary reasons. Over time the focus on that target customer has reduced and in the future I expect the “egg-free” aspect to be less central to CBOX’s marketing – although the cakes will remain egg-free. Customers come to CBOX for their offering of good quality egg-free cakes, at a reasonable price and readily available (click-and-collect within 1 hour). CBOX is a leading scale player in the UK for celebration cakes.

The following slide gives a sense of products and pricing (source: company pres):

CBOX’s key cash input costs are raw materials, staff costs and the cost of operating and maintaining its sites and vans.

The manufacturing sites are in three key locations:         

The franchise store portfolio has grown nicely over the last decade (FYE March):

The economics of opening a new store are reasonably attractive. Typical opening costs are around £120-130k. Franchisees can borrow a majority of that and CBOX seems to have good relationships with the major UK banks. Mature stores can take £6-7k / week in revenue. About 40% will be spent on COGS, 20% on staff, 10% on rents and rates and 5-10% on utilities. That leaves 25-30% to cover any depreciation, interest, tax and owner distributions. A 3-5 year payback on a new store is achievable on a normal performing store according to management.

To become a franchisee, applicants must pass a multi-stage application process and pay a £5k deposit to secure the franchise. CBOX will manage the design and fit out of new stores using 3^rd party contractors, with the cost being covered by the franchisee’s initial investment. The franchisee is responsible for hiring and training staff.

CBOX has a base of 90+ franchisees, built around a core of loyalists. The top 5-6 franchisees have more than 5 stores each, while 44 franchisees are multi-franchise owners. 70%+ of stores are likely owned by ~50% of franchisees.

Beyond the 214 stores, CBOX also had twenty-seven kiosks as of FY23. Eighteen of those were in supermarkets. CBOX only started adding kiosks in 2021. One kiosk can generate about half the sales volume of a store. Kiosks tend to be located near a store and use the store’s kitchen and storage to fulfil sales.

CBOX employed 173 staff as of FY23. The majority of those were in production, logistics and maintenance (126). The balance were in administrative (41) and director (6) roles.

Management

Sukh Chamdal is the CEO and founder. Sukh opened the first store in 2008 and co-founded the CBOX franchise business in 2009. He and his wife still collectively own 25%+ of the equity.

Michael Botha is the CFO. He joined in April 2023. He is a qualified accountant and spent 2005-2016 at Domino’s Pizza in financial and commercial roles. He subsequently worked at one of the largest Domino’s franchise groups in the UK and Ireland.

Dr Jaswir Singh is the Chief Commercial Officer, and final management team member sitting on the board. He has been with the business since 2010, previously running his own restaurant business.

Competitive Positioning

The franchisee stores operate in an intensely competitive market. The barriers to entry for a new cake shop in close proximity are very low. There is already significant competition from supermarkets, mom & pop cake shops and even a 21 store CBOX imitator called Cake Inn.

However, CBOX franchisee stores (and therefore CBOX itself) enjoy relative benefits from CBOX’s scale, compared to the local mom & pops and smaller imitators.

One example of this is CBOX’s relative bargaining power with suppliers. In the LTM, CBOX spent £17m on COGS. That provided enough cake ingredients to service 200+ stores. By comparison, Cake Inn likely spent closer to £1-2m on COGS (it has just 21 stores vs. CBOX’s 200+). Spending 10x more with suppliers than Cake Inn should afford CBOX better prices. This in turn should allow CBOX to offer more competitive prices to its franchisees, and ultimately to its customers, making it harder for smaller operators to compete directly with the CBOX stores at a similar price/value point.

Another example of scale benefits is in marketing spend. CBOX has started a concerted push in central marketing – something they haven’t done historically. In FY23 CBOX spent £308k on advertising. That equates to ~1% of revenue. Assuming the Cake Inn has about 10% the revenue of CBOX (they have about 1/10 the store count), they would need to commit 10% of that smaller revenue base just to keep up with the total £s spent by CBOX. As CBOX grows, this differential will become bigger, making it harder to compete.

Beyond the scale benefits enjoyed by franchisee stores, CBOX should also benefit from the fact that franchisees face reasonably high and increasing switching costs. All of a franchisee’s inventory, product designs and marketing come from CBOX. If the franchisee wanted to switch, they would need to replace all of this themselves or join a smaller competing franchise (not clear that there are any that would be appealing given the scale issues discussed above). Switching could be expensive, disruptive and involve meaningful execution risk. Integration with CBOX is also likely to increase over the next 12-24 months as CBOX roll-out new centralised ERP and PoS systems across the full network.

