Key points

• Selling in Retail Food is probably overdone at current levels so expect it to trade above $5 within 12 months.
• Earning guidance for 2015-16 was for 20% growth in NPAT. Not many other industrials are expecting underlying profits growth of that much.
• Retail Food Group is no Domino’s. But nor is its valuation. Its PE is less than a quarter of Domino’s forecast PE of 43.

Australia’s love affair with fast food is replicated on the share market, to varying degrees. Domino’s Pizza Enterprises has soared and fried-chicken group Collins Food has leapt this year. But Retail Food Group has fallen too far and is a buying opportunity.

Retail Food was a market darling last year. It soared from $4 in May 2014 to $7.85 in March this year as investors applauded its expansion strategy in gourmet pizza and coffee. Then it slumped to $4.12 after announcing higher costs and write-downs and is back near the 52-week low.

Retail Food Group

Source: Yahoo!7 Finance, 1 October 2015

Retail Food was due for a share-price pullback. It ran too far, too fast, as the market focused on its acquisition and international expansion strategy and overlooked the challenges in its legacy Australia-based franchises, some of which look a bit tired.

Moreover, Domino’s incredible success and nose-bleeding valuation encouraged investors to seek cheaper options. Retail Food was the next best thing and rapid growth in its gourmet pizza division, via its acquired Crust and Pizza Capers chains, attracted investors.

Arguably priced for perfection at its peak, Retail Food was hammered after its market update in June. Same-store sales growth of 2.9%, an extra $3.3 million in short-term costs (to achieve long-term savings), and an $18.5 million provision disappointed. Selling in Retail Food intensified in the third quarter as the share market slumped.

Four of five broking firms that cover Retail Food now have strong buy or buy recommendations, according to Thomson/First Call consensus analyst forecasts. Price targets range from $5 to $7.83 and the median target is $6.50.

If the consensus is right, Retail Food is badly undervalued. Either the market is hopelessly wrong on it at the current price or brokers are far too optimistic. To put its valuation in perspective, the group’s share price is back to levels before its transformative café and coffee chain acquisitions in 2014 and early 2015.

I’m not as bullish as most brokers, but believe selling in Retail Food is overdone at $4.12 and expect it to trade above $5 within 12 months. Here’s why.

A multi-brand strategy

Retail Food owns the Donut King, Brumby’s Bakery, Michel’s Patisserie, bb’s Café, Esquires, Gloria Jean’s Coffees, It’s a Grind, The Coffee Guy, Cafe2U, Pizza Capers Gourmet Kitchen and Crust Gourmet Pizza Bar. It is also a significant wholesale coffee roaster through Di Bella Coffee, Evolution Coffee Roasters Group and Roasting Australia.

It has grown quickly by acquisition. Retail Food bought Pizza Capers and Crust Gourmet in 2012; Cafe2U and Gloria Jean’s in 2014; and Di Bella Coffee in March this year. The group has 2,450 outlets and expects to open more than 250 stores in 2015-16.

The plan is to build a larger multi-brand portfolio, achieve greater operational efficiencies, and rapidly expand overseas. Supplying Retail Food Group coffee to franchises and leveraging technology investments across the group are key opportunities.

The strategy is working. Return on Equity has averaged about 15% over the past five financial years and should edge a few points higher in the next few years. Earnings per share have grown strongly and there have been nine consecutive annual dividend increases. The three-year annualised total return (including dividends) is 17%, even after heavy recent price falls.

The balance sheet is solid. Net gearing of 33.1% in 2014-15 is supported comfortably by interest cover of 11.1 times and there is plenty of headroom in its banking facilities. Continued strong growth in cash flow supports Retail Food’s debt position.

Short-term profit growth has been strong, although it was needed to justify rapid share-price gains in 2014. Retail Food reported 63% growth in underlying revenue to $210 million and 49% growth in net profit after tax (NPAT) to $55.1 million in 2014-15.

