7 winners and losers in the leisure sector

The leisure and hospitality sector has had a crazy ride since the beginning of 2020. Revenues went to zero for many companies during the pandemic lockdown, but subsequently bounced back.

Then Russia’s invasion of Ukraine saw energy prices spike, as well as wider inflation pressures. This has been a huge headwind over the sector with many businesses forced to close due to rising costs and falling revenues.

Many of these businesses have high operating leverage due to fixed costs. Once these costs are covered, profits can rise substantially. However, if revenues fall below the costs required to keep the lights on, they are forced to stop trading.

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I’m a firm believer that in every sector there are always winners and losers. Every crisis can throw up a new opportunity. So is there any value on offer yet?

An easy place to cut back

Gym Group (LSE: GYM) was an obvious stock to short in 2022. When consumers’ spending power falls and people look to cut back wherever they can, there is increased competition for every pound.

My thesis was supported by data from the company’s annual report. In 2019 (the last pre-pandemic year) only 44% of members visited the gym at least four times in a month.

That meant a staggering 56% of members were going less than once a week. I believed that people wouldn’t want to be paying monthly for something they rarely use, and that view proved correct.

The company reported on 16 March 2023 that business had “slowed in the short term by the cost-of-living pressures which are having an impact on underlying demand”. I like Gym Group’s model of opening up in prime areas to drive traction, but I think these shares are risky.

Energy costs are set to be £10m higher in 2023 and while the business says it is 96% hedged for the year, it fails to mention anything in 2024. Along with the “uneven start to 2023 versus board expectations”, I’ll be steering clear for now.

Good food but not cheap enough

Tortilla Mexican Grill (LSE: MEX) was listed in October 2021 and like most initial public offerings (IPOs) that year it bombed. Still, the business performance hasn’t been completely terrible.

Group revenue increased 20% to £57.7m and UK like-for-like (LFL) sales were up 16.4% compared with the 2019 fiscal year. That tells me the brand’s appeal is growing.

Tortilla’s is the biggest Latin American-themed food chain in the UK and it’s not bad (I’ve tried it). As a point of comparison, Chipotle has over 3,000 stores in the US. It’s hugely popular.

However, Chipotle hasn’t managed to recreate that success in the UK – it has only ten units here, all of which are in London. Can Tortilla fill that gap? And is there even a gap? Well, so far it seems so.

Units have grown from ten to 80 since 2012, with accelerating growth in the last two years. I can see how this business rolls out nationwide.

I doubt it’ll ever be as spectacular as Greggs (to be fair, nothing compares to sausage, beans and cheese melts), but the business has had steady growth so far and there’s no reason to assume why it wouldn’t continue.

Against that, I don’t see this as a high-quality business. I’m just not interested in holding fast-casual dining businesses like this (or companies in this sector in general) long term unless I think there’s a significant chance of a material gain.

In this case, if everyone believes in the potential from rolling out more restaurants, then all the value is probably priced in, and so superior gains are unlikely. Still, these are solid tortillas, so a thumbs up for the product from me!

Strong signs of recovery

I would be remiss not to include sector behemoth JD Wetherspoon (LSE: JDW) in this article. Spoons, as it’s widely known by many regular customers, said earlier this month that sales in the current financial year are likely to set a new record.

The number of outstanding shares has increased as a result of several fundraisings during the pandemic, but the recovery is already showing promise with profits expected to be at a record high for 2023.

However, the business currently trades at 21 times forecast earnings for the 2024 fiscal year (estimated at £43.9m profit after tax). It’s not a business I’m interested in buying, as much of the success appears plentifully priced in.

I wouldn’t be surprised if Wetherspoon traded at higher levels in the future, but perhaps a smaller and nimbler operator could provide more upside.

Taking advantage of a battered sector

That brings us to Nightcap (LSE: NGHT), which listed in January 2021 with the explicit goal of taking advantage of the battered leisure and hospitality sector. It aims to acquire and develop brands that have the potential to be rolled out across the UK.

