Guzman y Gomez’s ASX debut on June 20 is one that captures the imagination. This is partly because a lot of us will have eaten the burritos. We don’t need to Google what a quesadilla is or take a punt on some technology we don’t really understand.

Guzman is also a relatively young growth story in an industry home to some of the best growth stocks of all time.

The quick service restaurants (“QSR”) hall of fame

It isn’t hard to come up with a list of the world’s most successful fast food brands. Take your pick from McDonald’s, KFC, Domino’s, and Burger King / Hungry Jacks. No matter what state or town you live in, you will probably have one or several of these nearby.

There are five McDonald’s in a kilometre radius of my desk at Morningstar’s Sydney office. If I was writing this piece from Morningstar London, there would be three of them within a mile. And if I was writing it from our Singapore office, there would be three or four. Only a handful of brands achieve this kind of global ubiquity, putting the most successful QSR brands in the company of the Apples, Nikes and Cokes of this world.

As you can imagine, this has yielded impressive returns for early investors that held on.

  • According to Nasdaq, buying 100 shares at McDonald’s IPO in 1965 would have turned USD 2250 into a fortune of over USD 8 million after stock splits and stock dividends.

  • Through its original US business and various master franchisers worldwide, Domino’s has been responsible for at least 3 different “15 bagger” stocks since IPO. The US listed firm is up almost 40 times since 2004.

Of course, those examples were served up with a big dollop of survivorship bias.

The reality is that the business and share price performance of McDonald’s, Domino’s and Yum! Brands (which owns the KFC brand) are outliers. This is because the restaurant business is characterized by fierce competition, low barriers to entry and virtually non-existent switching costs.

All of these things stop most restaurant businesses from earning attractive returns on capital for an extended period of time.

What makes the top QSR brands different?

The most successful QSR brands have all managed to earn very healthy profits and returns on investment for years on end. This can be explained by their businesses reaching a tipping point where the economics – and ability for these economics to be maintained – move considerably beyond the industry average.

Here is a simplified illustration of the dream QSR scenario:

  • Happy customers and effective marketing starts to result in brand loyalty and perceived product differentiation. This leads to elements of pricing power, which along with high footfall and efficient systems lead to attractive restaurant profitability.

  • Once this has been proven in a handful of stores, there is no reason the concept cannot be copy and pasted to more locations across the region or country. As long as there are enough people living nearby, there’s a chance the success of the first stores can be repeated until the company runs out of suitable locations.

  • The presence of a “sure winner” attracts investors and unlocks an avenue of faster and even more profitable growth: franchising. Instead of the brand owner paying to expand the store network, franchisees put down the capital. The franchisees also pay to operate the restaurants and pay royalties on revenue. Lower capital intensity and more revenue means higher profits and higher returns on capital for the brand owner.

  • Throw in some economies of scale and there is a chance these high returns on capital could prove to be sustainable. These economies of scale could include buying power for key ingredients and materials, as well as being able to advertise nationally and spread the cost over many more customers than smaller competitors. This makes it easier for big QSR chains to keep building their brand, which is a key source of pricing power and competitive advantage.

It’s important to point out that franchising isn’t the only route to fast-food nirvana.

Wide Moat Chipotle’s shares have gone up more than 70 times since it was spun-off by McDonalds in 2006. They have only gone global in a limited way, and they don’t franchise out a single restaurant. They have just opened a lot of stores in the US - from under 500 locations when it went public to more than 3000 today. Copy and paste growth in action.

Franchising or otherwise, the key thing is having the store economics and brand power to support store growth and stop competition from eroding returns.

Is Guzman the same calibre of business?

If investors in Guzman’s IPO want to reap returns anything like the global QSR brands we have mentioned, they will need the business to show similar characteristics as companies like McDonald’s and Domino’s have over time.

This was the first question I asked Lochlan Halloway about Guzman’s growth ambitions, which you can watch here.

Lochlan stressed that while the early signs are promising, Guzman is at a far earlier stage than these proven and global heavyweights. The prospect of ‘getting in early’ is an exciting aspect of the Guzman IPO. But it is too early to tell if Guzman has the makings of the moat needed to underpin a huge location rollout.

