Churchill China PLC – A Stalwart of Boring Britishness

CHH.L Write Up. As per usual folks, I am an idiot on the internet. Please do not take any of the following write up as a guarantee of returns. Its just my opinion.

Churchill China are British company who manufacture high quality crockery such as plates and bowls. They were hit very hard by Covid as their core market is the international hospitality industry. Despite this, I feel now may be an interesting time to evaluate buying into the company who posted impressive numbers pre Covid. If the international hospitality industry has truly bottomed out, this could prove to be an excellent investment in a high quality company that has seemingly been forgotten by the market. Quality investing has become quite cringeworthy over the last few years with investors willingly paying ridiculous multiples of 35-40x earnings for companies who they then find out are not as bulletproof as they once were. Quality, as with growth has a price but in this case, I think CHH justify their very fair PE of 16 with an excellent and durable business with a legitimate moat.

Background

Churchill China are a very old company. They were established in 1795, the same year as the invention of the pencil. The business in recent years has undergone a sort of transformation. If you bring up the data you will see that from 2013-2019, ROIC jumped from 10% to nearly 23%. Very impressive indeed. How did this happen? In short Churchill stopped focusing on traditional retail customers for its crockery and shifted its focus to the hospitality sector where plate designs and durability are far more important to their customers than low prices. Restaurants, hotels, even premium airlines want to buy plates that look good and make their food look good to add to the experience they are trying to offer. If one of their plate’s chips, it gets thrown out and they buy replacements. Therefore durability and design are far higher priorities than just a low cost that the average retail consumer is prioritising. You will no doubt have a number of chipped plates or mugs in your cupboards at home and I doubt you have paid much attention to getting rid of them due to a small mark. You might not bring them out for your houseguests though, and this illustrates how Churchill have created a successful niche in the hospitality sector. Churchill has changed its target market from a price conscious one to a quality conscious one, allowing it to increase its returns over time.

This attitude difference between average consumers and the hospitality sector clearly explains how Churchill was able to transform a rather boring and unimpressive operation to one generating excellent returns due to a reliable and more frequent customer base who are focussed on the quality and durability of their products rather than the lowest priced Chinese exports they can get their hands on. If you think about it logically, a hotel chain may be able to get cheap plates for half, maybe even a third of what it would pay for CHH’s products. However the amount of breakages they would suffer in transport, in use and during frequent washes would mean a much faster replacement cycle. This costs money, time and is a headache for hospitality management, who do not want to worry about replacing their crockery all the time in the name of minor cost savings. In reality you may even end up spending more replacing the cheap plates. The convenience of having high quality plates far outweighs the possible cost savings before even considering the way this enhances the experience offered to your customers. I’m a big fan of businesses who’s sales are based on having a better/more reliable product than others as this is much harder to disrupt than a price advantage in most cases. The convenience factor, coupled with the superior quality means CHH have a great set of selling points attracting customers and protecting them from competition.

Rather unfortunately however, the very means of the company’s success proved to be its downfall. With Covid lockdowns and the total wreckage of the hospitality sector globally, these sales all but dried up and Churchill are yet to return to their 2019 level of operating profit. They are not far off though, and I expect that this year they will surpass this number for the first time in its history. This business has literally survived its doomsday scenario (and made a profit no less) which gives me great confidence in the durability of the business.

The Business

So what makes Churchill’s business unique from others globally? Well, there are 3 main pillars to the business that has allowed them to differentiate themselves from competitors.

1.      Customer Service

As mentioned earlier, most of CHH’s revenue comes from commercial sector. One of the biggest advantages you can have to increase your appeal to a commercial client is fast customer service to replace their broken plates and fulfil orders at short notice in an emergency. Churchill aim to fulfil orders within 48 hours, possible thanks to the significant inventory kept on hand and a network of over 700 distribution partners that link 3 company owned warehouses in Stoke, Rotterdam and Chicago, to their customers. It is hard to overstate the importance of high quality customer service in this sector.

Imagine you are a large hotel chain who also operate restaurants at your locations. Lets say you have 10 Restaurants that all seat 300. The normal ratio of plates to person is around 3-4/1. The top end of this would require 1200 plates per location (Forgetting smaller plates, bowls, dishes etc). This means 12,000 plates may need to be ordered at once, if for example there is a menu change that the chef decided needed a new style of plate. This is a huge order and illustrates the scale to which Churchill have to efficiently operate and also the barrier to entry for serving the largest hotel chains in the world such as Hilton. Clearly this is quite an extreme example but these are the kinds of clients that Churchill have managed to provide for and clearly they provide great value to these large clients and they are willing to pay more for this service. Being able to fulfil orders when others cannot, creates loyalty amongst customers and increases the likelihood of repeat orders.

