When it comes to eating out, Indians are very fond of Western QSR (Quick Service Restaurant) brands, which mainly focus on pizza, burgers, and chicken food.
McDonald’s, KFC, Burger King, Domino’s, Pizza Hut, Subway, etc. are the reliable brands in this segment as some of them entered India in the late 90s (Domino’s, McDonald’s and Pizza Hut) and early 2000s (Subway and KFC).
Talk to any management and they will cite long-term trends in a younger population, increased urbanization, growing wealth, accelerated shift to digital, and shift to the organized sector as reasons why you should be bullish.
However, if you look beyond these beaten-down words, investing in fast food stocks isn’t an easy task. For one thing, valuations are very expensive. The five major fast-food stocks have a combined market capitalization of Rs 90,000 crore but generated a meager profit of Rs 650 crore on sales of Rs 14,900 crore.
There’s no question that interest in fast-food stocks has surged over the past two or three years, with the recent pandemic-induced trend in online ordering and delivery providing a boost. But a different trend can be seen in the fast food inventory space in India.
Restaurant Brands Asia (formerly Burger King India) has gained 113% since its IPO in 2020. Shares of Devyani International (the franchisee of KFC and Pizza Hut) have surged 135% since its 2021 IPO, but so have shares of Sapphire Foods (another company). KFC and Pizza Hut franchisees have traded lower at 25% since their IPOs that same year. Among Indian fast-food companies with long public records, shares of Jubilant FoodWorks (master franchisee of Domino’s) are up 13% in three years, while shares of Westlife Foodworld (owner-operator of McDonald’s restaurants) are up 13% in three years. 2.5 times. To better understand this sector, you need to understand the key dynamics of fast food stocks. Here they come:
Store Sales Difficulties
Brick-and-mortar restaurants rely on their brick-and-mortar locations to generate revenue. The five major fast food companies operate a total of more than 4,600 stores. The expanding fast-food market opportunities and penetration beyond metros have prompted India’s fast-food giants to expand their stores. In this article, we focus primarily on the Indian operations of top fast-food restaurants, as the international market is much smaller.
The QSR chain continues to add stores at a rapid pace following the disruption caused by the Covid-19 pandemic. But opening a store requires money. The capital expenditure per store ranges from Rs 13 crore to Rs 35 crore depending on the store size and location. Store rent as a percentage of sales ranges from 8% to 15%. However, the average order value across brands is Rs 450-600. Store sales don’t start firing on all cylinders right away from day one. If a store is unable to operate, it will either be rationalized or operations will cease (for example, in fiscal 2022, Jubilant opened 23 stores and Sapphire opened 12 stores).
For a variety of reasons, store count growth does not equal revenue growth. Jubilant Foodworks, India’s most mature fast-food restaurant, has a compound annual growth rate of 10.3% in the number of stores during FY20-23, but revenue growth during the same period lagged behind at 9.2%. Likewise, Devyani’s store count grew at a CAGR of 35.4%, while revenue grew at a CAGR of 25.4%. However, some companies, such as Westlife Foodworld, seem to have found the right formula by controlling expansion. Although the compound annual growth rate of the number of Westlife stores is 4%, the compound annual growth rate of sales is 13.8%.
Investors should also be aware that a soft demand environment could impact store sales. In the first quarter of fiscal 2024, most fast-food chains reported negative same-store sales growth (SSSG), worsening from the already poor growth rates in the fourth quarter of fiscal 2023. Investors have shown a preference for substantial same-store sales growth. When a large portion of a company’s revenue growth comes from new store expansion, it may be a sign that demand for the company’s products is stabilizing. In turn, this means that future revenue growth should be minimal once the company reaches saturation in its total store count.
profit margin fluctuations
Despite the enthusiasm for the high-growth Western fast food category, the valuations of companies operating in this space may actually depend on their profit strategies. QSR stock has gross margins of 65-75% and EBITDA margins of 11-23%. Store margins are closer to EBITDA margins. Net profit margins are lower (5% to 10%), except for the loss-making Restaurant Brands Asia (FY23). Generally speaking, margin expansion is driven by operating leverage, but complicating the matter is margin volatility.
Margin fluctuations can be caused by a variety of reasons, such as sticky input cost inflation. Cost-saving initiatives and pricing actions have limited impact. In fact, in most cases, fast food chains have to absorb inflation. For example, in fiscal 2023, Jubilant Foodworks’ results were broken into two parts. After the festive season, demand suddenly decelerated as rampant inflation weighed on discretionary consumption. In one year, cheese prices increased by 40%, flour prices by 28% and chicken and carton prices by 30%. As a result, Jubilant’s operating margin was 24% in the first half of fiscal 2023, fell to 21.5% in the third quarter, and further fell to 19.6% in the fourth quarter.
