Geared-up Collins has places to go

Many listed companies remain all cashed-up and lowly geared, and they’re happy to stay that way.

Corporate Australia followed global peers in shedding debt during the global financial crisis, and fear has prompted some managers to batten-down the hatches and fatten up their balance sheets by accumulating cash.

Average cash balances for the 500 stocks in the ASX All Ordinaries Index surged 23% over the past year to a record $325.4 million, while the average net debt-to-equity remains at roughly half the levels reached in the three years prior to the global financial crisis.

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But those companies willing to take on debt– and that can demonstrate they can manage it well – could enjoy a re-rating. And that’s why embattled Collins Foods (CFK) is being re-rated by analysts, with the restaurants owner and operator having taken on debt to break out of its slow growth trajectory and accelerate its expansion across Australia.

When I first highlighted Collins Foods as a “buy” in an August 7 article (The next dividend dazzlers) when the stock was trading at $1.76, there were very few brokers who saw the same potential in the business as I did. The overwhelming majority polled on Bloomberg had a “hold” rating on the stock.

Now all five brokers are encouraging investors to buy the stock and BBY became the sixth when it initiated coverage on the stock last week with a “buy” recommendation.

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Collins Foods, which owns KFC and Sizzler restaurants in Queensland and New South Wales, is betting big on growth with the group increasing borrowings by nearly 60% to $164 million to fund the purchase of the largest KFC franchisor in Western Australia and Northern Territory.

The $55.6 million deal to buy Competitive Foods will see Collins Foods’ KFC store network expand by around a third to just under 170 stores and add around $110 million to annualised revenue before synergies and store improvements.

The WA and NT KFC outlets are less profitable than those in Queensland as they typically generate an earnings before interest, tax, depreciation and amortisation (EBITDA) margin of around 8%, which is a little more than half of what Collins Foods can get at its current stores. Management plans to lift margins in WA and NT by 2 percentage points over the next few years.

However, its entry into WA and NT represents a new and material growth corridor for the group as both states have only light coverage. This means Collins Foods can roll out more KFC outlets without fear of cannibalising on existing stores.

This makes the current financial year ending April 2015 a year of transition for Collins Foods, as management will be bedding down the acquisition and aggressively expanding its stores footprint.

Capital expenditure is tipped to surge 60% to around $33 million in 2014-15, and will hover at just under $30 million the following year.

It’s not only the opening and refurbishment of KFC stores that will weigh on cash flows. Management also is trying to turnaround the underperforming Sizzler Restaurant chain, which suffered from years of neglect under Collins Foods’ private equity owners prior to its poorly received float in August 2011.

Even though many of Collins Foods senior managers and board members have decades of experience in the casual dining sector, finding what strategies work for Sizzler has been a trial by error exercise. It’s interesting to note that advertising heavyweight Russell Tate – former chief executive of STW Communications Group (SGN) – is the chairman.

Management tried a number of things in 2013-14 and is now hopeful that it has formulated the right strategy, with performance at the pilot Cleveland restaurant in Queensland having exceeded expectations.

It’s early days yet and I think it would be a win if Sizzler could just hold revenue steady this financial year.

The other potential growth driver is the company’s small investment in Snag Stand, which serves gourmet hotdogs. Management paid $1.85 million for a 50% stake in the business and has high hopes that it will grow into an 80-store food chain in the coming years from its current five.

To be conservative, I’ve factored in the investment small capex requirement into my model but have not added any revenue from the business.

Further, I am only counting on a 4% to 6% growth in KFC revenues over the next few years, which should be achievable given new store rollouts and other operational improvements. This gives me a price target of $2.45 a share and this comes on top of a forecast 11.25 cent a share dividend in 2014-15.

More importantly, Collins Foods should be able to grow dividends steadily for the next few years, despite fairly subdued organic growth in its business and high capital requirements to grow the business.

The fact is, Collins Foods is a very cash generative business and that is the key reason for my “buy” recommendation last year.

However, the capital intensity and higher debt repayments will leave less room for mistakes. The risk to dividend growth is higher now, although its 7%-plus yield (including franking credits) should appease income seeking investors and appeal to those looking for earnings growth. 

I reiterate my “buy” recommendation with a “medium” risk rating to reflect the relatively defensive nature of the industry and management’s recent track record.

To see Collins Food's forecasts and financial summary, click here.

Update

STW Communications (SGN) is following much in the same footsteps by leveraging up its under-geared balance sheet to purchase retail marketing firm Active Display Group (ADG).

The purchase is expected to add 21%, or $97.8 million, to STW’s revenue in 2015. This means the group’s top-line is now expected to jump to $552.2 million, although earnings before interest, tax, depreciation and amortisation (EBITDA) margin is expected to fall as ADG’s margin is smaller than STW’s overall margin.  

That’s mainly due to the nature of ADG’s industry. The target provides retail marketing solutions, such as the in-store marketing displays you see in supermarkets.

This is a higher growth but lower margin industry with ADG enjoying a 20% compound annual growth rate over the past five years. ADG is regarded as the leading player in this field.

Post acquisition, STW will have a net debt-to-equity of under 20%. What’s more important, the purchase could give management greater scope to lift dividends, although I prefer to err on the side of caution and leave my dividend forecast unchanged until 2015-16.  

As I pointed out on June 4 (A hidden high yielder), the stock will appeal to income seeking investors as STW is expected to yield close to 10% (including franking credits) in 2014-15.

I have also lifted my price target by 10 cents to $1.70 a share. You can see the updated forecasts and financial summary here.