2.      Manufacturing Process

The second point of differentiation from competition is the manufacturing process that Churchill use. Thanks to being UK based, they have access to raw materials that international clients would not use (at least cost effectively) and this feeds into their unique manufacturing processes which aid both in creating unique designs and increased durability of their products which competitors struggle to match. A few years ago they took control of Furlong Mills, a manufacturing company who produce the mix of raw materials needed for producing ceramic products. This means that aside from the literal mining of raw clay, CHH are involved in nearly every part of the process for their products from materials to sales, allowing them to better control costs and have price visibility on their materials.

They claim to have one of the strongest ceramics in the world thanks to both their use of local materials and a manufacturing process which has been refined over 225 years, aided by the experience gained from the acquisition of Furling Mills in 2019. This means that consumers are confident in the lifespan of the products they order, allowing them to more confidently plan when things will need to be replaced and avoiding needless breakages which helps them to retain customers. A quite literal ‘If it ain’t broke don’t fix it’ attitude helps to retain customers relationships, especially when coupled with fast delivery times. Customers know they are not buying off the shelf products but rather crockery designed to meet the heavy demand of the hospitality industry. Designs are imprinted on the plates underneath the glaze meaning that they are far more durable than other plates and able to handle the frequent wash cycles of an industrial kitchen. This is a process that Churchill do not see others imitating as they have already got their own processes they have used for many years and would find it hard to jump into an entirely new method of making ceramics.

3.      Moat

Evaluating moats is not an exact science and can often be the breakdown of an otherwise sound thesis. One thing pressed in my mind is Warren Buffett’s comments at a Berkshire AGM some years ago when he said he asks himself if he was given a company’s market cap, if that would be sufficient to take their business. If I gave you Apple’s market cap or Coke’s market cap, you would get nowhere near taking those company’s market share in their respective industries, let alone outcompeting them.

When I look at the £131M market cap Churchill trade for, I can’t help but think I would get absolutely nowhere near taking their business away for that amount. As already explained, being such an old company with such in depth knowledge of their manufacturing process is such a huge advantage compared with a new start up. Also, Churchill made a transition from high volume, low price to lower volume, high quality hospitality clients. If you were a new start up you would be unable to quickly capture this high quality customer base. Even if you were an established player mass producing for the general consumer market, you would be unable to pivot to higher income revenue sources in the hospitality sector without changing your manufacturing process, significantly denting your business in the short term/medium term, and you would be unable to build out your distribution network to CHH’s level, meaning the likelihood of you creating repeat business is very low. Churchill were already creating high quality products cheaply but simply not marketing them in the right areas. This illustrates their cost advantage as they were able to sell to the consumer market profitably using effectively the same manufacturing processes whereas a competitor would have to completely uproot what they are doing in order to meet the demands of hospitality clients.

Many of you will know I feel moats in micro caps are very unimportant for the most part as low valuations and low market caps mean you can often make money easily without having a bulletproof business. However Churchill’s moat is unavoidable and clearly unusually wide for a company of this size. The value of its business and services to its clients is immense and if they can return to their higher growth pre 2020, I think this could be an exceptional long term hold.

Concerns/Challenges

The major concern that CHH had been working through was a shortage of trained staff. When things began opening up again in 2021, the company did its best to ramp up production in order to meet increased demand. Despite its efforts, its lack of trained, permanent staff meant that they struggled to meet production targets. By 2022 this began showing its impact and CHH were unable to meet their high standards of customer delivery deadlines. Despite this, they kept ticking over but this does highlight the importance of having enough staff to meet demand, or being able to increase the amount of automation in their factory to offset this pressure. I will say that it is unlikely that we will see another situation like Covid in the next few years but it does still show the importance of being prepared for difficult circumstances. This really was the one glaring hole I could find with CHH in recent years and it is something that the company now seem on top of and I expect continued and increased investments in automation will also play a part in reducing reliance on a large workforce, benefitting the bottom line in the long term. It is worth saying that this issue also shows how hard it would be to disrupt their business as if Churchill as the biggest player have struggled with this, a competitor would no doubt struggle to get the high skill labour or invest large amounts in automation, let alone be able to do this while maintaining profitability. Their scale is a massive advantage and continued automation would be a huge tailwind to increase their profitability. Once again though, to underscore the durability of this business, in 2022 when they were struggling to meet this demand and struggling with staffing, they still cleared 17% ROIC.