While scale and switching costs likely protect CBOX and the franchisees from the long tail of smaller competitors in the market, the battle with major supermarkets is less clear cut. Scale seems less likely to be a relative benefit in this fight. However, CBOX should benefit from its established niche position as the leading scale provider of quality egg-free cakes in the UK. None of the supermarkets specialise in this segment. Similarly, the supermarkets tend to have a much more limited, less exciting selection of celebration cakes and they lack the customisation options that pull many customers to CBOX. As CBOX continues to grow, the relative differentiation should widen making CBOX’s position more robust. Nonetheless, this dynamic needs close monitoring. Although unlikely, if the major supermarkets were to start expressly focussing on the egg-free cake niche, that could be detrimental to CBOX over time. This risk feels relatively low though.

Growth Opportunities

The business should be able to continue growing both revenue and margins.

• UK store count growth:

Management have stated a short term target of 250 UK stores and a longer term target of 400 UK stores. As of 1H24 (Sep-23), CBOX held deposits on 44 new stores, which would clearly be enough to get them to their 250 target. However, that depends on there still being enough space in the UK to accomodate the new stores. I believe that there is enough space.

Mature UK cities have 0.5-1+ CBOX stores per 100k people. There seem to be at least 17 UK cities with populations over 200k that have less than 0.5 stores per 100k people. Getting each of those cities to a 0.5 ratio (low end of mature range) could add 20 stores to the group. Getting to 0.75+ would add more than 45 stores. Glasgow and Edinburgh alone should be able to support 8-15 new stores. Based on just these major cities, CBOX seem to have enough white space to be able to reach the 250 store target in the next few years. There should also be a longer tail of other cities and large towns (beyond the 17 mentioned) that can accommodate new stores (the likes of Carlisle, Norwich, Exeter etc).

• International growth:

Longer term, there should be an opportunity to expand internationally. The manufacturing footprint is simple and relatively straightforward to replicate, so is the franchise model. Management has already proven it can roll-out new manufacturing and distribution sites through its footprint expansion from London to Bradford and to Coventry. Clearly, at 214 stores, the franchise model is also already proven. The US, Canada and Australia/New Zealand are obvious markets to consider expansion to. Parts of Europe could also work. I don’t expect international expansion in the next couple of years, and it is not core to the thesis here, but it is a clear tail upside opportunity over the longer term.

• Other:

There should be further incremental growth on the back of CBOX’s ongoing professionalisation. In the last year the management team has been improved through the addition of a new CFO (ex Dominos PLC and Dominos franchise group) and a new Marketing Director. The business has for the first time started to ramp-up central marketing and is in the process of launching a full branding refresh and professionalising its approach to advertising campaigns. CBOX is also rolling out new centralised ERP and POS systems across the franchise network over the next 12-18 months. This should improve the business’ approach to data gathering/analysis, stock management and logistics in general. The combination of an improved management team, a new central marketing approach and an increasingly professional approach to IT and data should all contribute to further revenue growth and margin improvement over time.

***Valuation***

In simple terms, I think about value as being split between four pockets:

• The existing store portfolio
• Reasonably expectable growth over the next couple of years
• Existing net cash on balance sheet
• Longer term optionality

Existing Store Portfolio

CBOX generated £32m of revenue from the sale of goods to franchisees in FY23. Goods are typically sold at around a 50% GM, so that’s £16m gross profit. There was approximately £10m of cash opex in FY23, so recurring EBITDA (i.e. ignoring any income from new store openings) was about £6m. Typical maintenance capex spend is £1-2m, leaving £4-5m of EBITDA after Capex. At 25% corporation tax - and ignoring de minimis interest costs for simplicity - that’s around £3m of re-occurring FCF in FY23. Given the growth potential outlined above and risk free rates of ~5%, a 10-12x FCF multiple does not seem an unreasonable floor assumption. That would suggest a static business value of at least £30.0-36.0m. I'm probably being too conservative here given that CBOX and other listed franchisors currently trade at higher P/E multiples (15-20x+), but I prefer to err on the side of caution. 