Guzman wants to go from roughly 180 Australian locations today to 1000 in twenty years – roughly the same as McDonald’s have locally today. A key variable here will be how the profits and sales of each location hold up as Guzman network becomes more saturated. This is vital because it affects how attractive the business remains to potential franchisees, AKA the least capital intensive and most profitable source of future growth.

Our analysts think Guzman can open around 40 stores per year for the next decade and maintain healthy store economics. Beyond this, things could get tougher. 1000 stores in the long-run doesn’t look impossible but getting there would require Guzman to show Wide Moat credentials. Given that Guzman’s moat is still unproven, our analysts aren’t willing to price this growth into their valuation.

Our analysts think that Guzman’s shares are worth around $15 per share. Compared to the offer price of $22, they look expensive.

Better value elsewhere?

The timing of Guzman’s IPO is interesting because the ASX’s biggest QSR shares have suffered in recent years.

Domino’s Pizza Enterprises, which is probably Guzman’s closest comparable in the ASX, is down around 75% from its peak in 2021. This has mostly been due to lower store profitability due to higher ingredient prices. This hits earnings from restaurants that Domino’s runs itself and makes it less attractive for people to open their own Domino’s franchise. The shares have also been hit by concerns about the consumer environment.

At current levels, our analysts think that shares in Domino’s Pizza Enterprises offer far better value than Guzman’s IPO price.

Unlike Guzman, Domino’s Pizza Enterprises doesn’t own the brand globally – just the right to sell Domino’s franchise in Australia and several other countries including New Zealand, Japan, Singapore and The Netherlands. As master franchisee, though, Domino's also has limited capital requirements and attractive returns on invested capital. Over three-quarters of its store network are run by franchisees who pay the firm a royalty on store revenues.

Even though Domino’s is a far more mature brand than Guzman, Morningstar’s Johannes Faul thinks there is still plenty of growth left in the tank. In Australia, he thinks Domino’s can increase its store base by about one third in the next few years. The growth opportunity in its European markets looks more substantial, with the potential to more than double its store base to around 2,900 outlets during the next decade.

Further growth in the Domino’s store network could result in materially higher earnings thanks to the attractive economics of franchising. Its potential store growth is less eye catching than Guzman’s target of quintupling (5x) its number of locations in Australia. But it’s a level of growth that our analysts can place more confidence in. After all, Domino’s has an established global brand and a proven ability to grow its store count over many years.

This is reflected by Faul assigning Domino’s Pizza Enterprises a Narrow Moat rating. In addition to strong global brand recognition, Domino’s has highly valuable intangible assets in the form of internally generated intellectual property. The firm is a leader in restaurant logistics and has developed technology tools that build and maintain customer engagement and loyalty. Faul thinks its investments in streamlining its cooking and fulfilment process makes it the "go-to" location for individuals who covet the fastest and most reliable service.

While the offer price of Guzman shares appears to bake in a good deal of optimism, expectations for the more proven Domino’s look overly pessimistic. Faul also thinks the market is underappreciating the ability of Domino’s to meaningfully expand operating margins in the near term as input cost pressures subside and consumer demand picks up, fueled by fiscal stimulus and rising incomes. Of course, this could also be good for Guzman.

On the downside, Faul notes that changing consumer tastes are always a risk and that differences between Australian, Asian, and European business environments could lead to execution risk when it comes to Domino’s growth plans. Good management can navigate these changes, though. For example, McDonald's modified its menu in response to an increasingly health-conscious society.

Faul thinks Domino’s Pizza Enterprises has a fair value of $61 per share versus a price of around $37 today – a discount of around 40%. By contrast, Guzman’s initial price of $22 is almost 50% higher than our estimate of fair value. Faul’s main takeaway for Guzman y Gomez is that the business model and growth prospects are attractive but the price simply looks too high.

guzman-vs-dominos

Learn more about Guzman y Gomez's IPO

Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.