Valuation

CHH are forecasting EPS to rise from just over 79p to 82.5p by 2025, an increase of 4%. At their current share price of 1150p, this puts them at a 2025 PE of just under 14 (Excluding cash of nearly £13 Million). Their median PE over the last decade has been 20 and its current PE is just over 16, providing some room for multiple expansion to their mean multiple when the economic environment stabilises in the short term. This is not some major gap in price and value but CHH to me are less of a majorly overlooked and beaten down name and more a long term stalwart who have proven their business to be reliable and resilient. As much as you might want to resist it, you need these companies in a portfolio. Not everything can be a 10 bagger moonshot in 3 years and a lot of your money as a serious investor will be made in a 15% a year multi decade long hold. Churchill’s run in the lead up to the Covid pandemic proved to me that the company has carved out a valuable niche in the market which provides them with consistently high returns and a long runway of expansion opportunities. Their products clearly provide significant value to their customers and their model is clearly effective in leveraging their distribution network and production capabilities to their advantage. The quality of the business has clearly been forgotten or overlooked since Covid. They did not lose money in 2020 despite their entire target market being essentially destroyed by the pandemic and they post gross margins in the 80s consistently with operating margins generally falling between 10-15%. In 2019, their best year to date, they had GMs of 84%, OMs of 16% and did 82p in EPS, just under the 2025 target of 82.5p. It is therefore reasonable to expect similar operational metrics in 2025 and continued growth going forward as they move from recovering their business to growing past their 2019 highs.

If you take their EPS increase in the 5 year period from 2014 to 2019, they went from 31p to 82p, an increase of nearly 165%, or an annual increase of 33%. I am not going to forecast this going forward in an attempt to be conservative but lets say that CHH are able to grow their earnings at just 12% per year over the coming 5 years. So from 82.5p in 2025, in 2030 they would be doing just under 150p in earnings, a PE of just under 8. This gives us an implied upside of over 100% based on the current PE of 16. If we take a more extreme example, lets say they did an incredible 20% per year, closer to their 33% track record from 2014-19. That would put them at 2030 EPS of 220p, a PE of just over 5. Taking their average PE of 20, this would means an upside of nearly 300%. Churchill are nowhere near their ceiling for their addressable market and are still a relatively small company. It is not hard to see them successfully expanding their operations and continuing on the path they were on.

Ultimately these assumptions mean little to me. I don’t know for sure what will happen with earnings and how much they will be able to grow as I am not an expert in the growth of the international hospitality sector. The bottom line is I don’t see CHH’s earnings going down, their market being disrupted or their multiple suddenly being cut. The way I see it is CHH have a great, high quality, durable business that has survived what is basically its worst nightmare and remained profitable. It will likely grow its earnings over time by a decent amount thanks to strong international demand and if it is able to return to solid growth, deserves a rerate back to its historical PE of 20. If it continues to post good operational metrics and high ROIC, it will cement itself as a high quality company in the market’s eyes, further deserving this PE of 20 and you can’t forget they also have 13 million in net cash which I hope they will put to good use.

Management and Future

Management have a great understanding of their business but in addition to this do not want to overextend themselves. The following comment stood out from their last AR,

“The Company strategy has always been to deliver sustainable and steady growth in areas where we have a good market understanding and the opportunity to build scale through innovation and differentiation across our product range. The Company will continue its growth in export, particularly in Europe which has become our largest market and where we see significant opportunities for further sales expansion. We also selectively review other markets for growth opportunities. We intend to continue our £4m-£5m per annum capital expenditure programme which is factory-focused on long term productivity and process improvement, as well as energy efficiency and product sustainability, placing the Company in the right place for the future.”

It is very positive to see such clean direction from management. They know their core markets, where the growth opportunities are and how much they are planning to spend on cap ex and on what. As a potential investor, this puts me at ease and I know not to expect sudden changes in spending amounts or habits and can trust them to continue the same strategy they have been using to great effect. CEO Robin Williams (not that one) has guided for improvements in trading to begin starting in the second half of 2024 but highlighted the company’s ability to improve its margins in the last year despite decreases in sales volume and is confident their investment programme will bear fruit once the hospitality sector improves.

If you read their Annual Reports, management are also clear that their business objective is to serve their shareholders. Overall you get a good sense they are well aligned with your investment. Insiders also own just under 20% of the company so what benefits them benefits you.

Conclusion

The main criteria with an investment is to not lose money. CHH’s earnings base seems well protected going forward and this provides downside protection as earnings stability is the minimum expectation. As the hospitality industry continues to stabilise, earnings visibility should get more clear, as well as understanding of expected growth over the next half a decade. A worsening economic environment would be a negative impact on their earnings and this is the key risk that I see. Aside from this it seems like over the long term CHH will continue to grow its earnings and continue to develop its relationships with their existing customers. The number one rule in investing is don’t lose money. I don’t think you will here. How high it can go, I really don’t know but I’m trying to learn to invest with the expectation of no loss rather than great gain. And besides, if nobody knows for certain how much something will grow, the more likely it is that it is mispriced. Churchill China PLC to me are a wonderful business and they trade at a fair price. I think I might own enough ridiculously mispriced equities so it might be time to buy something with a bit more quality and forget I even own it it. Lets see where it gets in 10 years.