Execution critical for Retail Food Group

Since we last wrote about Retail Food Group, the Australian multi-food franchise operator has entered into a joint venture in China, released its first-half result for FY15 as well as settled the Di Bella Coffee acquisition.

The Company delivered a solid interim result, which was largely in line with expectations (after adjusting for one off items).

It was the first insight into how the business is digesting the significant acquisitions made in late 2014. These acquisitions included Gloria Jeans Coffee, Cafe2U and Di Bella Coffee.

While initial indications suggest that things are on track, the first real test of the success of these acquisitions will become clearer at the FY15 result later in the year.

A brief recap on RFG

Retail Food Group is one of Australia's largest multi-food franchise operators, with well-known brands such as Donut King, bb's café, Michel's Patisserie, Esquires Coffee, Pizza Capers, Crust Gourmet Pizza and the Coffee Guy.

The Company was established in 1989, primarily to manage and develop the Donut King and bb's café Brand Systems, and since listing on the ASX in 2006 has been a consistent and successful acquirer of food related franchise systems.

The acquisition path continued in 2014 with the Company adding Cafe2U, Gloria Jeans Coffee and Di Bella Coffee to the stable. Together, these acquisitions significantly increase RFG's exposure to coffee along the supply chain.

1H15 reported earnings

The traditional businesses had mixed results. Donut King was the clear performer, delivering increases in revenue and earnings before interest, tax, depreciation and amortisation (EBITDA) of 10.8 per cent and 23.3 per cent respectively.

QSR, or the Pizza division, had a net increase in stores of 42, resulting in an 11.4 per cent increase in revenue against a relatively modest 7.1 per cent increase in EBITDA.

Michel's Patisserie, a key profit generator, increased revenue by a modest 1.5 per cent. Nevertheless, EBITDA increased 15.1 per cent on improved margin outcomes.

Brumby's continued to struggle. Total outlets decreased by nine stores when compared to the previous corresponding period (pcp) despite eight new commissionings.  Nevertheless, despite sales falling 10.2 per cent, EBITDA was largely unchanged at $5.7m – an impressive margin outcome.

The company reported ‘underlying' 1H15 EBITDA up 39.7 per cent on the pcp to $39.3m. However, underlying earnings includes and excluded a number of items.

Specifically, this number excludes $4.8m in acquisition costs, but includes a one-off $5.7m licensing fee and a $2.8m accounting adjustment. The latter relates to increasing the time frame of recognizing fees received for brand system access.

Adjusting for these items results in a statutory increase in reported EBITDA of 22.5 per cent to $34.5m.

Cafe2U and Gloria Jeans made their first contribution to earnings in 1H15. It is still very early days to gauge success or otherwise of the integration but management so far appears pleased with trading.

Returns decline but likely to improve

The key driver of RFG's earnings growth in recent years has been the numerous acquisitions undertaken. Since listing the Company has acquired Brumby's Bakery, Michel's Patisserie Brand System, Esquires Coffee, Evolution Coffee Roasters, Crust Pizza and others.

In order to fund these acquisitions, RFG has consistently raised capital in the equity market. This has been largely done by underwriting the company's dividend reinvestment plan, a small capital raising in 2010 and raising in excess of $100m over FY13/FY14 and $68m in FY15 thus far.

RFG recently underwrote their 1H15 DRP plan, which effectively raised an additional $13m. This was done at a price of $7.05 per share.

It goes without saying that raising additional equity capital reduces the proportional share of company earnings on a per share basis. As a result it is interesting to note that earnings, on a per share basis, have been broadly flat for the past 6 years despite the increase in gross operating profit.

When compared to 1H14, RFG delivered a decline in return on capital by 1.7 per cent; however, this largely reflects that recent acquisitions are yet to contribute a full period of earnings.

Outlook

Management increased its FY15 earnings guidance for net profit after tax (NPAT) to be $55m (previously $50m). However, this primarily relates to the $5.7m one-off licensing fee associated with the Chinese JV and is less about operational improvements of the business.

The current share price implies a 16.2 times price-earnings (PE) multiple for RFG's FY16 earnings per share (EPS) which compares to the S&P/ASX200 at 15.7 times.

This suggests that the current share price is already discounting the much of the potential success of the recent acquisitions. 

Considering that it would be unusual for an integration of this size to not have some stumbling blocks along the way and much of the success appears largely priced in, we retain a “hold” recommendation and price target of $5.78.