Equity Strategy
13 September 2023
Margin Recovery on the Menu
Adding More Exposure to Cost Disinflation

One of the key themes from reporting season was the positive impact of cost disinflation or deflation on certain companies.

The Australian economy is in the early stages of disinflation, leaving further runway on this theme over the medium-term.

James Hardie's (JHX) earnings were upgraded on the back of improved margins, mainly due to easing cost pressures.

JHX's freight and raw material prices fell considerably from the previous quarter.

Despite the fact that our portfolio is positioned to benefit from cost disinflation, we want to add more exposure to this thematic. 

Figure 1 highlights 9 key ASX 200 stocks that have experienced margin pressure over the past 12-24 months. The ASX 200 was screened for stocks with margin erosion in FY23, as well as a qualitative overlay to determine the stocks most impacted by raw material and freight costs.

This screen intends to identify stocks that could undergo a similar margin recovery as JHX. 

In this cycle the market has proven itself to be a relatively poor forecaster of margin recoveries resulting from easing cost pressures, potentially a consequence of the unusual inflationary shock caused by the pandemic. We think risk is to the upside on FY25 margins for some of these stocks.

To gain more exposure to this thematic, we have added Collins Foods (CKF) to the portfolio. We believe this thematic will gain more traction over the next 6-12 months. The portfolio currently plays cost disinflation through JHX and Amcor (AMC).

Figure 1: ASX 200 Cost disinflation stocks
Name Ticker Sector EBITDA Margins FY21 EBITDA Margins FY23 EBITDA Margins FY25 What has hit margins? Margin outlook
Wesfarmers WES Consumer Discretionary 14.9% 12.8% 13.6% Cost pressures have been broad-based, with the largest margin impacts coming from labour market constraints/wage pressures and elevated freight/supply chain costs. While lower freight costs will present a tailwind, broadly cost pressures are expected to persist through FY24. Over the medium-term WES is well placed to adjust costs in line with trading conditions and improve its margins given its multi-year investments in productivity initiatives and its capacity to leverage its scale and sourcing capabilities.
Boral BLD Materials 16.5% 13.1% 15.3% BLD has experienced broad-based pressure across raw materials, energy, labour and logistics costs, partially offset by overhead reduction, procurement initiatives and price escalation. The recovery in BLD's margins will be driven by cost savings initiatives and price increases that flow through in FY24, which coupled with guidance for 'flat to up' volume growth should drive significant operating leverage that pushes margins higher.
Amcor AMC Materials 15.8% 13.7% 14.1% Amcor's margins have been hit by higher costs of raw materials and freight, which combined with softer customer demand due to inventory de-stocking has crimped margins given the fixed cost leverage in the business. There is upside to AMC's margins over the medium-term in our view, given evidence that inventory destocking is easing, end-consumer demand has remained resilient, and certain cost items like freight have fallen away from pandemic era highs.
Bapcor BAP Consumer Discretionary 15.4% 14.8% 16.7% Bapcor has experienced increases in its input costs albeit gross margins have remained steady. EBITDA margins were impacted by a higher cost-of-doing business driven by capacity build, as well as higher debt costs and increased depreciation/ammortisiation from technology and distribution centre investments. Over the medium-term, BAP's margin outlook relies on its 'B2B' transformation initiative, which targets an ~$100m EBIT benefit by FY25.
Domino's Pizza Enterprises DMP Consumer Discretionary 19.3% 15.1% 17.1% DMP and its franchisee's margins have been hit by unprecedented rises in ingredients and other operational costs, coupled with weakening same-store growth as the business has been unable to pass on higher costs to consumers without weakening volumes. DMP's medium-term margin outlook has softened. The business will likely have to endure lower EBIT margins than pre-covid to restore volume growth. Reduced franchisee profitability has seen DMP lower it store roll-out targets, further dampening the group margin outlook. This will be partially offset by recently announced cost savings from restructuring (i.e. the closure of non-profitable franchises).
Collins Foods CKF Consumer Discretionary 17.5% 15.4% 15.2% Margins have been squeezed by sharp increases in the cost of ingredients (e.g. chicken, potato), labour and energy, albeit CKF has managed the environment well with proactive menu price increases sustaining high single digit same-store sales growth. While management expects cost pressures to persist in FY24, overall CKF is expected to be broadly margin neutral in FY24 before a recovery in FY25 which will be supported by the lagged disinflation of certain COGS items (e.g. chicken costs) and supportive menu pricing. We believe margin recovery could be quicker than the market expects. Wilsons analysts expect EBITDA margins to be 16% by FY25E.
Reliance Worldwide Corporation RWC Industrials 26.0% 22.1% 22.5% RWC's margins have been impacted by higher input (copper, zinc) and freight costs, partially offset by price increases and cost reduction initiatives. An improvement in RWC's margins will largely rely on its cost-out initiatives rather than price given the soft outlook for its end-markets. RWC is on track to achieve $15m of annualised cost savings from FY24 onwards. As the easing of copper and freight costs has yet to be felt by the business, this could provide another tailwind in FY24/5. We see risk to the upside on copper prices over the medium term.
ARB Corporation ARB Consumer Discretionary 28.2% 23.7% 23.7% ARB's margins have been impacted by a higher cost of raw materials/consumables, labour, rent and the resumption of marketing activities, which combined with a modest decline in the top line has resulted in weaker gross and EBITDA margins. Management notes that gross profit margins have now recovered to historical levels with recent price increases now fully in effect and product costs mderating.
James Hardie Industries JHX Materials 26.3% 25.2% 27.7% JHX's margins have been hit by a combination of softer volumes and higher raw materials (e.g. pulp, cement) and freight costs. Following a strong Q1 update, we expect JHX's margins to improve markedly in FY24 driven by the disinflation of freight and certain raw materials costs and price/mix gains. Some of this is now reflected in consensus forecasts.

