Churchill China: The Proof Is In The Pudding

Churchill China is a small, UK company that specialises in the production of ceramics for the hospitality industry. Founded in 1795 in Stoke on Trent, Churchill has over 220 years of history in ceramics and is widely revered for its product design and durability. Reporting full-year results yesterday, Churchill has had a tough 2020 with revenues collapsing to £36.4m vs £67.5m the year prior. Whilst this has broken an enviable streak of growth for Churchill, I will aim to detail why I believe Churchill’s best years are still ahead of it.



Topics covered in this article:


Business Structure


Churchill’s business can be divided into two areas, Ceramics and Materials. The Ceramics business in 2019 attributed £62.6m in revenue vs £7.8m from the Materials business. Therefore, it is fair to say that Churchill’s main business unit is Ceramics. The Ceramics business provides high-quality tableware primarily to restaurants, pubs and hotels. However, Churchill does have accounts with sports venues, hospitals and other public catering businesses. Churchill also sells ceramics to the retail market through its retail partners and designs for consumer brands such as Cath Kidson. The Ceramics business was bolstered in 2019 by the addition of the brand and intangible assets from Dudson Ltd, a long time competitor that had collapsed into administration.


The Materials business relates to a subsidiary named Furlong Mills, which was acquired in February 2019. Furlong Mills is a ceramic materials manufacturer based in Stoke on Trent, which provides processed clay body and glaze to Churchill and other major manufacturers. With revenues of only £7.8m in 2019, the Materials business makes up just over 10% of Churchill’s total sales. Whilst this contribution may be small, it aids the understanding of materials science for Churchill designers and will play an important part in the ongoing innovation of Churchill’s business.


Churchill sells products in global markets, and as of 2019, 58% of revenues were derived from the export market, with 36% of revenues sourced from Europe, 11% from North America and 11% from ROW (Rest Of World) markets.


Recent Performance


2019 marked a record year for Churchill China; revenue growth hit 17.4%, which was an even better result than in 2016 when the crashing pound led to significant export demand for Churchill’s products. This trajectory even carried through to the first two and a half months of 2020, for which Churchill saw record hospitality sales (if only the hospitality sector knew that Q1 2020 was not the time to be ordering tableware!) This record-setting environment came to a swift end in March 2020 with pandemic driven lockdowns closing the doors on hospitality businesses across the UK and Churchill’s other main markets. Still, despite the pandemic, Churchill managed to achieve revenues of £36.4m during the year and amazingly avoided a loss by posting an operating profit of £0.9m (down from £11.2m in 2019) and a pre-tax (after exceptionals) profit of £0.1m.


In a year in which many businesses serving the hospitality sector experienced heavy losses or went bust, to avoid a pre-tax loss in 2020 for Churchill is significant, especially with quite inflexible overheads such as ceramic facilities, design studios and clay materials factories. Further to this resilience, I also want to point out to readers that no equity raise or placing was undertaken at any point during the year. Contrast this to many businesses in the UK that undertook dilutive equity placings during 2020, shareholders have benefitted from Churchill’s ability to withstand the pressure to raise additional capital.


Churchill China’s Quality Features


I think there are a few reasons investors should look to Churchill China as a quality business and certainly as a lower risk means of getting exposure to the hospitality market, the main reasons for which I will provide below.


Firstly, we can consider Churchill’s operating history of more than 220 years as a significant quality factor. To navigate over two centuries of business is impressive — in fact, I think it is probably one of the oldest businesses I have ever come across. This gives me reassurance that Churchill China will likely be in business for a few more years to come! But not only this, it is telling of the level of disruption of Churchill’s product line. In the modern age of technology, many traditional industries are being disrupted by new ways of doing business. However, it is unlikely that the method of serving food in a restaurant will significantly change from the current status of the dinner plate. Yes, colours and trends may change, but it is unlikely Churchill will see technological disruption of any form. This long operating history also has a beneficial effect on the business in terms of brand value, reputation and customer relationships, all of which take significant time and resources to build. However, Churchill has this quality inbuilt, unless of course its reputation is damaged.


The second quality feature of Churchill’s business is actually the management running it. Churchill often talks in its investor materials as having a long term vision and being a well-run business. In the 2019 annual report it read:


‘Churchill is a well invested, resilient and highly responsive business led by an experienced

management team.’


Well, 2020 was a year that would put this statement to the test. Looking over the year-end results in 2020, I do believe Churchill’s management have stood up to this test. Regardless of 2020 performance, there are three specific areas that I believe attest to the management’s capabilities.


Firstly, financial management. Churchill’s balance sheet is very strong and debt-free. Whilst it does have some long term liabilities related to pensions and deferred tax, Churchill’s balance sheet is very clean. Churchill entered 2020 with £12.5m in cash, plenty enough to cover all current liabilities for the year. This balance sheet strength will have been a primary reason for not requiring additional capital in 2020.


Secondly is the recent acquisition of Dudson Ltd, a long term competitor to Churchill China. The fact Dudson went under is probably testament already to Churchill’s strengths. However, waiting to pick up Dudson’s brands and intangibles from the wreckage is smart. Churchill only paid £2.1m for Dudson’s brands, which you would expect was a significant discount compared to if Dudson was a liquid operating business. The Dudson acquisition was also just for the purchase of brands and intangibles, so Churchill China didn’t have to take on any factories or loss-making facilities. These brands and intangibles (such as product designs) can be worked into Churchill’s existing design and manufacturing facilities, which will reduce costs and improve margins.


