Should you gobble up shares of the Guzman y Gomez IPO?

The initial public offering (“IPO”) of Mexican fast food chain Guzman y Gomez on June 20^th is one of the most anticipated ASX listing in years. Morningstar initiates coverage with the full report available to Morningstar Investor subscribers.

Related: Is Guzman y Gomez the next McDonald's?

Guzman y Gomez is on a growth tear. In a little under a decade, the Mexican-inspired QSR chain has almost quadrupled its Australian store count, to 183 at the end of 2023 from 53 in 2014. Over the same period, Euromonitor estimates Guzman's share of Australian quick service restaurant (“QSR”) sales has increased to 2.0% from 0.5%. By turnover, Guzman is the country's sixth-largest QSR brand.

Guzman operates a hybrid store ownership model, running corporate-owned restaurants and licensing its brand to franchisees. The company expects around one third of stores will be corporate-owned by the end of fiscal 2024, approaching 40% over the long run.

The vast majority of stores are in Australia, but Guzman also has a nascent presence in Singapore and Japan through a master franchisee agreement and runs a handful of corporate stores in the US. Rolling out stores under a franchise model significantly reduces Guzman's capital investment and funding needs. Franchisees are responsible for new-store capital expenditure and ongoing maintenance. In return for use of its brand and operating model, Guzman collects a royalty fee.

The royalty rate flexes with store turnover and averaged about 8% of global franchisee sales in fiscal 2023. This is a higher royalty rate than KFC-franchisee Collins Foods pays to Yum! Brands. However, after adjusting for other fees, we estimate a franchisee's total payments to the brand owners, as a share of sales, are on par. The more capital-intensive corporate stores provide Guzman with greater control over customer experience and serve as a testing ground for new ideas.

While the mix of franchisee to corporate stores varies widely across global QSR franchisors and between jurisdictions, lowering the share of corporate stores in the portfolio below the 40% we forecast could free up cash to be either reinvested or returned to shareholders.

The Australian QSR market is highly fragmented. The five largest brands by turnover—McDonald's, KFC, Hungry Jack's, Domino's, and Subway—collectively represent around one half of industry sales. Guzman has positioned itself as a youth-focused health-conscious QSR brand. As a result of its premium offering, average spend per transaction is around 15% higher than major QSR peers. We estimate that average unit volumes of around AUD 4 million per store, a key determinant of restaurant profitability, are close to best-in-class QSR peers McDonald's and KFC in Australia.

Promising early signs, but no Moat yet

Despite a strong brand presence in Australia, Guzman has yet to carve out an economic moat. The restaurant space is highly competitive. Switching costs are nonexistent for patrons, and barriers to entry are relatively low. Those restaurants which manage to carve out a durable competitive advantage typically do so by building intangible brand assets and cost advantages through scale.

Despite Rapid Growth, Guzman Is Still Emerging

Established in 2005, Guzman is still a relatively young brand when compared with the bulk of our restaurant coverage, and the larger players in the Australian QSR market. Domino's Pizza started operating in 1983 and is managed by master franchisee narrow-moat Domino's Pizza Enterprises. Yum! Brands' KFC started in Australia in 1968—no-moat Collins Foods is a franchisee. The QSRs with the largest store counts, Subway and McDonald's, started in 1988 and 1971, respectively.

Ambitious long-term growth aspirations

Guzman aims to expand its Australian network to more than 1,000 stores. This goal reflects the company's estimate of 3-kilometer catchments with a population of 30,000. A network of this size would be broadly comparable to McDonald's Australian footprint today.

Guzman's market share has grown rapidly, supported by its store rollout and strong same-store sales growth. But there is some uncertainty around the company's long-term ambitions. Healthy-store-level economics are crucial for Guzman's corporate stores and for franchisee willingness to invest behind the Guzman brand. The company needs its target store economics to hold to roll out its ambitious new-store plan.

