Jenny Ruth: Striving to overcome disappointment

COMMENT

Disappointing the market is nothing new at Restaurant Brands. So there was some relief when the company maintained its first-half dividend, despite the net result falling.

The fast food operator will pay out a little more than its net $4.3 million profit for the six months to September 8, with directors saying that's because they are "confident of a stronger profit performance in the second half". They are predicting it will match last year's second half.

But, as foreshadowed in the second-quarter sales figure, the result was nearly 15 per cent down on last year's first half, despite a 4 per cent increase in sales.

Each division has its woes and challenges, particularly the company's main profit engine, the KFC chain. Its ebitda (earnings before interest, tax, depreciation and amortisation) profit margin fell to 15.1 per cent of sales from 17.4 per cent in its last financial year and from 20.4 per cent the year before that - every percentage point of margin at KFC is worth about $1.75 million a year. That helps to explain KFC's 12.5 per cent drop in ebitda to $14.3 million. Another worrying sign is that KFC's sales were also down 1.6 per cent.

The other big problem area, the Pizza Hut operations in Victoria, contributed a $300,000 ebitda loss. While that was down from the $500,000 loss in the first half last year, it's a far cry from the company's expectation when it bought the business in early 2002. Then it said the business would be cash positive in the first year and start contributing to profit in the second year.

The smaller Starbucks coffee house chain saw same-store sales drop 6.1 per cent, suggesting that all that opening new stores is achieving is cannibalising existing sales.

The star performer was the Pizza Hut New Zealand operation, which lifted ebitda 25.4 per cent to $6.7 million.

The big worry there is that the arrival of the Australia-based Domino's pizza chain, with six stores opened and 60 planned over three years, will erode margins. There were signs of margin erosion, down to 14.8 per cent from 17.1 per cent in the second half of last year, but that higher performance was probably unsustainable. The margin in the first half last year was only 12.9 per cent.

The company is discounting this competitive threat.

Then there's the fact that it is grappling with all this with a new management team since former chief executive Jim Collier left suddenly in July, followed by chief operations manager Noel Dempsey and KFC general manager Chris O'Reilly.

Their departures might end up being a good thing. The market had clearly ceased to trust the old management team, having been twice around the rollercoaster.

After the company's shares listed in mid-1997 at an issue price of $2.20, they sank as low as 64c in 1998. From there, it was a slow grind back until in early 2002 the shares had nearly clawed their way back to the issue price (there had also been a one-for-12 bonus issue in 2000).

The company had largely won back the market's faith and had been boosted by AMP building a nearly 20 per cent stake.

Then came the Australian purchase. The collective view was that Collier was an Australian and knew the market there and the fast-food business.

A view perhaps not held by everyone. AMP sold half its stake in May that year, before the bad news that Australia wasn't going to plan started rolling in.

The shares slid to $1.22 late last month, although they have since recovered to $1.34. That's way below analysts' valuations, indicating just how disenchanted investors are. Forsyth Barr analyst Jeremy Simpson values the shares at $1.69 and Warren Doak at Macquarie Equities is slightly more optimistic at $1.76.

He says that's conservative, assuming no growth for KFC's earnings and that Pizza Hut's margins will erode due to the Domino's competition.

While AMP has held on to its 9.8 per cent stake, most other institutions have long departed the stock.

Tower Asset Management is an exception, as analyst Paul Robertshawe acknowledges.

"Basically, the market doesn't believe the cash flow valuation is achievable because each of the divisions is facing issues. It's a hard story to tell and sentiment's gone massively against the stock."

But while he waits to see if the new management team can turn the company around, the company is still delivering a high dividend yield, 11.2 per cent with the stock at $1.34, Robertshawe says.

The company's response to the recent departures is to have Vicki Salmon, who has been a director for six years, step in as acting chief executive (she's also a contender to permanently occupy that position), to move Rod de Vries from running Pizza Hut in New Zealand to running KFC and to move commercial services manager Russel Creedy to running Pizza Hut.

Salmon said much of de Vries' 13-year career with the company had been spent at KFC and that Creedy had been with the company three years. He hasn't and won't be replaced as commercial services manager because most of the company's major contracts have been renegotiated.

This includes KFC's chicken contract. Tegel is the company's supplier but from July next year the company will change to Inghams with a $5 million a year cost saving, providing hope that some of its recent margin losses can be clawed back.

Salmon said Inghams had developed "some very innovative products" in the snackfood area which her company would be able to take advantage of. "We own dinner time. If you go into our stores around dinner time, it's busy." But it didn't "own" lunch time, largely because of a lack of suitable snack-type products.

A worrying issue the latest results revealed was the company's comment that a "gourmet" pizza promotion in Australia was one reason for its continuing losses.

Restaurant Brands bought much of the Victorian business from receivers and it was very rundown. But it isn't the only Pizza Hut franchisee in Victoria. Salmon said it had about 80 per cent of that market.

But it would be very difficult for Victoria to go it alone on the marketing front because of the way the media works in Australia, so all the Pizza Hut marketing is run through a nationwide co-operative.

Not only did the "gourmet" promotion not work anyway, but Restaurant Brands' operations were poorly placed to run it. "We were probably doubly hit," said Salmon, but she insisted it would not happen again.

Restaurant Brands is now much more involved in the co-operative, although she acknowledged this still didn't give it the same control over marketing as it enjoyed in New Zealand, where it was the sole franchisee of its brands (owned by US multinational Yum Brands).

Of the company's woes, Salmon said: "We've had some operational issues. We've made two major acquisitions, both of which took longer to do than we thought. Probably we were overly optimistic about how long it would take."

Eagle Boys in New Zealand was the other and Salmon said this had been "tremendously successful". She also counted among the company's successes the turnaround at Pizza Hut, which had been "a very old-fashioned, run-down brand", transforming it from the old "red roofs" restaurants into "delcos" or home delivery outlets.

She also counted the introduction of the now 35-store chain as a success, noting that it had been built up with practically no marketing. Rather than stand still with two brands in one market, it now had three brands in two markets.

"The issue with our market is we have a very short-term focus. They expect you to buy a business and in six months' time it's all going to be making extra profits."

As for the future, "We've got some very good people. We just need to be more consistent about running the business every month."