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Sapphire Foods’ Q1 print was below our estimates; consol. revenue/EBITDA grew at 19.8%/9.0%, while PAT declined 34.8%. KFC/PH India revenue grew at 21%/12% with flat SSSG in KFC, yet declined 9% for PH. However high inflation and direct taxes, SriLanka revenues grew 27% with flat SSSG. In Q1 SF added 17/16 stores under KFC/PH format (total stores count KFC/PH/Sri Lanka at 358/302/118). Despite higher inflation in dairy SF’s gross margin inched up to 68.5% (+60bp), with KFC at 68.1% (+80bp) and PH at 75.1% (-20bp). However higher employee cost (+24.3%) and other expenses (+26.7%) ensued post-IndAS EBITDA margins at 18.6% (-184bp). SF took 3.5% price increase in KFC portfolio in Apr’23 to mitigate cost push. Despite soft demand management held store expansion target with single digit SSSG led by strong menu innovation. We tweak our earnings and retain BUY, with a revised DCF-based TP Rs1,542 (implying EV/EBITDA of 11.7x FY25E EPS).

Persistent weakness in Pizza demand coupled with local competition cut SSSG in Q1

SF reported consol. revenue at Rs6.5bn (+19.8%) YoY driven by persistent weakness in Pizza demand and local competition. With flat SSSG, KFC India revenue grew at +21%, while PH saw 9% decline in SSSG led by 12% revenue growth. Despite high inflation/direct taxes Sri Lanka revenues grew 27% with flat SSSG. In Q1 SF added 17/16 stores under KFC/PH format in India (total count KFC/PH/Sri Lanka at 358/302/118). Management attributed weak revenues and SSSG to, (1) consumer down-trading to value menu, (2) negative operating leverage due to higher scale of store addition, (3) cut in ADS for KFC/PH by 4.2%/14.8%, and (4) rising competition. That said, SF upped media spends and also launched 10 new pizzas and Chicken roll/Snackers priced at Rs99+ in Apr/May’23. Management set key brand priorities led by, (1) enhance relevance for fried chicken category, (2) innovation to retain craveable taste, (3) built value proposition, (4) develop seamless customer experience using digital kiosks, (5) operational excellence, and (6) improve accessibility.

Weaker margin on account of higher chicken/ dairy inflation and adverse impact in Sri Lanka

SF’s gross margin inched up to 68.5% (+60bp) YoY, reflecting Pre-IndAS restaurant/company EBITDA margin to 18.0% (-90bp) and 11.8% (-150bp) due to (1) higher inflation in chicken/dairy, and (2) adverse impact in Sri Lanka business. Despite higher employee cost (+24.3%) and other expense (+26.7%) company EBITDA grew 9%, settling post IndAS EBITDA margin at 18.6% (- 184bp). SF effected 3.5% price increases in KFC portfolio in Apr’23. Higher depreciation and interest expenses PAT declined by 34.8% to Rs0.25bn.

Valuation and risks

As argued in our recent QSR Thematic report, with strong management, besides sharp improvement in its execution capabilities we expect turnaround in SF’s performance. However weak demand, incremental competition in chicken QSR, and rising inflation in chicken/dairy pose short term challenges in our view. We reckon the management has reworked store expansion strategy with resizing of stores ~1000-1200 sq. ft. and also launched value offerings under PH /KFC format could ensure margin trajectory. With 3.5% prices increases in KFC portfolio, and falling milk inflation we tweak earnings for FY24E/FY25E by 8.5%/10.0% and retain BUY rating with a revised DCF-based TP of Rs1,542 (implying EV/EBITDA of 11.7x FY25E). Key risks to our call prolonged weakness in demand, rising inflation in key RM/PM and severe competition in chicken portfolio from organized/ unorganized players.

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