International expansion likely tough

Guzman's international operations are more challenged. Restaurants in Japan and Singapore are included in the Australian segment, with little capital tied up in these jurisdictions, as they operate under a master franchise agreement, representing about 2% of EBITDA at midcycle. The US stores are currently loss-making, and we are not expecting them to turn a profit in our explicit forecast period. We think Guzman is likely to struggle to achieve a meaningful presence in the US against well-established and strong competitors both within the Mexican niche, like wide-moat Chipotle, and QSR in general, like wide-moat McDonald's.

We see a path to a Moat in Australia

We forecast average ROICs over the next five years of about 7%—below our 9% WACC estimate. Return on invested capital ("ROICs") trail weighted average cost of capital ("WACC") in the initial forecast years as capital is invested today, both in new stores and investments in supporting infrastructure and administrative capacity, but earnings take some time to catch up as new stores ramp up.

If store economics prove resilient despite the rapid planned rollout, and the brand matures and strengthens, we will revisit our no-moat thesis. Indeed, many QSR brand owners under our coverage enjoy economic moats. Next to capital expenditures, same store sales growth is the key driver of store economics. The strongest brands can maintain sales growth ahead of inflation—defending, or improving, store-level economics.

Guzman's recent history is promising. Double-digit Australian same store sales growth for the past five years compares favorably with Domino's and Collins in the single digits. This strong growth has supported stable same-store margins in the high teens over the past three years, indicating Guzman has significantly increased sales volumes while also passing through some cost inflation. But this growth in part could be explained by Guzman's early positioning in its lifecycle. Operational changes like increasing trading hours, optimizing store formats, and improving the menu can increase sales, but we believe most of the easy tweaks have been exhausted.

Without a Moat, our valuation is below the offer price

Our fair value estimate for Guzman is $15 per share. Against this, the AUD 22 offer price is too high. Our fair value estimate implies an adjusted fiscal 2025 EV/EBITDA ratio of 26, and a P/E ratio of 250.

While Guzman's valuation multiples look excessive on fiscal 2025 earnings compared with peers, they reflect the earlier stage of Guzman's rollout story. We see Guzman differently, with the story centered on rapid growth, and strengthening and monetizing an emerging brand.

Rolling our fair value estimates forward by a decade to capture a tripling of Guzman's global footprint from fiscal 2023, the difference in adjusted EV/EBITDA multiples fades between peers. Guzman's fiscal 2033 EV/EBITDA multiple of 9 is broadly in line with Domino's at 8, with both still ahead of Collins Foods at 6. Collins Foods is leveraged to the more mature KFC brand, and we think this means it has fewer long-term growth prospects. Guzman's higher multiple relative to Domino's reflects some of the remaining rollout potential after our explicit forecast period, with the 1,000 Australian store target in two decades' time almost twice the 570 stores we forecast by fiscal 2033.

To reach a valuation near the $22 offer price, we would need to assume Guzman's new-store economics persist over the longer term. But without a moat, we are hesitant to fully bake in management's 1,000-store long-term projection. However, if we valued Guzman with a narrow moat and extended the period of rapid store growth by five years, our valuation would be $19 per share. A wide moat, which would assume an additional 10 years of rapid store growth, would see our valuation lift to $22.50.

Our valuation is also highly sensitive to our discount rate assumption. We assume a cost of equity of 9.0% for Guzman, in line with Australian QSR peers Domino's Pizza and Collins Foods. For some of the largest global QSR players with brand-based economic moats we cover, such as McDonald's and Yum Brands, we assume a cost of equity of 7.5%. In part, this reflects the more mature and diversified nature of these businesses. If we were to lower our cost of equity to 7.5%, but leave our no-moat rating unchanged, our valuation would lift to $18.50.

We see more-attractive valuations in Australian QSR peers Domino's and Collins Foods, both trading at discounts of around 40% to our fair value estimate. We think the market is underappreciating the ability of both companies to meaningfully expand operating margins in the near term, as input cost pressures subside on stabilizing food commodity prices, and consumer demand picks up—fueled by fiscal stimulus and rising incomes.

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