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Stellar performance in 1QFY23

Staggered royalty increase to offer better earnings visibility

* Westlife Development (WLDL) delivered a strong operating performance surpassing our estimates. Dine-in recovered to pre-Covid levels while the Convenience channel (delivery, on-the-go, and drive-thrus) sales continued to remain elevated – resulting in WLDL’s SSSG of 97% in 1QFY23 (est. INR76%).

* The full impact of the 5% price hikes taken towards end-1QFY23 should be reflected in 2QFY23E leading to sequentially improved margins.

* The management stated that FY23E royalty rates would be 4%, rising to 4.5% in FY24E and 5% in FY25/FY26E. It is in talks with McDonald’s Corp to stagger the royalty rate increases beyond this as opposed to being sharply increased to 8% in FY27E as per the current franchise agreement. This offers better visibility on earnings over the next four years.

* While WLDL’s prospects are improving, earnings growth could still be weaker than its peers, given: a) uncertainty on the scheduled rise in royalty rate to 8% in FY27E, and b) limited room to improve gross margin, with 80% of its stores already having McCafé outlets. Maintain Neutral.

All-round beat on our estimates

* WLDL reported a sales growth of 107.6% YoY to INR5.4b (est. INR4.7b). SSSG stood at 97% YoY (est. INR76%).

* It opened five McDonald’s stores, taking the total store count to 331 at the end of 1QFY23.

* Gross margin contracted 110bp YoY and 70bp QoQ to 64.3% (est. 65.3%).

* Restaurant Operating Margin (ROM) expanded 22.3% QoQ to 21.6% v/s 9.8% in 1QFY22.

* EBITDA came in at INR873m (est. INR676m).

* EBITDA margin stood at 16.2% v/s 1% YoY and 13.8% QoQ (est. 14.5%).

* The company declared an adjusted PAT of INR236m (est. INR163m) as against a loss of INR334m in 1QFY22.

* Average annualized sales per store stood at INR67m v/s INR39m YoY and INR61m QoQ.

Key takeaways from the management commentary

* The management guided for SSSG of 8% on a steady-state basis.

* WLDL has 12 stores under construction and is poised to add 17-19 stores in 1HFY23. It remains on track to add 35-40 stores in FY23E, in line with its stated target.

* There was a blended price hike of 5% taken towards the end of 1QFY23. The full impact of this hike on margins will be visible in 2QFY23E.

* The royalty rates in FY23/FY24/FY25/FY26 will be 4.0%/4.5%/5.0%/5.0%, respectively. The management is in the process of negotiating the rates beyond FY26 with McDonalds Corp. The earlier contracted rate was 8% from FY27E, in line with global rates. This is now likely to be gradual, according to the management

Valuation and view

* The beat on our estimates leads us to revise our FY23E EBITDA up by 16%. However, there are no material changes to our FY24 estimates.

* With a revival in mobility, WLDL’s higher dine-in salience places it on a strong footing as the country steadily emerges from the pandemic. Price hikes, better mix, revival of McCafé, and operating leverage have helped to maintain margins.

* While the management is in talks with McDonald’s Corp. to stagger royalty rate increases beyond FY26, there is still lack of clarity. Moreover, better operating performance in coming years may not present a strong case for further deferment.

* We maintain our Neutral rating, given its: a) fair valuations, b) scheduled increase in royalty rates to 2x of the current levels eventually, and c) limited incremental gross margin levers. Our valuation of 25x pre-Ind AS Jun’24 EV/EBITDA leads to a TP of INR575.

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