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Navigating challenging times through focused format strategy

 For the QSR industry, the operating environment has been challenging so far in FY24; however, the issues are more cyclical in nature and the penetration-led story is intact. We like Sapphire’s format strategy to deal with the challenging/volatile situation by a) fortifying KFC’s presence in the chicken segment through aggressive store expansion, b) calibrating store expansion in Pizza Hut (PH) and taking steps to improve brand recall and drive transactions and cost efficiencies, and c) bridging portfolio gaps (KFC Snackers, late night delivery in PH) to enhance play across dayparts for both brands. Domestic business apart, weakness in the Sri Lanka (SL) business (which was a drag in FY23) is bottoming out vs. peers whose overseas operations (Devyani – Nigeria) are either seeing challenges or still work in progress (RBA). Resilient KFC margins and recovery in SL profitability should help Sapphire offset some impact of the weakness in PH. We continue to believe in Sapphire’s superior execution (link), and forecast 19%/24% sales/EBITDA (pre-Ind AS) CAGR over FY23-26E. Current valuations (21x/17x FY25/26E pre-IND AS EV/EBITDA) are not demanding; there is headroom for the discount (c.35-40%) to Devyani to narrow over time. We reiterate BUY.

? KFC - Fortifying presence in chicken segment; well ahead of competition: Regional competition is not a threat in this category and no formidable No. 2 brand has emerged despite the entry of large QSR peers. In our view, apart from getting unit economics right, creating top-of-the-mind brand recall, getting the right location and building back-end supply chain (important for fresh chicken-based QSR) are not easy and happen over the long haul. This is visible from Popeye’s pace of expansion since launch (JUBI is looking at 250 stores over next 4 -5 years vs KFC sapphire/Devyani at 381/540 stores currently). We have seen the first-mover advantage that Domino’s (in Pizza), and Westlife (in Burger) enjoy even today despite scale-up by No. 2 players in those categories. We believe KFC is far ahead of competition & enjoys similar advantages in the chicken segment. Sapphire’s execution here has been impressive, providing assurance on the runway for growth. We forecast a strong 20%/21% sales/ROM CAGR for KFC over FY23-26E.

? PH remains a focus; favourable base apart, several initiatives underway that should aid gradual ADS recovery: Category has seen aggressive scale-up by competitors; however, some of them have adopted the sub-franchisee route, which enables faster expansion in a shorter time. But maintaining quality standards becomes a challenge while dealing with multiple franchisees. This could potentially impact consumer experience/product quality in the long run, in our view. We have seen PH struggling in the past due to the multiple franchisee model, and post consolidation to two franchisees it did see a significant turnaround. While PH has been able to get the store format right, more work needs to be done on strengthening brand recall. Several initiatives have been undertaken – a) increased marketing spends, b) ramp-up in innovations, c) integration of Dragontail technology to enhance consumer experience, which, along with a soft base, should aid ADS recovery.

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