The directors own over 20% of the issued share capital and so I would expect them to be mindful about diluting themselves heavily with a discounted share placing.

The company raised significantly more capital than originally intended in May 2021 due to strong demand from investors. While some might have said this was overkill at the time, it now appears to have been a welltimed move.

Nightcap is in a much stronger position as a result of raising funds then instead of potentially trying to do so in the future, since the share price has more than halved to 9.5p from the 23p placing price.

The company is forecast to hit £49.3m in sales in 2023, with a maiden post-tax profit of £0.64m. It reported its interim results on 13 March 2023, which said that Christmas trading beat expectations (despite “significant rail strike disruptions”) and cash generation from operations was £4.1m.

The latter number is important because cash generation boosts cash flow available for the roll out of its businesses, alongside the tactical use of debt. Nightcap refinanced its banking facilities and has access to £10m of debt funding in total, comprising a £3m term loan and a £7m revolving credit facility.

As of 1 January, it had £4.1m in net debt drawn, and so there is still plenty of dry powder. Note that the company’s goal is to invest and grow its capital, and so anyone seeking dividends to be paid out of profits would do better to look elsewhere. This is a growth story and shareholders will expect to see returns through share-price appreciation.

An underwhelming recipe

Cake Box (LSE: CBOX) is a franchise business that sells egg-free cakes. The shares reached a high of 426p in 2021, then traded down to as low 97p in 2022 due to a series of profit warnings.

However, a trading update in April said that revenue is up by around 5% and adjusted profit before tax is in line with market expectations. Analysts are forecasting £5.23m in profit before tax, according to SharePad.

On this number, the shares are on around 9.5 times pre-tax profits for 2023. With next year’s forecast pre-tax profit set to grow around 9.5% to £5.73m, the company seems to be fairly valued in price/earnings-to-growth (PEG) terms.

There is scope to grow by rolling out the concept nationwide. The valuation has certainly come down compared with historic levels: the 2021 price/earnings (p/e) ratio was 26. But I can’t get excited by the rate of growth here and would leave this share alone for now.

On track for break out

XP Factory (LSE: XPF), which operates escape rooms and activity bars, featured in my “four small caps to buy in 2023” article on 5 January 2023. The company has since put out a solid trading update, describing a transformational year in which the group revenue tripled.

Management also said that margins had continued to surpass internal benchmarks, with sitelevel earnings before interest, tax, depreciation and amortisation (Ebitda) margins on track to beat the expected 35% for 2022.

House broker Shore Capital forecasts that revenue will almost double to £39.8m from £21.9m), producing Ebitda of £6.1m and £2.2m of adjusted profit before tax. It also expects that this year the company will be able to self-finance future rollouts from its own cash flow.

There has been no update on trading in 2023, but if last year’s strong performance has carried through into 2023, then I believe the shares have further to go. The price is just slightly down from my 21.5p buy suggestion, at 20.5p this week.

Tired brands and tough competition

Shares in Restaurant Group (LSE: RTN) have performed poorly in recent years. From a high of 545p in the spring of 2015, the stock had already fallen to 165p before the pandemic. Still, the misfortunes of earlier shareholders shouldn’t concern us as we are focused on the present and the future.

I find it hard to get excited about Restaurant Group and its brands, such as Frankie & Benny’s and Wagamama, but management reported at the start of May that the business had been performing ahead of its expectations.

Management has been proactive in hedging energy costs: all of its 2023 and 2024 costs are hedged, along with 80% of volume hedged for the first three quarters of the 2025 fiscal year.

This may mean the group makes a loss on the hedges if energy, prices soften, but provides certainty for shareholders, which is reassuring considered that it had £581.7m of net debt in its last results compared with the current market cap of £368m.

The business is highly cash generative, with net cash flows from operating activities of £118.9m, allowing it to pay off £110m in borrowings. Management wants to get the net debt to Ebitda ratio below 1.5 within three years. Still, I think the group has tired brands and there are many fast-casual competitors, so it’s not for me.