Reasonably expectable growth

CBOX currently holds deposits on 44 new stores. Given LTM cadence of new openings, and given the white space discussed above, I think at least 40-60 new stores can be successfully opened over the next couple of years.

Each store opening generates approximately £125k of one-off franchise package fees to CBOX (full cost for pre- and post-opening set-up) on which they earn approximately a 20% GM (i.e. £25k GP). So achieving 40-60 new openings would add £1.0-1.5m of one-time value / cash.

Thereafter, CBOX typically earns about £140k of revenue and £70k GP per store. So that’s an incremental £2.8-4.2m of recurring GP to the business. That should be earned with minimal incremental opex as there is significant capacity within the existing manufacturing and distribution footprint. At similar multiples to those discussed above, that additional GP/FCF could be worth at least another £28.0-50.4m.

Existing net cash

There was approximately £6m of net cash on the balance sheet as of FY23 and the business should remain cash flow positive going forward. There is probably more than that on the balance sheet today.

Longer term optionality

Beyond the reasonably expectable growth, management have outlined a 400 store target. This would probably require international expansion. If they do expand internationally, reaching that level of stores doesn’t seem wildly unreasonable. Using back-of-the-envelope math, similar to the above for “reasonably expectable growth”, suggests there could be further value upside of at least another £109-130m if the portfolio gets to 400 profitable stores.

Summary

Bringing that all together, the pockets of value combine to look something like this:

For simplicity, this analysis neglects to include another £3m+ pa of value from ongoing FCF that I expect to be continuously distributed to shareholders via dividends. Over a three year period that could be at least another £10m of value or another 25p / share.

If you want to be less conservative and assume market P/E multiples (say 15x instead of my crude/conservative 10-12x assumption), that probably adds another ~50% to the low end and ~25% to the high end. 

Note: in Jul-23 CBOX turned down a 160p / share offer from The Cheesecake Shop which is owned by River Capital. CBOX rejected the offer on the basis of it supposedly undervaluing the company.

***Investment Thesis***

CBOX creates value for both its customers and its franchisees. For customers, CBOX is the leading scale provider of egg-free focussed celebration cakes in the UK. Prices are affordable, the product is customisable and lead times are short. For franchisees CBOX offers an attractive ROI, a tried and tested business model and a relatively easy start-up process.

The business still has room for growth. Just from the deposits they already have, store count should get into the 250+ area over the next few years. Longer term there should be an opportunity to expand beyond that - perhaps internationally. There should also be some improvement in revenue and margin on the back of the ongoing professionalisation in the business which includes the start of centralised marketing as well as improved IT systems and use of data.

The quality of operations is likely to improve over the short/medium term as the business continues to professionalise. For the first time CBOX now has a “professional” C-suite to support Sukh. In the last twelve months they have hired a new CFO (ex. Dominos) and a new marketing director.  

The financial record is strong. ROE has been impressive (see below) despite de minimis leverage. FCF has grown ~20% pa over the last 7 years. EBITDA less capex margins have been 20%+ in all but two of the last eight years. FCF has been positive every year. Capital intensity is low: there is some need for WC and maintenance capex but FCF is otherwise free for distribution. CBOX has paid a dividend since 2018 (£3.1m in FY23).

Risk of permanent impairment seems low. Liquidity is healthy while leverage is low. There was £7.4m of cash on balance sheet as of Mar-23 against just £1.2m of mortgage debt relating to the sites. Trade working capital requirements are reasonable at about 4-7% of revenue. The largest overhead is staff. Capex (3-6% of revenue) should be manageable and is subject to some discretion in any given year. As currently capitalised, the business should be able to withstand a decent amount of external pressure over the medium term.

Owner/manager. Sukh has meaningful skin in the game and his incentives align him reasonably well with minority shareholders. He has taken money out of the company through the IPO but still owns 25% of the company.

Undemanding valuation. Trading on a 7% TTM FCF yield, 5% TTM dividend yield. This does not seem expensive for a company with a decent competitive position, clear runway for growth and strong financial metrics.

***RISKS***

Some of the key long-term risks I see here:

1. Franchisee health
2. Governance

Franchisee health

If a material number of franchisees are not making adequate returns they will eventually close, thereby reducing CBOX revenues and earnings in the medium/long term. Evidence that franchisees do not make adequate returns would also make it harder for CBOX to open new franchises, depressing the group’s growth prospects.