Better earnings diversification stood out. Retail Food’s international earnings delivered 14% of earnings in 2014-15, from 4% a year earlier. It wants the international operations to account for a quarter of earnings by 2017-18. By segment, it wants earnings from commercial operations (ie coffee roasting) to almost double to 40%.

Earning guidance for 2015-16 was for 20% growth in NPAT. How many other industrials are expecting underlying profits growth 20%, in this market? Retail Food said its acquisitions would meet or exceed forecasts, and that synergy-extraction gains were ahead of budget.

If the strategy succeeds, Retail Food will rely less on sales from Australian franchises, and have greater leverage to fast-growing emerging markets. It wants to open at least 25 Gloria Jean’s stores in China within 12 months and has its eye on India.

Short-term challenges

Three-quarters of Retail Food’s earnings still come from its domestic franchises, and growth is tepid. A slowing economy and greater competition are weighing on store sales.

Same-store sales (SSS) growth of 2.9% in 2014-15 is a concern. Within that, Michel’s Patisserie had SSS of less than 1%; Brumby’s was 1.9%. Crust and Pizza Capers, key growth engines for Retail Food, had a disappointing 1.3%. Domino’s expanded gourmet offerings and aggressive price discounting is clearly hurting operators across the pizza industry.

That means Retail Food has to open more stores, acquire more franchise chains, and find efficiency gains that boost margins. Organic growth from older franchise systems will be harder to achieve in a slowing economy.

Retail Food knows its legacy food chain needs refreshing. Its Project Evo, an impressive store transformation and upgrade strategy, has been implemented in a quarter of the Donut King, Brumby’s and Michel’s chains – the parts of the business that need most work. Project Evo is gaining traction, but stronger results are needed in the older brands.

The $18.5 million impairment charge was needed to rationalise lower-performing brands and stores and focus on better growth opportunities. The group probably has too many small brands and too many stores in franchise systems that need refreshing.

I suspect the market has had trouble digesting Retail Food’s spate of acquisitions in the past 18 months and the transformation underway. Only a handful of analysts cover the stock and the acquisitions, particularly Gloria Jean’s, have elevated Retail Food to a new level.

Long-term potential

Although there are short-term challenges, Retail Food’s overseas expansion strategy has terrific long-term potential. Another 3.1 billion middle-class consumers in emerging markets by 2030, on OECD forecasts, will drive demand for western-style food and quick-service restaurants.

The group should expand quickly overseas through master franchise and joint-venture agreements that reduce risks and the need to raise extra capital.

The big upside is in exporting more Australian coffee, which is well regarded overseas, to Asia. I doubt the market fully understands the potential of exporting coffee to Asia, or the strength of the Gloria Jean’s and Di Bella brands.

The key question, of course, is valuation. At $4.12, Retail Food trades on a forecast Price Earnings (PE) multiple of 10 times 2015-16 earnings. That is undemanding for a company with strong leverage to a booming coffee segment and a growing global footprint. An expected 6.3% yield, fully franked, is another attraction.

Signs that Retail Food is extracting more synergies from its recent acquisitions and a lift in same-store sales growth are the most likely catalysts to stem the losses and re-rate the share price. Other acquisitions are expected, but the market probably wants to see Retail Food digest what it already has, rather than take on more franchise systems.

Retail Food Group is no Domino’s. But nor is its valuation. Its PE is less than a quarter of Domino’s forecast PE of 43, according to consensus estimates. Domino’s deserves a massive valuation premium, but its PE is too high for value investors.

Collins Food, owner of KFC and Sizzler restaurants, also looks fully valued after share-price gains this year. Retail Food, in contrast, appears undervalued and is trading near price support levels on its chart, using technical analysis. If it can hold above $4, traders might expect a bounce in its share price when the broader market stabilises.

Capitalised at $671 million, the small-cap stock suits experienced long-term investors who can tolerate higher risk.

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at September 30, 2015.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.