Description

Historic financial summary below:

I have 2017 EV/after-tax FCF at 14x as follows: £5.94 share price, 74m shares, £440 MC, £22m net cash, £418 EV.  2017 E FCF of £30m is £55m of EBITDA, less £16m maintenance capex, £7m tax, and £2m minority interest.  If the scope of their business were to remain status quo, I estimate a 35% share price increase over the next few years based on 15x 2018E FCF of £33m and cash build.  However, it’s more likely that Hilton’s scope continues to expand.  I will outline how Hilton’s earnings power could grow significantly over the next few years.

How the sausage is made

Hilton serves the market leader in five of the top ten countries in the world, as measured by grocery spend per capita.  In each of these geographies, it is the retailer’s largest supplier in the category.  To my knowledge, Hilton has never lost market share with a customer.  The following table of historical volume by customer illustrates their impressive track record:

Volume per Customer (k tonnes)
Customer (country)             2004                       2015                        
Tesco (UK)                             33                           77
Ahold (NL)                             28                           68
ICA (SE)                                  3                              40
Tesco (IE)                               5                              18
Coop (DK)                              10 (2011)              13
Woolworths (AU)                 25 (2013)              40
Ocado (UK)                           new (2015)
Sonae (PT)                             new (2016)

To illustrate the difference in thinking, here are some statements from Hilton and competitors on strategy:

• Hilton: “Building volumes with and extending product ranges for existing customers; Partnering with existing customers in new territories; Gaining new customers in new territories; Maintaining an uncompromising focus on unit costs, quality and product development.”
• HK Scan: “We improve our performance by more efficient and transparent Group-wide business processes, competences, leadership and communication. We increase our profitability by developing brands, offerings and cutting nonperforming activities.”
• Danish Crown: “This is a growth plan which is expected to increase both revenue and earnings in the group in the coming years, while at the same time making the group less sensitive to economic cycles. The first step in this development is the acquisition of Germany’s fourth largest pig slaughterhouse business.”

The differences in plain speak vs. buzzwords and customer focus vs. own take are subtle, yet meaningful.

By partnering with a single customer in a geography, Hilton creates user value beyond the traditional model.  On the cost side, Hilton co-locates at the retailer’s distribution center, reducing transport cost.  As they are the majority supplier for each single customer, Hilton achieves significantly higher throughput volumes per production line, reducing labor cost.  In total, I estimate that Hilton can reduce its customer’s cost by 10%, which is compelling in the grocery world.

On the revenue side, they increase contribution per square foot for customers.  By integrating their systems with the retailer’s point-of-sale data, Hilton can change up specialty product combinations (e.g. summer BBQ combo packs) on the fly, increasing yield.  In some geographies, Hilton employees effectively manage the category for the retailer.

Industry trends aid Hilton's growth.  In existing countries, cost pressures on the traditional supermarket model are shifting volumes to pre-packed products.  The butcher is the highest cost (non-manager) in the store and production economies of scale in store level are abysmal.  Cost aside, final product processing at the store level is unwanted because it increases health safety risks and decreases shelf life.  The fresh meat segment of food retail is bifurcating between specialist butcher shops and pre-packed, providing structural growth for Hilton.

Growth

Within Hilton’s current geographic scope, it should continue to grow low to mid-single digits per year, based on market share gains and product line extensions.  Stores in existing geographies are still being switched over from butcher to pre-packed.  The variety of seasonal products Hilton can offer is expanding.

Regarding new geographies, the obvious near-term possibilities are Australia, Portugal, Belgium, and the US.  Management has commented that the reason they currently have a net cash position is because they expect to invest it in these geographies.  Estimates for these prospects:

• Portugal (Sonae): 80% probability, 20k tons, £2.5m EBIT
• New South Wales Australia (Woolworths): 66% probability, 60k tons, £7.5m EBIT
• Belgium (Ahold/Delhaize), 50% probability, £4.0m EBIT
• US (Ahold/Delhaize): 33% probability, 150k+ tons, £15-20m EBIT

Based on those estimates, that works out to total earnings growth of £14m, or 42% over 2016E EBIT of £33m.  The total potential is from those opportunities £34m, or double current EBIT.

Hilton is already working with each of these retailers in one form or another.  In the case of Ahold, where a US entry for Hilton is possible as part the post-merger integration of Alhold/Delhaize, the partnership started in 1999. 

Beyond the clearly identifiable, I believe Germany, Switzerland, and Canada are also each suitable geographic candidates for Hilton, though I am aware of no current plans to enter those markets.

Mispricing

The share price has done well over time and the few covering analysts like the company.  In my view, however, the market underrates the economics of the business.  One reason for this could be the customer concentration risk and low margins, things frequently associated with bad businesses.  In regards to the risk customer loss, Hilton is the opposite of its peers.  Its model takes years to build up, but once accomplished is robust.  Regarding the low gross margins, I would argue it’s a bit deceiving as Hilton often does not take inventory risk.  In Australia (an unconsolidated JV with Woolworths), the revenue model is a management fee, with no cost of goods running through the JV’s P&L.  Of course for customer discussions, it’s in management’s interest to represent the financials in a way that shows a low margin – and not focus on ROIC.

A second reason for undervaluation could be that analysts include cost of business development in their forecasts but exclude the benefit.  The Portugal JV with Sonae is a current example of how this impacts the financials.  Consensus expectations (5% annual growth in net income for 2016-2018) exclude the possibility of expansion of the business as outlined above, despite Hilton’s compelling value for its customers and its \track record. 

Catalyst

Geographic expansion announcements