Welcome to ask the analyst, where members of Morningstar Australia’s equity research team answer questions from the Morningstar community. If you have a question about an ASX company or industry in our coverage, please send it to tyger.fitzpatrick@morningstar.com.

Today’s question focuses on reassessing GYG following its recent decision to exit the US market. While the US business was experimental, it did represent a huge growth opportunity that was a source of investor excitement at the IPO.

Without this growth option, how will GYG drive returns for shareholders? Furthermore, can the Aussie business alone provide enough growth to move the needle on the share price?

I spoke with our equity analyst Johannes Faul to better understand the key drivers behind Morningstar’s view on Guzman Y Gomez (ASX.GYG) and what investors need to be aware of going forward. Firstly, let’s assess the context surrounding the concerns with Guzman’s endeavours in the US.

Shaking off investor concerns

Investor sentiment towards Guzman y Gomez has finally begun to stabilise following its decision to exit the US retail market in May. There are signs of stabilisation in the share price which is up 12% since the company announced its US departure.

Compared to my previous article on the most shorted ASX companies, total short positions in GYG shares have also trended downwards from 13.4% in March to 10.75% today. It appears investors are relieved that GYG is no longer competing against US heavyweights Chipotle and Taco Bell.

The company’s most recent earnings result in February saw shares fall 14% intraday due to widening losses in its stores in Chicago. This scepticism was a recurring theme particularly in earnings season, as shares typically sold off shortly after. In fact, the stock has only closed higher once across its four earnings releases post listing, averaging an 8% decline on the day of reporting. The news from the US overshadowed the strong sales growth in the Australian business.

With the US drag now removed, the market is refocusing on the true earnings engine: the Australian business. While the Australian store economics rival those of KFC and McDonald’s, Johannes believes that this might not be enough to move the needle in reference to valuation.

Australia is the main game

GYG has evolved from a niche fast casual concept into a scaled and differentiated player in the Aussie fast-food market. Its positioning centres on fresh, Mexican-inspired food with a focus on quality and speed. This Australian business remains the clear value driver for the company.

Johannes noted that while GYG has established a foothold in Asia with 24 stores in Singapore and a small presence in Japan, these operations currently contribute little to nothing in fair value. Expansion offshore is unlikely to materially move the needle in the near term compared to the domestic business.

Guzman is expected to open 32 new restaurants in the current financial year and has a committed pipeline of more than 100 sites. As it stands, this brings total stores currently operating in Australia to around 250 sites.

The long-term goal for Guzman is to open 1,000 stores which would set them on par with their largest fast-food rival, McDonalds. Johannes is less confident in the pace of this rollout, crediting roughly 600 stores by 2035. He believes Guzman is constrained in how many stores it can open each year.

An average net new store openings of 40 through to 2025 brings total stores in Australia closer to Johannes forecast. To bake in 1,000 stores over the next decade into the valuation, there simply must be more evidence of brand durability according to Johannes.

An interesting point Johannes brought up was the diminishing upside to new restaurants as Guzman expands to new areas in Australia. As Guzman rolls out new stores, it must find new catchments in Australia to penetrate which may have less overall foot traffic.

Australia’s population is densely packed in urban areas and expanding into more rural or suburban areas could prove less profitable. So it does come down to whether existing store (like for like) sales can continue to grow above peers in the long run.

The key to success

The most important metric investors should focus on is same store sales or “like for like” sales. Analysts use like for like sales comparisons to show how fast established stores (12 months running) are organically growing. In the core Australian segment, like for like sales rose 4% in the February earnings result. While this was above peers, there were concerns Guzman may be approaching the industry average. However, the third quarter update in April saw like for like sales rebound back to 7%.

Maintaining high growth in same store sales over the long run feeds through to both the expansion strategy onshore as well as increasing overall returns to shareholders. Comparatively, if same store sales diminish over time, the intended expansion rate is far less likely to come to fruition.

To justify GYG’s growth narrative, the company should ideally grow same store sales faster than the combined rate of population growth and inflation. Achieving this would indicate genuine pricing power, brand strength and customer loyalty. These are the three key ingredients for a sustainable competitive advantage and may be a pathway to a moat.

Is Guzman on track for a moat?

Despite the strong growth profile, Johannes notes that it is still too early to assign GYG an economic moat. While store economics are attractive and management execution has been solid to date in Australia, overall returns remain below the cost of capital. Earnings are also lagging investment due to continued spending on new stores and support systems. This is expected to improve over time given the company is still early in its growth phase.

Johannes expects Guzman will maintain attractive store economics over the next decade. However, there needs to be firm evidence that the brand and store economics are holding up (ie. same store sales) as the store rollout progresses to award a moat and extend optimism beyond the next 10 years. While the pathway to a moat is there, same store sales will remain key to whether Guzman can move the needle and sustain returns above the cost of capital.

What moves the needle for valuation?

GYG currently trades at a premium to our $16 per share fair value. Despite the premium, this forecast bakes in 10-year compound annual growth rates for network sales and adjusted profit before tax of 14% and 28%, respectively. The rapid expansion of the Australian stores is the key driver behind our fair value.

The forecast includes like for like sales growth averaging 4% per year for the next decade. Profitability is forecast to improve as costs become more centralised, royalty revenue increases and improvement in corporate restaurant margins.

The wild card for Guzman is it owns the brand. This means that international expansion offers blue sky if they can successfully execute. A good example would be expansion into Europe through franchise licensing agreements. The reality of such success involves time.

Typically, a successful brand takes about a decade to reach a footprint of 100 stores in large markets such as Europe. Furthermore, entry into markets with established Mexican fast-food chains such as the US is likely to be far more challenging than what Guzman has experienced in Australia.

The bottom line

GYG’s exit from the US removes a key source of uncertainty and allows investors to focus on the true earnings engine in Australia. While this simplifies the investing narrative, it also narrows the pathway for growth.

To move the needle on valuation, all roads lead back to same store sales growth. If GYG can consistently maintain its uniquely high same store sales growth in Australia, it opens doors for faster expansion and optionality in new markets.

At current levels, the market is already pricing in strong growth, with shares trading above our fair value. Without the US as a growth lever, upside will need to come from delivering on ambitious Australian rollout targets and improving profitability over time. In short, GYG is a cleaner, more focused story but one where execution risk in Australia now matters more than ever.

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