Ibersol: It’s Okay to change your favorite pizza

Some of you might remember my older writeups and portfolio holding Kotipizza, the biggest national pizza chain in Finland.

I have sold my shares few months ago (with about zero gains since the last writeup, not one of my best recommendations…).

The reason was that Kotipizza decided to move on multi-concept strategy. I thought it was not good move as the Kotipizza brand has unique position in Finland (original deeper writeup here) and the new brands have not.

Why move from position of competitive advantage to where you have none? Restaurant business is hard so I couldn’t emotionally handle the 21x trailing P/E anymore as I expect higher costs, more explanations for “non-recurring items” and higher probability for operational disappointments in the future.

Recently, I stumbled on Ibersol, which is Portuguese fast food restaurant and coffee shop chain with 10x P/E multiple and potentially good replacement for Kotipizza in my portfolio.

(Note that the article is based on 10.85 EUR/share stock price when most of it was written vs. the 12.25 EUR/share stock price currently, but I think the conclusions stand.)

Introduction

Ibersol’s business is quite simple and consists of 504 owned and 142 franchised restaurants divided into three main types:

1) International brands: Burger King, Pizza Hut and Kentucky Fried Chicken restaurants through master franchise or franchise contracts in Portugal, Spain and some in Angola

2) Concessions and catering: Various own and franchised coffee shop, restaurant and catering businesses located in airports, railways, motorways and other venues in Portugal and Spain through concessions

3) Local brands: Own Pans & Company sandwich concept and other local own or franchised coffee shops and restaurants in Portugal and Spain

Financials

Ibersol has good long-term growth track record with ~10 % revenue CAGR:

In last five years, Ibersol’s revenues and profitability have grown significantly, explained partly by recovering economies in Portugal and Spain partly by acquisition in end of 2016:

Ibersol_income statement

On longer term chart, Ibersol’s EBITDA is now higher than in pre-crisis year, both organically and through M&A:

Ibersol EBITDA

The long-term EBITDA growth is pretty solid 10 % CAGR, in line with the revenues, but the dip in 2010-2014 shows that this is not cycle free business.

In the crisis years, Ibersol’s capital returns dropped quite low, but in current more normal environment ROIC, TROIC and ROE figures are back to solid levels (seen in the more normal 2008-2010 years):

Ibersol_ROE

With the solid profitability and cash flow dynamics in last two years, Ibersol has been paying back acquisition related debt very fast (27 meur reduction in 2017 vs. 81 meur net debt in end of 2017 and 330 meur market cap):

Ibersol_Balance sheet

There is still decent amount debt left which will provide some boost for the equity returns in the future (assuming things go well).

Ibersol’s growth is based on opening new restaurants. The organic restaurant openings are back on growth track since 2015 and was boosted by acquisition in end of 2016:

Ibersol restaurants

According to this article, Ibersol has plan to open 36 new restaurants this year vs. the 646 restaurants currently (the openings include 26 Burger Kings, 3 Pizza Huts, 7 drive through KFCs and central kitchen for their catering business).

I don’t know how many restaurants they are planning to close but it seems that the plan is to continue on the gradual growth track.

In addition to the new restaurant openings, Ibersol has newish growth cell in Angola with 10 restaurants. Longer term plan is to grow there significantly as the region develops and if the business gets good traction.

In addition to the gradual growth from new markets and new restaurant openings, the recovering economies “should” provide nice tailwind for growth at least near term.

Ibersol_Market

Valuation

Given the growth and quality dynamics valuation multiples look quite low:

Trailing P/E 10x

Trailing P/FCF 10x

Trailing P/FCF ex. growth capex 6,5x

If the future growth would resemble the historical growth and the debt reduction continues compound equity value, the current 10x P/E is clearly too low.

As the management seems solid and not hostile to minorities, and the debt level manageable, the explanation for the low valuation should be in the business or growth prospects.

Segments

In official reporting, Ibersol has three segments; Restaurants, Counters and Concessions&catering.

But as the Restaurants and Counters segments as separate entities include various mix of international and local brands without much logic which belongs to where and why, I have lumped them together  to “Restaurants and counters” segment for simplification in the table below and for rest of the analysis.

The concessions and catering is shown as reported:

Ibersol_business2

From the table it can be seen that the Restaurant and counter segment is 69 % of the revenues and Concessions&catering 21 % but let’s go through them one by one to find if there is potential problems in any one of them explaining the low valuation multiple for Ibersol.

1. Restaurant and counters segment

I think that the segment is best thought as having two sub-segments with differing trends, namely the International brands and Local brands.

1.1 International brands

The international brands segment consists Burger King, Pizza Hut and KFC restaurants through master franchise and franchise contracts.

They are Ibersol’s main business with 48 % revenues:

Ibersol_revenues_international

The international brands business is the only segment with clear growth trend in restaurant openings:

Ibersol_international restaurants

The profit per international brand is not known but as;

1) all international brands are opening new restaurants, and

2) the official Restaurant and Counter segments are both nicely profitable with 7-10% EBIT margins, and

3) majority of the restaurants and counters segment’s revenues (~70 %) comes from the international brands,

I conclude that the international brands business doesn’t seem to have operational or profitability problems.

