Fast food gets a lot slower: Downgrades to bite quick-service restaurants

On their Q3 menu: They weren't able to absorb demand slowdown, cost pressures

After a muted performance in the October-December quarter (third quarter, or Q3) of 2022-23 (FY23), quick-service restaurants (QSR) are expected to have a bumpy ride in the near term, given softening demand outlook and margin headwinds. Most brokerages have revised their operating profit and earnings estimates for FY23 through 2024-25 (FY25) by up to 20 per cent.

The near-term overhang for the sector is on account of lower-than-expected operating metrics in Q3FY23.

The like-for-like (LFL) or same-store sales growth for the country’s largest listed QSR company, Jubilant FoodWorks (Jubilant), holding the master franchise rights for Domino’s Pizza, Dunkin’ Donuts, and Popeyes, was marginally higher at 0.3 per cent and way lower than Street expectations of 6 per cent growth.

What impacted sales for the company, after strong revenue performance in October riding on festival demand, was a sudden plunge in demand in November. While there has been an improvement in December and January, it is still below expectations.

Similarly, Devyani International (Devyani) - the largest franchisee of Yum Brands in India - posted a sequential decline of 4-5 per cent in average daily sales (ADS) at Kentucky Fried Kitchen (KFC) and Pizza Hut, led by weak consumer demand and downtrading.

Kotak Securities points out that the usual seasonal growth for the company is 5 per cent on-quarter. The LFL for KFC was up 3 per cent, while it was down 6 per cent for Pizza Hut.

Sapphire Foods India (Sapphire) – the parent company of KFC and Pizza Hut - too saw its ADS fall 5.6 per cent on-year, while it was up marginally 1.5 per cent on a sequential basis. The management said that a lower ADS was on account of a moderation in demand after the festival season, higher store additions, and higher competitive intensity in the pizza category.

While the LFL for Sapphire was better than Devyani’s, it came in below estimates at 3 per cent for KFC and minus 4 per cent for Pizza Hut.

Restaurant Brands Asia (formerly Burger King India) posted an LFL of 8.6 per cent, much lower than brokerage estimates that had pegged it at over 25 per cent. The metric was muted, given lower traffic across stores, especially in December.

The operating metrics of Westlife Foodworld (formerly Westlife Development) or Westlife, that owns and operates the master franchisee of fast food chain McDonald’s in West and South India, were an exception as it beat slowdown blues with a 20 per cent LFL for growth, compared with Street estimates of 16 per cent. Led by festival-related demand, higher walk-ins, and menu innovations, the company outperformed its peers.

For most QSRs, a weaker top line, coupled with higher costs, dented profitability.

For Jubilant, a flat LFL performance, cost pressures, and weak operating leverage hit its margins. Its gross profit margin fell 210 basis points due to an inflationary trend in the prices of cheese and flour.

Research analysts Vishal Gutka and Binay Shukla of PhillipCapital Research expect some headwinds for LFL. They highlight that persistent consumer inflation will lead to a reduction in discretionary spending and Jubilant’s delivery-heavy business could see slowdown as it faces consumer fatigue.

Raw material pressure may be difficult to offset, given that the company has already taken multiple hikes over the past year and a half. Higher fuel expenses and employee cost inflation add to the multiple pain points for the company, observes the brokerage.

The operating profit of Sapphire was better than expected due to better gross margins and control over costs. An increased proportion of KFC, which has higher margins, boosted its profitability.

Brokerages are positive on the stock. Emkay Research expects Sapphire to deliver a strong operating profit of 35 per cent over 2021-22 through FY25, led by a 20 per cent store count, 8 per cent LFL, and gradual margin gains. Valuations, too, are not demanding.

Westlife managed to improve its gross margins, notwithstanding inflation in dairy products, given the 2 per cent price hike in October last year. Operating margins, however, remained flat on account of higher staff costs. The company is the top pick of Nirmal Bang Research in the consumer discretionary space as it has yielded relatively healthy returns, backed by strong result delivery.

Motilal Oswal Research remains bullish on Devyani’s prospects, given KFC’s strong brand equity and its growth opportunity, a gradual turnaround in Pizza Hut, driven by the management’s focus on delivery and improved store metrics, network expansion, and healthy operating profitability.

While the medium-term outlook is strong on the back of store additions, operating leverage, and a gradual uptick in margins, brokerages expect the sector to have a tough year ahead.

Say analysts, led by Percy Panthaki, of IIFL Securities, “The sector is at risk from a combination of lacklustre demand and excess supply, with inflation (amongst other factors) suppressing demand, while companies have added (and plan to add) a record number of stores. History suggests that once a slowdown sets in, it doesn’t reverse for a few quarters; and therefore, we feel that consensus downgrade cycle will probably continue for two to three quarters more.”