Likewise, other QSRs have been affected by inflation. For example, Devyani’s operating margin fell 100 basis points in fiscal 2023. KFC’s main raw materials are chicken, oil, flour and packaging materials. Both they and vegetables saw some stabilization in the first quarter of fiscal 2024, helping operating margins find a base around 20%. Taking Sapphire Foods as an example, the quarterly operating profit margin fell from more than 20% to 17.5% from the first quarter to the fourth quarter of fiscal 2023. In a recent conference call, Sapphire management argued that as inflation slows, demand is expected to remain subdued for at least a year before stabilizing.
Dietary preferences also change, which affects some QSRs more than others. For example, the second quarter is typically the lowest seasonal quarter for chicken products. Usually, the Shravan/Sawan period is during this quarter when many Hindus adopt a vegetarian diet. Additionally, the rising share of value-for-money products does pose a risk to margins as the company competes on similar products (burgers and fried chicken). Higher salience of low-ticket/low-margin products (e.g. price tags below Rs 100) may lead to sales but will delay store payback period. Overall inflation trends (not just input prices) are also forcing consumers to buy less high-end burgers and pizza. The changing mix impacts profits. So investing in fast food stocks based on historical profit margin trends can be tricky.
While QSR talks about omnichannel (dine-in, app, online delivery, drive-thru, mobile) strategies, some key changes are taking place. Of course, in-store consumption is returning, but there is growing evidence that more and more occasions and habits are developing in favor of dining out. For Pizza Hut in India, off-store sales accounted for 56% of total sales in fiscal 2023. For Westlife, the overall contribution of the off-site business to revenue was 40% (Q1 FY24).
India’s online food delivery market has grown by 100% year-on-year in the past three years. Statistics show that the overall share of online sales in the food service industry has reached double digits (10.7%) in 2021, compared with single digits (1.9%) in 2016, according to Euromonitor. Before the COVID-19 outbreak, this proportion was 4.3%. Benefitting from the expanding reach of the Tier II/Tier III/Tier IV delivery ecosystem, consumers are now accustomed to the ‘cross-city delivery’ classification. Independent stores with a focus on dine-in service have been disproportionately affected due to the recent pandemic. This could indicate a possible shift in the market towards a delivery-focused business model, which could have implications for the future performance of fast-food companies. As a result, store-led growth strategies may need to be recalibrated. Nearly half of restaurants pay more than 20% commission (gross revenue rate) per order. Note that fine-dining restaurants pay lower median rates.
For example, Devyani (KFC and Pizza Hut) focuses more on smaller, delivery-focused stores compared to large F&B outlets in India. In order to serve online delivery, fast food restaurants will actively invest in cutting-edge technology to enhance digital capabilities, improve delivery efficiency and optimize overall operations. Similarly, an omnichannel strategy has allowed Sapphire, another KFC and Pizza Hut store operator, to reduce its restaurant size by 45%.
The acceleration of online growth through delivery apps has led to the importance of “cloud kitchens” where food is “made to order” to suit consumer tastes and preferences but remains affordable. While cloud kitchens began to gain traction as early as 2015, the popularity of “cloud-only” food service brands and businesses has only grown due to the COVID-19 pandemic. The growth is also supported by the concurrent rise of food aggregators.
While cloud kitchens in the online playground are strong competitors, their lack of physical brand connection with customers, low barriers to entry leading to a crowded ecosystem with high mortality, and lack of coverage beyond first-tier cities are their disadvantages. But if the Zomato and Swiggy aggregator ecosystem flourishes, customer connectivity, coupled with subsidized delivery costs and discounts/promotions, could pose a threat to QSR. Rebel Foods is the largest cloud kitchen and has successfully scaled up in recent years. Indirect competition from private label food brand aggregators may also intensify competition in QSR’s online sales space.
Valuation and growth expectations
Fast food stocks are undoubtedly expensive, given its association with consumption. QSR stock trades at 70-100 times forward earnings compared to the Nifty 50’s 1-year P/E of 22 times. Given the capital-intensive nature of QSR, even on an EV/EBITDA valuation multiple, these stocks trade at 19-19x. FY24 is 34x and FY25 is 15-28x, which is expensive.
Despite weak demand and lower-than-expected new store openings in Q1 FY23, companies have retained their annual store opening forecasts for FY24 (Jubilant: 200-225 stores, Devyani: 275-300 stores, Westlife: 40-45 stores , Sapphire: 130) -160 and restaurant brands: 50 (India)). These can be risky.
QSR stocks (Jubilant & Sapphire up 19%, Restaurant Brands up 26%, Devyani up 44%) despite Bloomberg consensus forecasts lowering earnings for FY24 and FY25 (versus January 2023 forecast) , Westlife up 46%) has participated in the broader market rally since the March 2023 lows.
At least in the short term, pizza makers like Jubilant are expected to face weak demand, increased competition and rising dairy inflation. These have led analysts to expect modest revenue growth. For pizza and chicken food manufacturers (Devyani and Sapphire), these challenges along with rising chicken prices are real, but small price hikes are expected to help them defend profits while increasing sales. Burger brand Westlife Foodworld has been an outlier of late as it has posted strong same-store sales growth while its peers have struggled. The company’s first dividend payment was also seen as a sign of management’s confidence in its growth prospects.