In a week that Australian investors were fixated on burritos we got a reminder about fried chicken as Collins Foods (ASX: CKF) reported earnings. There are encouraging signs in no-moat Collins Foods’ fiscal-year 2024 result, but the KFC and Taco Bell franchisee is under cyclical pressure.

Much like eating at KFC the results went down well and then caused some heartburn for investors. Following results the shares surged over 7% on the Tuesday and then dropped close to 9% on Wednesday. The shares are currently trading at a 36% discount to our fair value. 

The earnings before interest, taxes, depreciation and amortisation (“EBITDA”) margin for the core KFC Australia business, accounting for roughly 80% of operating earnings, lifted 60 basis points on fiscal 2023 to 15.6%. This was ahead of our forecast for flat margins, suggesting Collins is passing on some prior cost inflation through price rises. But group sales disappointed, rising 10% against our 13% forecast. The net effect was a 15% improvement

in underlying earnings per share (“EPS”), to $0.51, missing our $0.55 estimate.
Macroeconomic conditions are weighing on sales. In the first seven weeks of fiscal 2025, KFC Australia saw muted sales growth of 2% versus the previous corresponding period, or PCP. This was a deceleration from 5% growth in the second half of fiscal 2024 on the PCP, and 9% in the first half.

Consumers are under pressure and cutting back on discretionary spending like takeout. We think KFC will keep defending its value perception by keeping prices low in fiscal 2025, and we revise down our Australian EBITDA margin forecast by 1 percentage point to 16%.

Combined with modest downward revisions to our revenue forecast and a higher corporate cost assumption, our fiscal 2025 EPS forecast falls to $0.60 from $0.74 previously.

Despite the muted near-term outlook, our long-term thesis stands. We expect margins will improve as cost of living pressure abates and menu prices catch up with the strong rise in costs in recent years. We forecast a midcycle EBITDA margin for the KFC Australia segment of around 17%. Our $14.40 fair value estimate is intact, and Collins screens as significantly undervalued. We think the market is not factoring in any margin improvement, and shares look to have been caught up in the broader consumer cyclical selloff since the beginning of the year.

Business strategy and outlook

We think the success of the Australian KFC network will prove crucial for Collins Foods. Despite KFC expansion into Europe and the nascent roll out of Taco Bell stores in Australia, we expect Collins' Australian KFC network will continue to drive the vast majority of operating earnings over the next decade.

Collins is the largest KFC franchisee in Australia with over 270 restaurants out of a total of around 730 stores in the country. Its long-term earnings growth is mainly dependent on increasing sales, by increasing same store sales and adding to its store network. Collins grows its network through both new builds and acquisitions of existing restaurants from other franchisees. Similar drivers underpin growth of the smaller European business, although we forecast new builds to play a more important role.

Most recently, the KFC brand has prioritized sales volumes and market share over profit margins. In both Australia and Europe, Collins has strengthened its value proposition to customers by raising menu pricing less than cost inflation. Collins’ delivery channel is experiencing strong growth. While the channel has added sales and profits in absolute terms, online sales are slightly dilutive to operating profit margins. In the medium term, continued strong growth in online could risk cannibalizing higher margin drive-through and carry-out sales.

As a franchisee, Collins relies on agreements with Yum Brands to operate KFC and Taco Bell restaurants. In return, Yum receives royalty payments and mandates store rollout targets for Collins. These targets, typically extending over a period of five to 10 years, partially underpin Collins’ growth outlook and our valuation.

In Australia, we expect Collins to achieve its development target of 55 new KFC restaurants by fiscal 2028. However, we are less optimistic on the outlook for its underperforming Taco Bell network. The rollout of the Taco Bell brand in Australia has been suspended, and we expect Collins to ultimately exit the brand.

Moat rating

Collins Foods lacks an economic moat. Switching costs are nonexistent for restaurant patrons, and barriers to entry are relatively low, making it difficult for restaurant operators to carve out an economic moat. Restaurant operators generally source moats from either intangible assets or cost advantages, but we think Collins lacks maintainable competitive advantages stemming from brand equity or from the scale of its operations.

Collins is the largest KFC franchisee in the core Australian market—accounting for over 80% of group EBITDA—but the brand equity remains with its franchisor, wide-moat Yum Brands.

As a franchisee, Collins in subject to meeting its obligations to Yum, including the rollout of net new stores. As the franchisor, Yum has the ability to set royalty rates and development goals. These are set at the store level, with each individual franchisee agreement term on average lasting 10 years with an option to extend by a further 10 years. Relationships between franchisees and franchisors are generally structured as a profit-sharing agreement, but the balance of power largely lies with the owner of the franchise.

Gross profit margins are effectively set by Yum, which procures the ingredients for KFC’s Australian restaurants—including chicken, fries, and cooking oil—and generally sets national menu prices. This allows an even playing field for all KFC franchisee restaurants at the gross profit line. Yum decides whether it passes buying efficiency on to franchisees to entice store rollouts, or keeps some of these cost benefits.

The franchisor’s pricing strategy can materially affect Collins' margins and profitability. For instance, in fiscal 2023, Yum lifted Australian KFC prices by less than cost inflation to improve KFC’s competitive position relative to other quick service restaurant chains. Collins’ gross profit margin fell by more than 200 basis points to 50%, and EBITDA from the Australian KFC segment dropped by 5% despite a mid-single-digit increase in same-store sales growth. We expect competition among Australia’s top QSR chains to remain intense in the long term, and KFC could be forced to sacrifice market share to repair its gross profit margins. In July 2023, industry leader McDonald's Australia announced a AUD 1 billion restaurant rollout and refurbishment program.

KFC is the second-largest QSR chain in Australia. The network is significantly smaller than McDonald’s, but bigger than Hungry Jack’s and Domino’s Pizza. According to Euromonitor and measured on 2022 network sales, McDonald’s had a 22% share in the Australian QSR market, KFC 11%, Hungry Jack’s 7%, and the Domino’s Pizza’s share was 6%.

In the much smaller Dutch market, Collins has signed a corporate franchise agreement with Yum. This gives Collins more control over the local KFC strategy. The agreement allows Collins to develop, manage, market, support and operate the KFC business in the Netherlands, including the introduction, management, and oversight of other Dutch franchisees. In return for meeting long-term rollout target, Collins earns an incentive payment. However, we expect only immaterial economic benefits from this agreement, lifting midcycle group EBITDA margins by a mere 40 basis points.

While we think Collins has some scale advantages compared with other Australian KFC operators, they are limited to fractionalizing overhead costs. At the restaurant level, adding incremental restaurants doesn’t improve unit economics. We estimate the fractionalization of overheads explains most of the profitability gap between Collins’ Australian segment, and the second-largest Australian franchisee, Restaurant Brands New Zealand. We estimate underlying EBITDA margins are some 200 points greater than Restaurant Brands’ Australian KFC operations where its sales base is only 25% of Collins. Competition between individual KFC restaurants is limited by ensuring sufficient distance between catchment zones. Instead, KFCs are in direct competition with other QSRs, full service restaurants, and food retailers.

Get Morningstar insights in your inbox