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Sapphire Foods’ stock price has corrected by c.22% in the past 6 months, triggered by the subdued demand environment in the QSR segment, especially the post-festive period, due to inflationary pressures weighing on footfalls. The impact was more pronounced in Pizza Hut (PH)-India (c.22-23% of sales) and was seen across peers in the pizza category. On the other hand, the KFC business (c.64% of sales) has been relatively resilient, which is a key positive and reflective of its superior brand strength, network scale and myriad offerings. With RM headwinds in the chicken segment now behind, sustaining high-teen restaurant operating margin (ROM) in KFC should not be a challenge. This, along with gradual recovery in the Sri Lanka business will cushion some of the impact arising from PH’s weak performance on overall operating margin. Challenges in the PH format will continue in the near term. However, with rising share of compact stores and steady traction in Flavour Fun, the format offers potential for improvement in ADS and ROM over the medium term. We believe nearterm issues are more transient and the underlying business opportunity (penetration-led growth) and strengths (strong brands/ unit economics/execution capabilities) remain intact. Valuations at 20/15x FY24/25E EBITDA (pre-IND AS) are not demanding & at discount to peers. Near-term weakness should be used as an opportunity to add. Retain BUY.

* KFC resilience to continue; brand strength, healthy unit economics give assurance on scale-up opportunity: Despite weak consumer demand post the festive season and entry of new players (McDonald’s, Popeye’s), KFC’s performance remains relatively resilient (Exhibit1/2) benefiting from its brand strength, network scale and differentiation in food preparation for chicken offerings. Entry of newer players will only speed up the trend of increasing protein consumption in India and KFC with its first mover advantage has all the ingredients in place to capitalise on this. Further, the brand presence is relatively lower (both in terms of number of stores and cities covered) when compared to Domino’s, which provides enough headroom for growth (Exhibit 3). KFC, with its dominant leadership position and superior unit economics in the chicken segment, is well placed to capitalise on this penetration opportunity. We expect the pace of store additions to remain healthy in KFC (in fact, in the near term, KFC is likely to add more stores than PH).

* Weak demand to drag PH-India in the near term, increasing share of compact stores and traction in ‘Flavour Fun range’ a long-term positive: Post the festive season, ADS of QSR players (barring Westlife) has declined. Within sub-segments, while the performance of burger and fried chicken was relatively resilient, pizza as a category saw fall in demand (deceleration after festive season seen from weaker ADS and negative SSSG for both Domino’s and PH-India). This is likely to continue in the near term due to inflationary pressures (resulting in weaker footfalls especially in tier2/3 markets) and some uptick in competitive intensity. On the positive side, metro markets are doing relatively better than tier 2 markets. Also, the initiative to plug the portfolio gap with Flavour Fun (MRP< INR 100) continues to see healthy traction, thereby aiding customer additions and transactions growth. While negative operating leverage and dairy inflation will impact near-term ROM for PH-India, the salience of compact stores (Exhibit 5/6) continues to increase (c.60% in FY23 vs 49% in FY22), which should lead to superior ROMs once inflation-led headwinds start to subside over the medium term.

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