Source: Refinitiv, Wilsons.


“Did someone say KFC?” Adding CKF at 2%

Collins Foods Limited (CKF) is the largest KFC franchisee in Australia. The business operates 272 KFC restaurants across Australia with a focus on QLD and WA, and the business has a growing presence in the Netherlands and Germany with 64 European stores at present. CKF also operates 28 Taco Bell franchises across QLD, VIC, and WA. 

The investment thesis for CKF:

  • Cost disinflation – cyclical recovery in margins from cost disinflation/deflation.
  • Store growth – CKF continues to grow store numbers in Australia and Europe. 
  • Delivery driving higher revenue – broader customer base from delivery service and increased average revenue per restaurant.
  • Resilience from value offering - KFC brand is positioned very effectively with consumers, having built a strong perception of value.
  • Valuation – CKF looks attractive at a 12-month forward price to earnings ratio (PE) of 18.6x with earnings per share (EPS) growth expected to be 20% per annum (FY24-26). 

CKF - All the Ingredients for a Cyclical Recovery in Margins

The inflationary backdrop has put significant pressure on CKF’s (typically attractive and predictable) margins over the past ~18 months, due to sharp increases in the cost of ingredients (chicken, potatoes etc.), labour, and energy. 

Figure 2: KFC’s EBITDA margins are expected to recover by FY25; we see upside risk to these forecasts

To date, CKF has demonstrated a strong track record of managing the challenging cost environment by implementing menu price increases without materially impacting transaction volumes. CKF’s FY23 result confirmed resilient top line growth, with its KFC Australia segment delivering same-store-sales growth (SSSg) of +8.8% in the first 7 weeks of FY24, in spite of the softening consumer backdrop.

Input cost pressures should ease over the medium term. Slower cost growth, resilient SSSg, and CKF's proactive stance on menu pricing should underpin a positive 'jaws', providing a tailwind to margins in FY25. We also expect to see more evidence of easing costs in FY24, which could be a catalyst for the stock. 

There have already been improvements in agricultural commodity prices within CKF’s supply chain. Major Australian poultry supplier, Ingham’s, noted in its FY23 result that its feed ingredient costs (i.e. wheat, soymeal) stabilised during the year, while futures markets also point to further softening in some soft commodity prices (e.g. wheat), suggesting the rate of chicken price inflation (a key input) should ease from here. 

Figure 3: Expectations are for chicken price pressures to ease from here

Ultimately, the recovery in CKF’s margins towards historical levels is a timing (rather than structural) issue. Wilsons Research expects broadly flat earnings before interest, taxes, depreciation and amortization (EBITDA) margins in FY24, followed by a recovery starting in FY25.

Long-term Compounding of Store Growth

KFC Australia generating robust trend growth

CKF has a strong track record of store growth. Over the past decade, average Australian restaurant numbers have grown by 8%, or 14 new stores per annum. Store growth has been a key reason why CKF has grown revenue at 12% per annum since FY13. 

Store growth is set to continue. CKF guided to 9-12 new KFC restaurants in the Australian market in FY24 (vs FY23 of 272). CKF is expected to add another ~60 restaurants by the end of the decade. This provides underlying revenue growth to the business over the forecast period. 

Figure 4: Underlying store growth is key to CKF growing revenue

European Expansion to Drive Structural Growth Long-term

The key structural growth driver for CKF in the long term will be the continued expansion of its international store network via organic new store openings and acquisitions, with a particular focus on the Netherlands and Germany. CKF have nearly doubled its European store footprint over the past 5 years.

Consistent with this strategy, earlier this year, CKF announced the acquisition of 8 KFC stores in the Netherlands. CKF’s FY24 outlook guided to the development of 3-5 new restaurants this financial year, while management monitors the landscape for additional merger and acquisition (M&A) opportunities across the continent. The recent sale of the Asian Sizzler business provides capital (~$20m) to be deployed. 