Restaurants and counter segment’s profitability (that I lumped together in the table earlier):

Ibersols_segment_restaurant and counters

One potential problem explaining the low multiple would be that the international brand business is focused on “junk food” with potential market expectation that they are under threat from healthier alternatives.

But if you look at Domino’s, Papa John’s or McDonald’s P/E multiples, they are hardly indicating wide-spread market expectation of “death of junk food”:

McDonald’s 21,6x

Domino’s UK 21,5x

Domino’s Inc 35,0x

Papa John’s 22,9x

With Ibersol’s 10x P/E-multiple, the death of junk food threat, if any, seems to be pretty well priced in. Bigger potential problem would be ending of the franchise contracts.

The Burger King master franchise contract (or similar territorial right) started in 2001 in Portugal but the contract was renewed in 2015 to last until 2035.

The Spanish Burger King business started in 2006 through acquisition of second largest Burger King franchisee in the country (note that this is not master franchise but normal franchise). There is no information how long the franchise contracts are but my impression is that the normal franchisee contracts are more or less going concern as long as performance is acceptable.

The KFC and Pizza Hut businesses in Portugal, which I think are conducted through master franchise contracts or similar territorial rights, started in the 1996 and 1989, respectively.

It’s known that the Pizza Hut and KFC contracts are 10+10 years so their contracts have probably been renewed no later than 2016 and 2009, for otherwise the 10+10 year contracts (starting in 1996 and 1989) would have already ended (couldn’t find verifying information though).

If my contract renewal date estimates are correct the KFC and Pizza Hut contracts would be ending in 2036 and 2029 and thus indicate that there is no immediate problem with ending of the contracts.

There’s no (material) Pizza Hut or KFC business in Spain so ending of their contracts are not the problem either.

The management’s general comment on the franchise contract renewal risk is that;

“It has become practical for these contracts to be renewed.”,

but with following caveat;

“However, nothing obliges the franchisees to do so, so the risk of non-renewal may be verified.” .

So the management thinks that, yes, there is contract renewal risk, but that they have been historically renewed and that the risk is not highlighted as big one.

Management doesn’t seem to be worried about the Burger King, Pizza Hut or KFC contracts ending as it has plan to open total of 36 new restaurants this year, on top of the existing 284 existing ones.

The damage for valuation would obviously be big if some of the big contracts would end soon without high probability of renewal but I haven’t found much evidence of that scenario.

Profitable operations, growing business, long outstanding franchise contracts, long operating history starting from 1989 and no obvious other problems would indicate that the international brands is not the likely candidate explaining the low valuation multiple for Ibersol.

How about the other segments?

1.2 Local brands

Ibersol’s second major business is Local brands which includes about half a dozen own and franchised restaurant and coffee shop concepts that are more local national brands in Portugal and Spain and represent about 21 % of revenues:

Ibersol_revenues_local

In aggregate, total number of restaurants has come down from 287 to 258 about year ago:

Ibersol_local restaurants

Looking at the brand level restaurant numbers, essentially all of the local brand concepts have more or less slowly reduced number of restaurants, so there is clear problem here.

One of the biggest contributor to the local brands business is Pans & Co sandwich which has 52 MEUR sales, about half of the “Local brands” segment. It’s also one of the main contributor to the decrease in the number of restaurants, they have come down from 159 to 147 in a year.

The declining trend, however, seem to have stopped in Q1’18 as there was no net closures anymore and even opening of one new one.

Management says that Pans & Co is in “remodeling phase”, and for now the net closures seem to have stopped, so the longer term downward trend in the Pans & Co restaurant numbers might not be indicative of future trend anymore.

Other big contributors to decrease in the Local brands segment restaurant number is Santamaria, from 36 to 24 restaurants, and rest of the smaller concepts seems to be stable or decreasing one or two restaurants here and there.

It’s difficult to pinpoint the exact problem in the Local brands business because the decline in restaurant numbers is so wide-spread and there is no individual brand level revenue and profitability data.

More over, due to acquisitions there is only one quarter of comparable segment data for the whole Restaurants and counters segment:

Ibersol_restaurantsandcounters

But as seen from table above, the Q1’18 revenues grew by 6,3 % and EBITDA 5,5 % so it seems that the growth in the International brands is offsetting the decline in the Local brands and thus indicating that the decline in the Local brands doesn’t matter too much.

More over, if the Pans & Co decline has stopped as the Q1’18 numbers would indicate, basically brands contributing 87 % of the Restaurant and counters segment’s revenues would be either growing or stable (i.e. the International brands and Pans & Co), leaving the problems in the other Local brands almost immaterial to the profitability numbers.

From valuation perspective, this is good news because it would imply that despite some problems the Restaurant and counters segment as a whole is growing and thus multiples assuming no growth in the segment would not be warranted.

