Should you take a bite of Sapphire Foods IPO?

Close on the heels of the market debut of Devyani International, Sapphire Foods, another operator of KFC and Pizza Hut outlets as a non-exclusive franchisee of the Yum! brand is coming out with its IPO on November 9. In Devyani’s case, with debt to equity ratio of 6.5 times as of FY21, the company was looking to repay some of the borrowings from the IPO proceeds. Sapphire Foods has a lower debt to equity ratio of 1.82 as of FY21 and the IPO is entirely an offer for sale for about ₹2000 crore, with promoters and other investors looking to make a partial exit when the market conditions are conducive. Sapphire’s valuation is reasonable compared to peers. The company is valued at a market cap to FY21 sales of around 7 times at the price band of ₹1120 – ₹1180. Devyani was valued at 9.5 times at the time of its IPO, which has now risen to 15.5 times. The stock has gained about 60 per cent since the IPO. Peers such as Westlife Development (Mc Donald’s) trades at 9.3 times its market cap to sales. Burger King and Jubilant FoodWorks (Domino’s) trade at 12.5 times and 15 times respectively.

However, Sapphire’s financials don’t inspire confidence. The company was loss-making in FY19 even before the onset of Covid and continues to be so. While a young population and increasing urbanisation spells good for QSRs (Quick Service Restaurants) in India, the need to keep expanding and at the same time remain profitable is a challenge for most players.

What will make the business steadily profitable is strong same store sales growth (SSSG) and ability to control costs. While Sapphire has been taking measures for cost reduction, the benefits are yet to show up in the financials meaningfully. Long-term investors can wait and watch the progress on the path to profitability before taking exposure to the stock. We had recommended that long-term investors stay away from the Devyani IPO too, though the current bull market conditions as well as a Covid situation, appearing to be under control, has fuelled the stock since its listing in mid-August.

Weak financials

Of the four listed peers, only Jubilant has been making profits continuously in the last three fiscals. Sapphire posted losses in FY19 to 21, with losses expanding from ₹69.4 crore in FY19 to ₹159.07 crore in FY20, impacted by provisioning of ₹2.6 crore for obsolete inventory (predominantly food items which are perishable in nature) as well as impairment loss on goodwill in the Pizza Hut business to the extent of ₹91.7 crore. FY21 witnessed a loss of ₹99.8 crore.

In the last three fiscals, operating margins were the highest in FY20 at 13.8 per cent but has been at 12.2 per cent in both FY19 and FY21. In comparison, Devyani’s margins have been much higher at 16-21 per cent during these three years. The Pizza Hut stores (22 per cent of revenues) are a drag on the margins with restaurant level EBITDA in mid- to high single digits, while the company’s Sri Lanka business (19 per cent of revenues ) and KFC (58 per cent of revenues ) enjoy higher margins.

Cost control efforts

There is an agreement with Yum to open a certain number of KFC and Pizza Hut outlets over the years. Accordingly, the company added 141 outlets from FY19- FY21 in India (it closed down 38 outlets in this period). Though new stores shore up revenues, same store sales growth (SSSG) is a better determinant of efficiency. In this context, SSSG for KFC has come down from 13.9 per cent in FY19 to minus 30 per cent in FY21. This trend of falling SSSG is true of Pizza Hut (5 per cent in FY19 to minus 35.4 per cent in FY21) as well as Sri Lanka Business (8 per cent in FY19 to 1 per cent in FY21).

While part of this drop can be attributed to the pandemic, the point to note is that Sapphire had displayed weak SSSG vs peers operating in India even in FY19, a normal year. Burger King, Westlife and Jubilant showed SSSG of 29.2 per cent, 17 per cent and 16.4 per cent respectively in FY19. To its credit, Sapphire’s SSSG numbers in FY19 were better than Devyani’s.

In an effort to prune costs, Sapphire has been focusing on bringing down its store size as well as increasing its delivery revenues. From FY19 to FY21, average restaurant size for both KFC and Pizza Hut has come down by 39-40 per cent and the capex requirement for the stores have also reduced by 17-18 per cent. From 21 per cent in FY19, delivery format stores brought in 42 per cent of revenues in FY21. Delivery as a percentage of restaurant sales is higher for Pizza Hut stores than for KFC. It is worth watching if margins shore up over the medium-term due to these efforts.