The recent acceleration of new store openings in KFC Europe has given us further confidence in the long-term growth profile of the business. CKF’s store roll-out plans will be a key driver of its long-term revenue growth. We expect margins to move structurally higher through operational leverage as the business grows across a more extensive store network and as newer stores mature.

Delivery Driving Growth

Delivery has opened up a new way to service customers. CKF has invested in new software to enhance customer adoption of its app and digital ordering. A quarter of sales in 2H23 were from delivery (web or app), up from ~17% in FY22.

Delivery should continue to generate incremental revenue growth. Delivery uses the existing store structure to facilitate sales. 

Therefore, as delivery grows more popular, we expect average revenue per store to increase. Although delivery entails some additional costs (app costs, delivery fees and aggregator commission), the incremental gross profit on the existing cost base is return-on-invested-capital (ROIC) positive.

Figure 5: CKF’s improved offering should continue to increase average revenue per store

Delivery is now a valuable part of the sales mix and overall service offering to customers. 

Resilience from Brand and Value

CKF volumes should remain buoyant even as the consumer weakens. The demand profile for QSR’s (quick service restaurants) is reasonably resilient, given the low price point. The KFC brand is positioned very effectively with consumers, having built and delivered on a strong perception of value.

CKF's strong value offering positions it well to benefit from trading down, which we expect as the consumer continues to soften over the next 6 months. 

Figure 6: KFC Australia has not seen SSS go backwards in the last 10 years, highlighting its resilience

Valuation Attractive

CKF currently trades on a 12-month forward PE of 18.6x. This valuation looks attractive considering the 20% EPS compound annual growth rate (CAGR) (FY24-26), the resilience of sales and the risk upside to earnings, in our view. The stock is also trading below its 5-year average of 20.2x. 

Figure 7: PE looks reasonable relative to its 5-year average and considering the expected growth (20% EPS CAGR)

Wilsons Research have a $11.16 price target on CKF. The Wilsons Research DCF indicates a $13.90 price target, implying considerable potential upside. 

Read Collins Foods (CKF) | Resilient SSSg demonstrates brand strength

Why not Dominos (DMP)?

Taking Dominos (DMP) as its closest peer, CKF looks better value when you consider the earnings growth, lower multiple, superior balance sheet (lower debt) and higher ROIC.

While both CKF and DMP operate based on a foundation of value, CKF has demonstrated a stronger ability to safeguard its profit margins during a period of elevated inflation by implementing price increases. 

In contrast, DMP experienced a decline in sales volumes as a result of its price hikes, reflecting the heightened price sensitivity of its customer base. 

To qualify for a PE of 29x the market must assume that DMP can continue to grow beyond FY26 at a strong rate. 

We believe consensus forecasts for DMP are too optimistic, and see downside risk to DMP’s earnings. DMP has a habit of overpromising and underdelivering. This is not the case with CKF.

Figure 8: CKF looks better value than DMP
Company Name Ticker Beta Forecast Multiples EPS CAGR % Dividend Yield % ROIC Net Debt/EBITDA  FY24 EPS Revision % 90 days
12mth fwd PE 12mth fwd EV/EBITDA (FY1-FY3) 12mth fwd (FY24) (FY24)
Collins Foods CKF 1.04 18.7 8.3 20% 3.2% 18% 1.2 2.8
Domino's Pizza DMP 0.82 28.7 14.8 20% 2.7% 14% 3.4 -14.2

Source: Refinitiv, Wilsons.

Trimming James Hardie (JHX) -1%

We have trimmed our position in James Hardie to 2% after its strong run of performance with the stock up +74% to date this year. 

Our investment thesis remains intact. However, consensus is now more aligned with our thinking, implying less upside. Consensus earnings expectations have been upgraded significantly and the company now trades at a (modest) premium to its 10-year average PE, at ~19x. 

While we still see upside to JHX’s valuation over the medium term, our total return expectation has fallen by virtue of the positive share price performance. Therefore, now is an opportune time to take profits from JHX to re-allocate a portion elsewhere. 

Long term, JHX remains well placed to benefit from structural growth in the popularity of fibre cement use in housing construction, as well as from the ‘underbuilt’ and ageing nature of the US housing stock post GFC. 


Trimming Telstra (TLS) – 1%

Telstra’s underlying business remains in good shape. In line with our thesis, the all-important mobile business continues to benefit from a rational competitive backdrop, which is allowing the telco to raise prices without sacrificing market share (in fact, TLS has been gaining share). 

However, at the FY23 result, TLS announced it has abandoned plans to monetise more of its infrastructure assets held in its InfraCo fixed segment, for the time being at least. 

We had expected the partial sale or spin-off of these assets to be a material catalyst that would unlock shareholder value and fund significant capital management initiatives. 

While there is merit in maintaining full ownership of these high-quality infrastructure assets, this has removed a key catalyst for TLS, which has lessened our near-term enthusiasm towards the business. As a result, we have trimmed our position in TLS to 3%. 

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Written by

Rob Crookston, Equity Strategist

Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.

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