Concession and catering

The concession and catering business is the second most important business with 31 % of the total revenues:

Ibersol_revenues_concessions.png

It operates 103 restaurant and coffee shops mainly in airports but also in railways, motorways and other travel/venue locations in Spain and Portugal through 20+ own or franchised brands.

It’s peculiar business as restaurant in airport and railway stations are basically permission to print money as the people in the locations are typically on vacation mood, hungry, thirsty, in hurry, late, pissed off or not paying the cost by themselves (business travel), so they have loose wallets.

The value is how ever on the location, not in the restaurant brand, and thus the rents are high and based mainly on bidding contests for fixed time periods (about 5 years at the time according to my superficial understanding), at least in the airports which is most of the concession and catering business (about 70-80 %).

The segment report confirms that the “concessions and catering” business is nicely profitable with 7 % EBIT margins:

Ibersols_segment_concession

The concession and catering business has net closed about half a dozen restaurants in last year:

Ibersol_concession

The closures could be a sign of problem or it could be normal churn:

Problem, if the downward trend continues,

Churn, If I’m right about the ~5 year concession periods, as then nature of the business is constant bidding contests and contract renewals, occasionally winning and occasionally losing some.

From management commentary it can be found that on the one hand at least some restaurants will close in Barcelona airport in the next quarter (potential sign of the trending problem), and on the other hand that they will open new ones somewhere else (potential sign of the normal churn), and that their plan is to grow and participate in the bidding contests in the future (other sign of the normal churn).

While the net effect of the announced wins and losses to future restaurant numbers is uncertain, and the recent trend in restaurant number is down, the revenues for the concession and catering business rose 5,5 % and EBITDA 7,7 % in Q1’18 (first fully comparable quarterly figure):

Ibersol_concessions

It seems that the recovering market, especially foot traffic in the airports, has been able to offset the effect of closures, so there is no immediate sign of problem in the business.

Future will tell is the downward trending restaurant number problem or just temporary, from managements commentary it seems more or less business as usual (but from managements commentary, everything always is).

Conclusion

So there is some clear problems in Ibersol’s business. Restaurant numbers have come down in the Local brands and Concessions & Catering business, which is quite bearish evidence against Ibersol as together they represent more than half of the outstanding restaurants.

But somewhat strangely, despite the decline in number of restaurants, the revenues and profits for Ibersol group are growing (Q1’18 numbers, first year with full comparability):

Ibersol_Group_q1

This is probably explained by the growing International brands business, recovering markets and potentially closures of loss making restaurants, all very positive developments.

I think the main question is, with 10x P/E, should one believe the declining trend in number of restaurants or the growth in revenues and profits?

My thinking is that the bull case requires that;

1) Decline in Local brands’ number fo restaurants, especially in Pans & Co, is temporary or immaterial

–> I think this might be true given the stable Pans & Co number of restaurants in last quarter and growing revenues and profits in the Restaurants and Counters segment in general

2) Decline in Concession & Catering number of restaurant, explained by net closures in airports, is normal churn and the business will start to grow or at least stay stable in the future

–> I think this might also be true as per announcements there will be new openings  coming in the future, there is strategy to participate in further bidding contests and that the nature of business seems to be constant bidding contests indicating expectation of some natural variation in the number of restaurants

3) International business remains on growth track and there is no major risk in franchise contract renewals

–> The segment numbers back the growth story and long historical cooperation with the main franchise partners combined with the indication of long franchise contracts indicate that this assumption is also probably ok too

4) Portuguese and Spanish markets continue to recover, at least doesn’t collapse again

–> Managements guidance and recent trends point for market growth so no problem in this one

So in short I think there is enough evidence or green shoots of evidence that all those boxes tick so I’m turning to the bullish side in this case.

More over, it should be reasonably easy to spot if the situation changes in any of the parameters and to sell the stock.

And for reminder, historically Ibersol has been “compounder” type of business, as seen from the long-term EBITDA growth chart shown earlier:

Ibersol EBITDA

I think that’s a chart with not totally insignificant pattern as we are speaking of the 10x P/E multiple here, which implies that there is nothing of that sort expected in the future.

History shows that Ibersol has grown few times with bigger acquisitions (2006 in Spain to the Burger King business and 2016 the EOG), which could very well be repeated in the future years, especially as the net debt decreases with so fast pace.

Combined with the other growth initiatives (International brands and Africa), the historical tendency for acquisition is for me another bullish element for the stock.

If the growth and debt reduction continues, as Q1 trend would indicate, and if the current growth initiatives succeeds, and if there is bigger acquisition in the future, in that case, the current multiples would prove to be true bargains for equity claim holders.

ps. I started the post with criticism against Kotipizza’s new multi-concept strategy. Now I’m saying that I’m bullish on Ibersol’s multi-concept strategy. The difference is that Ibersol’s concepts have proven long-term track records, as opposed to Kotipizza’s new concepts that are anybody’s guess, and of course the 10x vs. 21x P/E multiple

Disclosure: Long Ibersol with 6 % position

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