I recently braved a giant shopping centre for some last-minute Christmas shopping. Even worse, I went to the food court, having missed breakfast. I counted about 20 fast-food outlets. My guess is about a quarter of all food-court patrons waited outside one store: KFC. The crowd was so large it blocked traffic.
Like or loathe it, KFC is popular with its target market. So, too, is Collins Foods, owner of KFCs in Australia, after its upbeat first-half financial year 2024 result.
As dozens of customers waited for their KFC box or bucket, I noticed a few things. First was the number of people ordering food online rather than at the counter.
Second was the speed of order fulfilment. As nearby competitors mostly took and fulfilled orders manually, this KFC store was like a food factory in top gear as staff shovelled food sitting in warmers into boxes and customers’ hands.
From a share market perspective, I thought about the impact of technology on fast food and how it’s creating a larger competitive advantage for Collins Foods and Domino’s Pizza Enterprises – this market’s largest fast-food stocks.
I see KFC and Domino’s increasing their competitive advantage this decade over smaller rivals, in terms of product value, menu innovation, brand and speed.
The KFC I watched busily combined all sorts of sides into lunch boxes, no doubt increasing the average customer spend and profit margin. Domino’s, too, is cleverly selling more sides in its specially designed pizza boxes.
Clearly, their customer base wants menu items that sample multiple food offerings. That takes smart technology and food-production processes to deliver.
Readers of this column know I have long favoured Collins Foods. I haven’t covered Domino’s for a while, partly because the stock looked massively overpriced when it traded above $150 in October 2021. Now at $56.63, Domino’s has been one of this market’s mid-cap disappointments over the past few years.
I have long thought the market underestimated Collins Foods’ defensive qualities. Yes, people cut back on discretionary spending when living costs rise. They also downgrade from pricier food options to cheaper ones that offer better value.
As the full effect of rising interest rates bites next year, more people will get their fast-food fix through cheaper takeaway options rather than casual-dining restaurants. That’s good for KFC and Domino’s and their budget offerings.
It won’t be all smooth sailing for fast-food operators. Stock selection is paramount. In New Zealand, Restaurant Brands (owner of KFC outlets there) has torched investors in the past year. I can’t get excited about RBD, even at these levels.
Still, in 2024, with interest rates in Australia having probably peaked, and employment remaining strong, consumers might be less likely to give up their fast-food treats.
Against that, rising food, energy and wage costs will be headwinds for fast-food operators, including Collins Foods and Domino’s, for some time.
Longer term, the trend towards healthier food is a challenge for KFC and Domino’s, neither of which has seriously followed McDonald’s lead to introduce more healthy-food options on their menu. Here is a snapshot of both stocks:
- Collins Foods (ASX: CKF)
The Brisbane-based company operates 275 KFC restaurants in Australia, 16 in Germany and 56 in The Netherlands. Collins also operates 27 Taco Bell restaurants in Australia, after reintroducing the brand here in 2017.
Collins’ KFC Australia business is the main game, delivering about 75% of revenue. KFC Europe delivered 21% and Taco Bell Australia added the rest.
Higher margins were a highlight of Collins’ FY24 interim result. A margin of 20.2% was 37 basis points higher on the same time a year ago. That’s a good result given the negative impact of higher commodity, energy and wage costs.
The increase in margins reflects pricing power – a key reason I have like Collins Foods. Customer loyalty, brand recognition and high product value create latent pricing power and the ability to pass on higher costs with the KFC brand – to a point.
Combine that with economies of scale, online ordering technology and e-marketing (through the KFC app) and one can see how Collins Foods is expanding its margins in a ruthlessly competitive fast-food market and high-inflation environment.
To put this in perspective, Collins grew revenue by 14.3% in a slowing economy that was buffeted by interest-rate rises. It also expanded margins when input and wage costs rose – and consumers supposedly could not handle price increases.
That demonstrates the resilience of the KFC brand and also superb execution by Collins Foods’ management in challenging conditions.
Not surprisingly, the market loved the result, driving Collins Foods sharply higher in late November. Collins’ current price of $11.88 is in line with consensus analyst price targets, suggesting the stock is fully valued.
I’m a bit more bullish and expect continued earnings growth as Collins’ European operations expand and as its Taco Bell outlets gain more traction. The Taco Bell brand has failed a few times before in Australia, but it’s a proven concept overseas and the timing here is much better for the Mexican food chain.
After its share-price rally – and the rally in Aussie equities generally in the past few weeks – Collins is due for a share-price pullback or consolidation.
Prospective investors might watch and wait for better value when this Santa Claus share market rally eases. Any significant price weakness would be a buying opportunity for long-term investors in one of this market’s best-run small-cap companies and strongest food brands.
In 2024, I expect Collins to test and break through its price high from late 2021. No stock rises in a straight line, so expect some pullbacks along the way.
Chart 1: Collins Foods
- Domino’s Pizza Enterprises (ASX: DMP)
I’ll cover Domino’s in more detail in this column next year. But suffice it to say the stock looks more interesting than it has in a long time.
In the past few years, Domino’s has blemished its strong long-term performance for investors. A three-year annualised total return (including dividends) of -10.4% crushed the true believers in Domino’s. The stock ran too far, too fast.
Domino’s was crunched by rising inflation and more people eating out as COVID-19 restrictions lifted. Soaring energy costs, rising wage bills and higher food input prices squeezed Domino’s margins.
But for all the short-term pain, Domino’s long-term growth story remains intact. The business has significant scope to increase its store base in Australia and especially in the fragmented European pizza market. Some analysts believe Domino’s could double its European store base this decade.
Domino’s brand and scale are formidable competitive advantages. Operating one of the largest global pizza franchises means Domino’s can vastly outspend smaller rivals on product innovation, technology and brand.
I never bought the hype that Domino’s had become a ‘technology stock’ (which demanded a sharply higher valuation). Nor did I believe the bears’ view that Domino’s is a mature business. Across its three key regions, Domino’s should be able to deliver double-digit annual sales growth through store openings and same-store growth this decade.
Some investment banks have 12-month price targets of around $80 on Domino’s, suggesting the stock is materially undervalued at the current $56.63.
I’m not as bullish. Morningstar’s fair value for Domino’s of $68 a share looks more realistic. In my view, Domino’s is undervalued, though not excessively so.
Still, as small- and mid-cap stocks return to favour in 2024 – and as inflation and interest-rate hikes abate – Domino’s could head higher again next year.
Many short-term challenges remain, but Domino’s has a valuable long-term position in its market, a growing global footprint and scope to open many more stores. And, most importantly, a more realistic valuation.
Chart 2: Domino’s Pizza Enterprises
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 18 December 2023.