Business
Loungers PLC is an operator of a chain of Café/Bars and restaurants in the UK. They have two distinct concepts: Lounges and Cosy Clubs. Loungers PLC has attractive unit economics, is well liked by its customers and has consistently grown L4L sales. It is trading below its pre-COVID levels despite remaining cash flow positive and has posted its highest ever half year period of sales. Its management team is incentivised to create as much value as possible over the next two years.
Overview
Lounges are difficult to categorize but can be reasonably thought of as a cross between a neighbourhood café and British pub. Lounges place a great emphasis on the social aspect of attending. Every Loungers location is unique and is tailored to its local area. Loungers tend to be located on the periphery of city centres when in larger cities and in town centres of smaller towns.
Cosy Clubs are found in larger city centres. They are more formal than a Lounge, taking reservations and offering sit down service. They see more activity than a Lounger both on the weekends and in the evening vs the morning or afternoon. Alcohol is a greater percentage of revenue compared to a Lounge. Cosy Clubs have higher Sales and EBITDA per location but also higher CapEx requirements.
Timeline
The first Lounge was opened in 2002 by three friends, Dave Reid, Alex Reilly and Jake Bishop. Dave Reid left the company but Alex Reilley and Jake Bishop remain, as Chairman and Commercial Director respectively.
In 2012, Loungers secured an investment from Piper PE as a way for the founders to sell a portion of their stake. In 2016, Piper PE exited their stake and Lion Capital acquired a majority stake in the company.
In 2019, Loungers went public on the London Stock Exchange as a way for Lion Capital to exit its investment in the Company. Today, Loungers PLC operates 31 Cosy Clubs and 153 Lounges.
Today
Loungers PLC does not break out Cosy Clubs vs Lounges, they are reported as one segment. However, given how Management is investing a far greater percentage of CapEx into opening new Loungers (by my estimate 74% of new CapEx will be put into Lounges vs 26% for Cosy Clubs), I would speculate they are more attractive on a unit economic basis. While you might initially suspect that would make forecasting the future operations of the comapny difficult, as long as Loungers opens new sites in roughly the same proportion as the current make up, we can extrapolate from the past with some degree of accuracy even without knowing the unit economics behind a typical Lounge or Cosy Club
At the time of writing, Loungers has 31 Cosy Clubs open and 153 Lounges. This means that Cosy Clubs comprise 16.85% of current sites and roughly 24.5% of cumulative CapEx. Lounges comprise 83.15% of current sites and roughly 75.5% of Cumulative CapEx. The company has stated its goal of opening 20 Lounges and 5 Cosy Clubs per year and. Historically they have fallen short of this goal. Over the two year period 19/04/2018 to 19/04/2020, Loungers PLC opened 36 Lounges and 8 Cosy Clubs; 90% of their target for lounges and 80% of their target for Cosy Clubs. Because of how each location is individual and distinct, I do not believe Loungers will achieve this goal in the future. I expect them to open 18 Lounges per year and 4 Cosy Clubs going forward. Even with Loungers PLC falling short in their goal, LFL sales and attractive unit economics can more than make up for this.
In a 2019 analyst presentation, Loungers PLC disclosed that the average CROCI across all sites was 34%. If Loungers can open 4 Cosy Clubs and 18 Lounges per year, I estimate this can add £4,060,000 of EBITA or a 26.6% ROIIC, far in excess of their cost of capital.
LFL sales have meaningfully outperformed the overall UK hospitality sector, growing 6.0% in FY2018, 6.9% in FY2019 and 4.5% in FY2020 (Loungers PLC financial year ends in mid/late April. COVID lockdowns did affect FY2020 performance, but not as much as you might initially suspect because of this). L4L growth is attributed to increased in customer volume per location rather than price.
Management believes in the business. Insiders continue to own a meaningful stake in the company post IPO. Senior Management and the Board of Directors collectively own 15.5% of the company. More importantly, their future compensation is primarily tied to share performance. A ‘value creation plan’ was created entitling executive officers and two managing directors to a pool of shares that has a value of
· 10% of any excess TSR above 12% per year and below 15% per year
· 11% of any excess TSR above 15% per year and below 20% per year
· 12% of any excess TSR above 20% per year
One-third of this pool vests on the third anniversary of the IPO, another third vests on the fourth and the final third vests on the fifth, with a maximum of new shares issued being equal to 6% of the groups share capital. Loungers IPO’d on May 3rd 2019, meaning management is highly incentivised to crate as much value as possible for shareholders over the next two years.
Sector/Industry
The two most important metrics when analysing a retail concept are L4L sales (also known as ‘comps’) and how many locations can be opened. L4L sales in particular is most important and valuable. It is important because it is a measure of the overall performance of the concept. A company that grows total sales by aggressively opening new locations in the face of consistently declining L4L sales is setting itself up for failure. L4L sales is particularly valuable as it requires virtually zero incremental investment (aside from an increase in NWC, which is quickly turned over).
Loungers PLC’s L4L sales have been extremely impressive over time, growing 6.0% in 2018, 6.9% in 2019 and 4.5% in the first 44 weeks of 2020 (prior to COVID affecting operations).
Loungers management believe it has the potential for over 400 Lounges and 100 Cosy Clubs in England and Wales (currently at 31 Cosy Clubs and 153 Lounges). Loungers PLC has the ability to reinvest at a high rate of return for a long period of time.
One issue that Loungers encounters when opening new sites is that it is not programmatic. New locations have grown linearly rather than exponentially. I anticipate a deceleration in revenue going forward.
