No-moat Collins Foods CKF is battling soft demand and cost inflation. In first-half fiscal 2025, sales in the core KFC Australia segment increased 3% on last year. This was all store openings, with like-for-like sales essentially flat. Cost growth, namely rent and wages, is outstripping sales, and margins are under pressure. Underlying EPS in first-half fiscal 2025 fell 24% on last year, to 20 cents.

A trading update indicates conditions are improving, albeit modestly. In the first seven weeks of the second half, KFC Australia like-for-like sales are up 1% on last year. This is encouraging but not enough to outpace cost inflation. The award wage for fast food employees, one of Collins’s biggest cost lines, is set to increase 4% in fiscal 2025.

We maintain our group EBITDA margin forecast of 15% in fiscal 2025, 70 basis points below fiscal 2024. In line with guidance, we reduce our fiscal 2025 group EBIT margin forecast modestly and increase our assumed tax rate. All up, our fiscal 2025 EPS forecast moves 10% lower, to 43 cents.

The key valuation driver for Collins is if, and when, margins recover to prepandemic levels. While we expect margins to improve, cost inflation is proving stickier than anticipated. We reduce our fiscal 2026 group EBITDA margin forecast 1 percentage point to 16%, and EPS falls 12% to 63 cents.

However, our longer-term forecasts stand. We expect consumer spending to rebound in fiscal 2025 and 2026, underpinned by tax cuts, jobs growth, and monetary easing. If this plays out, operating leverage should kick in. Cost disinflation should help, with management flagging near-term ingredient deflation.

By fiscal 2027, we expect the group EBITDA margin to recover to 17%, our midcycle assumption. Our $13.50 fair value estimate stands, with shares materially undervalued. To arrive at the current share price, we would need to assume KFC Australia margins never recover from our forecast trough in fiscal 2025 and no new stores are built.

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, Collins' Australian KFC network should drive the vast majority of operating earnings over the next decade. Collins is the largest KFC franchisee in Australia with more than 280 restaurants of a total of around 800 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.

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.

Collins bulls say

  • The KFC brand is relatively underpenetrated in mainland Europe. There is potential for Collins Foods to both grow its existing European operations and to expand into other countries.
  • Under guidance from Yum, management could revive its ailing Taco Bell business. In the US, Taco Bell operates at higher margins than KFC, offering upside if a turnaround is achieved in Australia.
  • Further consolidation of the Australian KFC market should grow earnings.

Collins bears say

  • Organic growth potential for the core Australia business, over and above population growth, is capped by the relative maturity of the KFC brand in Australia.
  • In the Netherlands, store rollout targets outlined in Collins Foods’ franchise agreements are ambitious and may prove challenging.
  • After absorbing cost pressures to capture market share, a recovery in gross margins once inflation eases could come at the expense of top line growth.

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