There are situations where the bad luck or the poor judgement of major shareholders undermine the valuation of a business to the point that there is a disconnect between a company’s intrinsic worth and the price the market ascribes to the shares.
The stock overhang scenario is a prime example of this law of unintended consequences.
A stock overhang works in this way: a holder of a large line of shares wants to exit its position.
The market picks up on what it perceives to be a surfeit of stock ready to flood the market.
This then weighs on sentiment (and by extension the share price) until the overhang is cleared.
The easiest and most elegant way to reverse out of a position would be to use a dark pool where sellers and buyers are matched anonymously.
This system was dreamt up to prevent speculation that leads to wild swings in the share price.
There’s only one problem, dark pools aren’t available for smaller quoted stocks.
Food for thought at Hostmore
Hence we see situations like Hostmore PLC (LSE:MORE), the new home of the FRIDAYS (formerly TGI Fridays) chain and a new bar and restaurant concept called 63rd+1st.
Hostmore’s share price has been run over since the business was spun off as an independent entity earlier this month.
Almost all of this has to do with the way it was introduced to the market and the antecedents to the company.
The restaurateur was demerged from an historic investment company called Electra Private Equity (LSE:ELTA) whose break-up created a City soap opera that garnered little or no interest outside the imaginary walls of the Square Mile.
It left investors who had initially backed Electra, a diversified investment firm, holding shares in a pure-play popular dining chain, meaning some were and still are likely sellers.
So, Hostmore is now sitting under a stock overhang, waiting for the sellers to exit and new investors to take their place. The process has been brutal.
This wash-through situation has seen the share price fall from just over 156p on the first day of trading to 107p today.
It should also be noted that the demerger process used to list Hostmore as an independent entity has been a tricky one that’s added a further layer of pain to the group’s birth as a separate, publicly listed entity.
Traditional IPOs allow investor and company to go through a period of what’s called price discovery, which allows prospective backers to learn more about the business in order to put a pre-float valuation on it.
The demerger process doesn’t facilitate this, and neither was there a price stabilisation mechanism that is sometimes provided by bankers organising mainstream stock market listings.
So, all in all, it has been a tough market debut for Hostmore chief executive Robert Cook and chief financial officer, Alan Clark.
Perhaps stability will begin to be restored once the company starts issuing updates on its financial performance, allowing the City’s number crunchers to form a consensus on the underlying business that provides a reliable valuation yardstick.
One suspects the picture is a little rosier than the current share price action suggests.
Trading above pre-pandemic levels
For example, the company in its demerger completion document on November 2 revealed that both revenues and underlying earnings (EBITDA) for the past six months have surpassed those of the comparable period in 2019.
In other words, trading at Hostmore is now above pre-pandemic levels.
Okay, the group, like others in the industry, has been hit by the Covid-19 ‘whiplash effect’, which has caused cost inflation and supply chain issues, but these are obstacles that, based on the earnings guidance above, the firm seems to be navigating.
According to the prospectus published just ahead of listing, the business had GBP36.2mln of cash as at June 27 (the last results) and GBP64.7mln of borrowings.
Free cash flow for the six months to the end of the reporting period was GBP6.9mln.
On that basis, there’s the financial wherewithal to potentially pay a dividend.
Whether it wants to make regular payouts is another matter.
Deploying capital most effectively
There may be more effective ways to deploy capital. For example, estate expansion is definitely on the menu at Hostmore.
Indeed, under the terms of its agreement with the owners of FRIDAYS, the company has an obligation to build nine new American-themed restaurants by 2024.
While the pandemic has been unkind to the hospitality industry, for those left standing the conditions could not be more benign.
Under-resourced competition has gone and it is a buyer’s market when negotiating leases for units on shopping centres, high streets and retail parks.
This bodes well for the expansion of the FRIDAYS brand, where the restaurants advance from open to break-even in around six to 12 months.
It may also throw up a few more opportunities for 63rd+1st, which is aimed at a more mature clientele and is now up and running in Cobham and Glasgow, with a third soon to open in Harrogate.
Discount valuation may offer an opportunity
Following the shakeout in the Hostmore share price, the stock is now trading on 5.9 times 2020 EBITDA or less than three times pre-pandemic EBITDA.
Effectively, Hostmore is valued at around a 50% discount to its nearest sector peers, Loungers and Fulham Shore.
Now that may be a slight problem for the current holders, but it also represents an opportunity if you expect the stock to re-rate once the overhang is cleared and when the market better understands the business and its prospects.
CEO Cook in a recent interview described the process post Hostmore’s listing as a ‘marathon’, one that’s likely to take endurance and patience.
He’s probably right. Hopefully, there will be more than a finisher’s medal at the end of the process.