The dominant theme of the hospitality sector has been the effect of COVID lockdowns on business. Loungers was not immune. It had revenue decline more than 50% and opened three net new sites. Despite this, Loungers still remained cashflow positive.
While the hospitality industry is currently benefitting from pent up demand, Loungers in particular is performing well. Its most recent half-year reported its highest ever sales.
Competitive Advantages
Loungers PLC benefits from two identifiable competitive advantages.
Loungers technically benefits from economies of scale. As more Loungers open more locations, its fixed costs, primarily its head office, will comprise a smaller and smaller percentage of its operating expenses. I do not believe that this will be a major competitive advantage for the company, other restaurant/café/bar chains will still be able to open locations that compete with Loungers, but I do feel confident underwriting future margin improvement.
I believe that what has made Loungers a success in the past and what make the business hard to replicate is its intangibles. It has consistently high reviews on Google reviews from customers who specifically cite the ‘atmosphere’ of the locations. A retail concept that is well liked by its customers, has attractive unit economics, consistently high L4L sales while also having each location be different and distinct is not an easy business for competitors to replicate.
In particular, would like a highlight a comment by a user named Pandora on ValueInvestorsClub.com when discussing an unrelated retail concept called ‘Noodles & Co’
“I have played this game before and it ain't fun. By that I mean assuming a concept that hasn't grown comps or units in a ~decade will somehow just grow by virtue of nothing more than me buying the stock.
The problem with Noodles and other concepts in this bucket is that the underlying problem - mediocre food that no one genuinely cares about - isn't solvable. Ask Potbelly, whose chart is identical. These things aren't fixable. All you get is constantly churning management teams and small-time activist investors who fiddle around the edges to hopefully breathe a tiny bit of life into the story.“
https://www.valueinvestorsclub.com/idea/NOODLES_andamp%3B_CO/0646608902
I believe Loungers can be thought of as the Anti-Noodles & Co. Loungers does not serve food that is ‘mediocre’, has consistent grown L4L sales, or ‘comps’ and management has stayed with the business over the longer term.
Valuation
I estimate a 21.83% IRR if shares are purchased at their current price and held for five years using conservative assumptions. These assumptions are expanded upon below.
The valuation is conducted on a Pre-IFRS 16 basis. Leases are treated as operating expenses and only borrowings are treated as debt.
2020 serves as our ‘base’ year as it represents our last mostly normal year of operations for the company. Loungers PLC’s financial year ended on the 19th April 2020. British COVID restrictions were announced on 23rd of March and legally came into effect on the 26th of March. This means that even in our ‘base’ year, there were still interruptions to the business. Because I am trying to use it as an approximation of a normal year of operations, we use operating profit before exceptional items. Loungers had significant one-time expenses that are related to a COVID induced impairment of PPE and IPO costs. These are true one-time expenses and do not represent the ordinary activities of Loungers. The £8.62 million of profit before exceptional items is on a post-IFRS 16, on a pre-IFRS 16 basis, our operating profit is £10.6 million.
If we assume 5% LFL sales in 2022 over 2020 sales and no new site openings, get £174.8 million pounds of revenue. If we then assume that Loungers can open 18 Lounges and 4 Cosy Clubs per year, that these sites contribute £24.3 million pounds of revenue per year and that loungers can achieve 5% L4L sales from 2022 to 2025 and 3% in 2026 and 2027, we arrive at a figure for revenue of £350.8 million pounds.
If we assume 5% growth in operating income over 2020, we get £11.1 million pounds in operating income. Like above, if we then assume that Loungers can open 18 Lounges and 4 Cosy Clubs per year, that these clubs contribute £4.06 million per year in operating income (no amortisation), that Loungers experiences 5% L4L growth from 2023 to 2025 and 3% in 2026 and 2027. We get a figure of £36.38 million of operating profit. This represents a margin of 10.37% compared to 6.35% in 2020. As discussed in the ‘Competitive Advantages’ section, I expected some margin expansion as fixed costs as a percentage of sales diminished with growth.
I would be happy if Loungers could invest every Pound of pre-growth CapEx FCF into opening new sites. Because I anticipate that Loungers will not achieve their goal of opening 20 Lounges and 5 Cosy Clubs, the Cash that would have gone into building out this location becomes available to shareholders in the form of free cash flow.
I assume a change in net debt that is roughly in line with cumulative FCF produced.
Risks
Loungers PLC is particularly sensitive to an economic downturn as eating out is considered a discretionary expense for customers. In the event of an economic downturn, customers would be inclined to eat at home. This would primarily affect Loungers PLC’s Cosy Clubs as they tend to be more expensive and, since reservations are taken, the possibly of an impulse stop is greatly reduced. The Lounges would still be affected but given an average Lounge visit costs less than a Cosy Club and is often an impulse stop, I believe Lounges, which makes up the majority of Loungers PLCs business, will be less affected.
Loungers PLC purchases large quantities of food. At the time of writing there are significant supply chain constraints, rising energy costs and rising fertilizer costs. Loungers L4L growth has come from volume increase, not price increase, we do not yet know how customers will react if Loungers PLC is forced to raise prices. If customers react ambivalently to an increase in price, it could be a sign that Loungers PLC has heretofore untapped pricing power. In an ideal scenario, Loungers PLC could experiment with pricing on its own terms rather than have it forced upon the company through inflation and supply constraints.
If Loungers PLC fails to open stores in line with its plans, future projections of NOPAT and FCF could be overstated. In the short term, this creates an opportunity for the company to repurchase shares, pay down debt, or pay a special dividend. I would still find it preferable for the company to invest all pre-growth CapEx FCF into opening locations, but should they fail to do so, it would free up funds for shareholders.