Collins Foods (CKF): Margin squeeze

Collins Foods is a KFC and Taco Bell franchisee in Australia and Europe. It operates 261 franchised KFC restaurants in Australia, 17 in Germany and 45 in the Netherlands, along with 20 Taco Bell restaurants in Australia. The company is also a franchisor of the Sizzler brand in southeast Asia, with 66 franchised restaurants, predominantly in Thailand but also in Japan. We recently raised our fair value estimate for shares in Collins Foods by 3% to $14.40, with shares screening as significantly undervalued. Our upgrade is due to the time value of money and a marginally better sales outlook. The Australian store rollout is tracking ahead of expectations, and we now anticipate 12 new stores will open in FY24, up from 10. The Europe segment, which accounts for around 15% of group earnings, is performing strongly despite cost pressure and headwinds to consumer spending. Our margin forecasts are unchanged, and our FY24 adjusted EPS forecast remains at $0.55. The key valuation driver is a reversal of gross margins from FY25. Yum Brands, the franchisor of KFC, manages both menu pricing and procurement across the entire Australia store network, in effect, controlling Collins Foods' gross margin.

Consumers are doing it tough, but Yum is strengthening KFC's value proposition by opting for sub-inflation menu price rises that are too timid to offset rampant cost inflation faced by franchisees. If Yum wants to keep expanding its KFC network, however, store economics need to be attractive to franchisees. We therefore expect Yum will let franchisee margins improve as severe cost-of-living pressures abate by gradually adjusting menu prices to reflect prevailing ingredient cost levels. Accordingly, we expect Collins' group FY25 operating earnings margin to lift by around 1.4 percentage points to 12.2%, up from our full-year FY24 forecast of 10.8%.