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Tasty Pizza-KFC combo available at appetising valuations

Sapphire Foods (Sapphire) operates ~37% of Yum Brands’ KFC/Pizza Hut (PH) stores in India and 100% of PH stores in Sri Lanka (SL). India has a lower: (1) QSR penetration at ~8% in Food Services vs. 20-40% in US/China/Brazil; and (2) per capita consumption [PCC] of chicken at ~3kg p.a. vs. global avg. of 17kg. Thus, we expect continuation of a mid-teen revenue CAGR for the Indian QSR industry over next 10-15 years. Sapphire has optimized the size of its new stores and ramped up its delivery channel, to tap into the consumption demand tailwinds; the company aims to double its network in the next 3-4 years (23-28% store CAGR), and reduce the extant 40% ADS gap in PH vs. JUBI with innovations and improved affordability. Sapphire’s SSG target is 6-7% for PH/KFC

Even after factoring-in a 12% annual EBITDA decline in SL [for FY22-25E], and building conservative forecasts near lower end-of Sapphire’s targets, we model company’s EBITDA CAGR at 42% for FY22-25E, driven by: 1) 21% CAGR in avg. store count, based on annual store additions of 125; 2) 7% CAGR in SSG; and 3) avg. annual increase of ~100bps in the EBITDA margin. We estimate that new format KFC/PH stores (opened from FY19) are generating 50%/20% RoICs, leading us to forecast pre-tax RoIC to rise to ~36% by FY25E from ~9% in FY22. We initiate coverage on Sapphire with a Buy rating and a Jun’24E TP of Rs1,500, based on 22x Jun’24E EBITDA, derived from a two-stage growth model. Our TP multiple implies a 40% valuation discount vs. DIL, justified by: (1) challenges in SL; (2) a smaller PH opportunity; (3) lower RoICs; and (4), lower liquidity amid lock-up expiry on certain pre-IPO shares. Faster improvement in PH margins and SL revival may reduce valuation discount to 20%. Key risk is slower execution. (Unless stated otherwise, EBITDA and margins are on pre-IndAS 116 basis).

Turnaround in profitability driving growth acceleration:

Retention of per-store revenues despite a ~50% cut in size of new-format stores has led to ~50%/20% RoICs for KFC/PH stores opened after FY19 vs. 20%/0% for the legacy stores. Aided by delivery aggregators and omni-channel investments, off-premise sales are now at 1.4x-2.2x of pre-Covid levels, and should lead to improve per-store metrics post 100% recovery in the dine-in channel (70%- 80% currently). Thanks to improvement in cash generation, profitability and aggregator presence in the top-1000 cities, Sapphire aims to double its store count in the next 3-4 years.

KFC an even ball game, but PH opportunity is relatively smaller:

QSR consumption is currently concentrated in metros as Top-8 cities contributed 85%+ to overall chain industry revenues in FY20 (Source: Burger King RHP). While DIL definitely addresses a higher nonveg eating population at 55%, Sapphire owns KFC rights for 5 of the Top-8 metros. In addition, the opportunity is similar if we only consider states with per-capita income higher than the national average. For PH, DIL has larger opportunity as it can also open delivery-focused stores in Sapphire regions (ex-TN). Nonetheless, Sapphire has significant growth potential for PH in its South/West regions as these states have: (1) higher per capita income; (2) six of the top-8 metros; and (3) lower store penetration at 40% for brand Pizza Hut vs. Domino’s

Margin expansion likely despite SL challenges:

We expect Sapphire’s India EBITDA margins to improve by ~150bps annually—80bps from higher brand margins + 70bps from lower Head Office [HO] costs. Brand-level gains should be driven by an increase in the mix of higher-margin new format stores and operating leverage. However, we remain cautious on SL recovery and expect consol. margins to increase by 100bps annually over FY22-25E.

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