Data on franchisee performance is not particularly detailed so it is not possible to make a complete assessment of franchisee health. However, one negative data point is that loans from CBOX to franchisees exist. From Sep-20 to Mar-21, this balance increased from £4k to £1.0m. There is also £339k of AR that has been outstanding for more than 90 days. This could suggest (and I would generally expect for this kind of business) a tail of struggling stores.

A few mitigants:

• Franchisee composition. ~70% of franchises are owned by ~50% of franchisees. There seems to be a core group who believe that the stores are worth having more of. Rationally, why increase exposure to stores if you are not earning an adequate return? On this basis, it seems reasonable to expect that at least 70% of the stores are performing acceptably.
• Loan balance coming down. The balance of loans from CBOX to franchisees has reduced from its Mar-21 peak as of latest reporting. If this balance were to start sequentially increasing over several periods I would be concerned. The fact it is decreasing could suggest that they have the tail of under-performers under control.
• Store-level LFL. This remained positive at +1% in FY23 and in the more recent 17 weeks ended Jul-23, LFL was +6.8% YoY. That represents an acceleration from the +5.4% YTD reported at the time of FY results announcement (i.e. LFL accelerating).
• Management conversations. From management, I understand that less than 5% of the franchisees have received loans. It also seems that many of these loans were “bridge financings” for new stores rather than bailouts of struggling existing stores. Allegedly, no stores are currently in arrears with their payments to CBOX.
• Online sales. Around 10% of a store’s sales are generated through the CBOX website. Cash on those sales comes first to CBOX, and is then sent on to the relevant franchisee. As such, CBOX is able to hold onto this portion of a franchisee’s cash flow in the event that there is an unpaid loan outstanding.

Overall the risk here seems reasonably contained, particularly given the material possible upside in the longer term from current prices.

Governance

This is a small business, still going through the transition from entrepreneur-led start-up to public company. In Jan-22, a micro-cap blogger identified a string of issues which suggested low quality internal systems and governance. It also identified related party influence. The fall-out from the article was substantial. The share price collapsed and the CFO ultimately left the business in short order.

The article is available here and is worth reading:

Cake Box Holdings has some accounting issues | Small-Cap Spotlight Report (LSE:CBOX) - ShareScope Articles

A quick summary of the issues raised:

• CFS in FY21 annual report contained a phantom £2m line item (didn’t affect subtotals or balances and issue wasn’t present in the RNS)
• Inconsistencies in the reporting of related-party transactions
• Didn’t immediately report a website breach (GDPR issue) to their auditor and customers
• Auditor identified weaknesses in stock control and ultimately resigned in Sep-21
• Reporting focussed on AP ageing rather than the more normal AR ageing
• Some evidence of overdue tax, curious use of R&D tax credits and optimistic revaluations of distribution centres

Clearly none of this is positive. In particular, the auditor resignation and website breach were not well-handled at all. However, my sense is that most of these issues arose from sloppiness/inconsistency/weak internal control rather than anything more nefarious. Positively, none of the issues have affected cash balances or profits.

I am reassured by the fact that the company quickly took steps to make amends in response to the article. Some of those include:

• CFO left the business in Mar-22, within months of the blog being posted (had been in the business since it was founded and is CEO’s cousin)
• Chairman now also leaving (also in the business since it was founded)
• Hired an experienced CFO, who seems independent of the founding family and used to be at Dominos PLC
• Hired BDO to do internal audit work

Overall I see this episode as symptomatic of a young business, growing rapidly and subsequently experiencing growing pains. I think management have taken appropriate steps to reduce the likelihood of a repetition. However, I could of course be wrong. I will be monitoring this closely going forward for further red flags.

***Conclusion***

CBOX is a high quality business available at an undemanding valuation as a result of a one-time negative episode in the company’s history (the blog post discussed in the risks section was the key catalyst behind the sell-off). I think that the business responded well to that episode and financial and operating performance has continued to trend positively since. There is clear runway for growth to 250 stores in the near term and longer term optionality beyond that. I see low risk of losing money over a two-to-three year holding period with potential to make a 15-20%+ IRR as well as longer term optionality.

Catalyst

Achieving the 250 target store count

Continuing to grow beyond 250 stores

Ongoing cash build-up and growing dividends