Lastly, whilst not necessarily a sign of good management but more my confidence in management, the Roper family own significant holdings in the company, and James Roper as an executive director owns 10% of the business. With three separate Roper family members in the top ten shareholder register, you can likely expect Churchill China to remain true to its word regarding the long term interests of shareholders.



It would also be unfair not to mention the quality of Churchill’s products, which are used in Michelin star restaurants across the globe. The product designs are fantastic, you can view them here, and whilst product aesthetics do not make up the whole investment story, they are certainly important for this type of business. Further than aesthetics, the type of product Churchill sells does have beneficial properties for us as investors. Tableware catered to the high-end hospitality market probably does not last as long as you would think. Replacements are required for knackered or broken ceramics, and every few years high-end restaurants will likely replace significant amounts of crockery to keep up with a trendy/modern look. Adding this to the high turnover of restaurant/bar owners due to the nature of the industry, I’m guessing the replacement factor is quite high for Churchill.


Outlook and Scope for Growth


‘There is now growing evidence from enquiries, order levels and sales that activity levels are

recovering across our markets.’


Churchill were quite cautious in their latest update with regards to their outlook for 2021. However, they did mention that order levels seemed to be rebounding. With such a precarious operating environment for Churchill’s end customer base, it would be foolish to pin too much hope on a full rebound in 2021. Thus Churchill’s main focus is to continue executing its strategy and invest in the business, whilst setting the target of returning to the strength seen in 2019 in the future. Regardless of near term prospects, Churchill has a few options to increase growth over the long term. A few areas of potential would be:


  • International expansion — Whilst export currently makes up 58% of revenues for Churchill’s business, large markets in the ROW category are still relatively untapped, with only 11% of sales derived from these regions.

  • Growth in the overall hospitality sector — Whilst the hospitality sector has been crimped by the pandemic, it looks increasingly likely that it will be a major beneficiary of a consumer spending led rebound, providing fertile ground for expansion, new hospitality businesses, and increased investment from businesses within the sector, all providing positive inferences for Churchill.

  • Product innovation — A business rarely gets through 220 years without innovation. Churchill’s tableware is renowned for its durability and performance, which are product qualities derived through innovation. The recent purchase of the materials business is a further testament to this, as Churchill integrates a business with not only operational, but knowledge benefits into the group.

Risks


As with any investment case, risks are present. The underlying market in hospitality is poor, with low quality, under capitalised, frequently ‘mom and pop’ businesses, thus it doesn’t take much of an economic shock to create lasting damage to Churchill’s customer base. Whilst hospitality businesses have suffered in this pandemic, the government support offered has provided a lifeline and likely improved prospects for Churchill China in the coming years with a healthier customer base. It is in regard to this weak customer base that we can view Churchill’s receivables with less quality and reduce expectations of Churchill recouping receivables in a tough operating environment. Churchill does mitigate this by running a solid balance sheet.


A key risk for Churchill going forward in my opinion would be currency risk. If GBP appreciation were to happen in the coming years as Brexit tensions settle down and economic confidence improves in the UK, Churchill’s export business may be hampered. A rise in the value of the pound would make Churchill’s ceramics comparably more expensive in foreign markets, thus reducing demand or forcing Churchill to weaken margins to combat this cost.


Labour price inflation could also hurt Churchill, however, there is significant shelter from the impact of inflation as Churchill’s main input cost into producing ceramics is clay, which in England is pretty plentiful and cheap to source. The value Churchill adds to the mud is in the design, kiln and glazing process, which are not as resource intensive as other industries subject to inflation.


Financials


The financial table above helps show the great progress Churchill China was making up until the pandemic. Revenue growth averaged 8.8% in the years 2015-19, ending 17.4% up in 2019. Operating margins were steadily increasing to 16.6%, a very solid level of profitability, and return on capital employed grew from 14% to 23.1% showing the growth in operating profit through the efficient deployment of capital. Growth has also been managed with a prudent balance sheet and no leverage, evidenced by the minute debt to equity ratio (total liabilities to shareholders equity) of 0.47 in 2020. This financial improvement was brought to a sudden halt in 2020, however, unlike other companies, Churchill has not weakened its financial position during the crisis and will still emerge from 2020 with no debt obligations. The extent to how quickly Churchill can bounce back to growth will dictate the future health of Churchills financials greatly, but it is good to see that going into the pandemic, Churchill was a very solid financial operator indeed.


Summary and Valuation


There is no doubt in my mind that Churchill China is a quality business, evidenced by a seriously long history as an operating business, wonderful products and sensible management. Churchill also has ample prospects for growth in the coming years with relatively untapped international markets and a track record of product innovation-led growth. However, Churchill’s end markets are of lower quality and are emerging from a particularly tough period, which could create a volatile environment for Churchill over the near term.


Churchill’s revenue and earnings are not expected to return to pre-pandemic levels until 2022. Even then, forecasts suggest both revenue and earnings will be slightly below 2019 levels. If 2022 estimates are to be hit, Churchill is priced at roughly 20 times forward earnings. If a hospitality boom occurs in the period post lockdown, Churchill could significantly beat these estimates and re-rate higher. Regardless of near or medium-term earnings potential, I think the long term prospects for this very well run business with a very solid balance sheet are evident.


Worth noting as a last point with Churchill China, the market cap is £160m and liquidity can be fairly low. This means the spread between the buy and sell price can be large, and volatility can be present. If considering a purchase of Churchill China do consider the timing of any trade as the spread can fluctuate.


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At the time of writing, The Twenties Trader owned shares in Churchill China.


For the full list of Twenties Trader Portfolio holdings, view here.


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