Collins Foods (ASX: CKF) has identified Germany as its second strategic growth pillar, behind KFC Australia. It will acquire eight KFC restaurants in Bavaria and has lifted its rollout target for Germany. Taco Bell is no longer a distraction, with Collins exiting the brand in Australia.

Why it matters: The Bavaria acquisition is priced at around 6 times EBITDA. This looks reasonable against an enterprise value/EBITDA multiple of 9 for the broader group, implied by our fair value. However, given the size of the deal, total consideration of approximately $50 million, it doesn’t move the needle.

  • Collins has lifted its German new-store target to 45-90 from 40-70 over the next four years. We are cautious about the expansion, given the underwhelming rollout pace of restaurants in the Netherlands. We assume new store openings near the bottom of the range.
  • We already assumed a full Taco Bell exit by fiscal 2027. We had expected all restaurants to transfer at zero cost, so the $1 million-$2 million in expenses to close seven irredeemable stores is only slightly higher than we assumed.

The bottom line: The German acquisition and Taco Bell exit are immaterial to our valuation. We maintain our fair value estimate for no-moat Collins Foods at $14.50 per share. Shares are undervalued.

  • We think the market is too pessimistic on the margin outlook for KFC Australia, which accounts for 80% of forecast midcycle EBITDA and the vast majority of our valuation.
  • Renewed cost-of-living pressures are a risk to consumer spending and earnings, but our long-run assumptions are not heroic. We assume a recovery to pre-covid margins, as the inflation shock subsides over the medium term, and operating leverage builds with store rollouts.

German expansion offers blue sky, but KFC Australia is the main game

We think the success of the Australian KFC network will prove crucial for Collins Foods. Despite KFC expansion into Europe, 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 around 290 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 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. In Europe, we forecast Collins to expand its footprint, focusing on Germany in the medium term.

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.
  • Normalized minimum wage increases should stabilize operating margins and improve menu and pricing planning capabilities.
  • Further consolidation of the Australian KFC market should grow earnings.

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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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.