Junk food

For dedicated gourmands, too much of a flavour, cuisine or a mix of both can perhaps never be a bad thing. Which is why, in a perfect world, culinary concoctions such as dosa-flavoured pizzas — with Andhra-style chicken sprinkled on top for good measure — and vegetarian chettinad pizza would probably sell like — pardon the pun — hot cakes. Domino’s recently introduced the aforementioned fusion pizzas in the south and items such as Taco Mexicana and the Junior Joy Box — a ₹99-meal featuring a pizza slice, breadsticks, dessert and a toy that takes on McDonald’s’ Happy Meal — in other markets. To top it all, the master franchise for Domino’s Pizza and Dunkin’ Donuts in India, has introduced new ‘pizza theatre’ concept stores, where customers get to see the making of pizzas.

But for all its efforts Jubilant Foodworks is still  feeling the heat, as a prolonged economic downturn results in even the die-hard loyal customers opting to eat at home. With rising food inflation and aggressive expansion, the company is facing intense pressure on margins and a falling return on equity.

Jubilant’s stock, however, continues to trade near its multi-year high of ₹1,400, valuing the company at a whopping 67 times its last year’s earnings and 14 times its book value. These soaring valuations don’t seem to be reflecting the ground reality, which has worsened and is expected to stay that way for some more time. “Owing to rising input costs, all the players in the industry — including us — had to raise prices by around 14%. Additionally, we also had to pass on to the customer the 5% service tax the government slapped on us last year. Coupled with rising inflation and, hence, less purchasing power, this meant that our customers shied away from eating out,” says Ajay Kaul, CEO, Jubilant FoodWorks.

Low economic growth has hit companies and customers alike; most importantly, the consumer’s wallet has shrunk, compelling them to spend less on discretionary items such as pizza, which is understandable given that a pizza meal for two at a Domino’s outlet today could cost you around ₹800-1,000. To put things in perspective, Jubilant’s same-store sales growth (sales from its existing stores) — a key indicator in the retail and food services market — has plummeted from a high of 27% in early 2013 to -2.4% in the first quarter of FY15, just a shade better than the -3.4% it registered in Q4FY14 (see: No longer hungry). To add to its problems, Jubilant has to pay higher wages, incur higher rent and deal with the skyrocketing prices of key raw materials, which adds up to 25% of its sales. 

To counter this, the company took two price hikes — a 3% increase in June and a 5% increase in November. But, in the face of flagging demand, there is little scope to raise prices further. That apart, Dunkin’ Donuts — the result of a franchise agreement between the Masssachusetts-based Dunkin’ Brands Group and Jubilant FoodWorks in 2011 with the intention of tapping into India’s vast middle class market and a target of 500 stores in 15 years — is acting as a huge drag on Jubilant’s margins and profitability and is Ebitda negative. Not surprising, then, that the company’s operating margins have fallen by 400 bps from a peak of 19% in FY12 to 15% in FY14.

This further hit its profits, which dipped to ₹118 crore in FY14, as against ₹131 crore in FY13. Nothing much has changed since. In the first quarter of FY15, the company reported an 18.5% year-on-year decline in its profits to ₹27.7 crore (see: Leaving a bad taste). What is even more striking is the fact that over the years, the company’s return on equity has fallen from 42% in FY12 to the current 24%, which again is not a very encouraging sign from a valuations perspective. 

To be fair, Jubilant is not the only success story to have soured of late — its competitors, the Yum! Brands-owned Pizza Hut and McDonald’s have also been feeling the heat, faring worse than Jubilant on every measure of growth. The Kentucky-based Yum! Brands has seen same-store sales growth fall from 5% in Q4FY12 to -3% in Q1FY13 and, except for a quarter of positive growth of 2% in Q2FY13, the figures have remained negative. And McDonald’s’ same-store sales growth would test the conviction of even its die-hard supporters: in Q1FY14, same-store sales growth for the burger and fast food major fell from a high of 7.2% in the previous quarter to 0.5%, plummeting to -5.5% in the next quarter, before settling at -9% in Q1FY15. 

Short-term pain

But, as they say, when the times get tough, the tough get going. Even as the Street worries about growth and return ratios, the company is busy rediscovering ways to become more efficient and is laying out strategies that will have far-reaching results in the event of a recovery. Despite the slowdown, the company continues to expand its store count from 465 in 2012 to the current 772 Domino’s outlets across 154 cities, with an eye on a 1,016-store target for FY16. It also owns 34 Dunkin’ Donuts outlets across 34 cities and plans to add 25 more outlets by the end of FY15. The company’s stated objective is to set up 150 Domino’s outlets and 30 Dunkin’ Donuts stores annually. 

In the short term, this could mean a drag on its financials but the company believes that as the economy recovers and demand kicks in, it will have a large base of stores that will effectively have a huge impact on earnings. Besides expansion, the other key decision by the Jubilant top management has been to invest in back-end and supply chain infrastructure. Four new commissaries — warehouses that provide the raw material used in pizzas, donuts and burgers — were commissioned in FY14 at Hyderabad, Guwahati, Nagpur and Greater Noida. All but the one at Greater Noida are operational and even this last commissary will be onstream by FY16. The company is also strengthening contracts and ties with cheese and milk suppliers.

Spending to grow

Aggressive expansion has driven the numbers 

To further control its costs, Jubilant has undertaken a four-pronged internal approach to reduce costs and improve efficiencies. Firstly, it started a scheme under which employees across the country sent in suggestions to reduce costs and improve productivity, with a separate team deciding upon the merits of the ideas and charting out their implementation. Secondly, it ingrained a six sigma practice across all functions and extended this to its business partners. Thirdly, it provided both top and bottom line incentives to store managers to reduce costs and improve efficiencies. Then, because of its hub-and-spoke model of commissaries, it buys all its requirements in bulk, giving the company a price advantage and ensuring that the ingredient quality is monitored at the vendor, commissary and store fronts. Though these steps may not have visible results in the short term, they will enable the company to spread its reach and improve same-store utilisations and realisations, while improving the economics of the stores and helping the company make higher return on its investments. “We believe that the benefits of our portfolio revamp (the launch of 10 new pizzas and the Junior Joy Box) and store expansion will pay off once the recovery starts,” says an analyst at Prabhudas Lilladher who is tracking the company. 

Analysts feel that such moves have a two-fold effect. Some argue that the scorching pace of store expansion and the ensuing higher rentals and maintenance costs have played truant with Jubilant’s margins. To be sure, the management is aware that the Dunkin’ Donuts expansion will be a drag on the company’s overall margins by 150 basis points in FY15. But the consensus on the Street seems to be that by going in for store expansion, Jubilant is placing itself in an undefeatable position of strength, because when discretionary spending picks up, the new store roll-outs and the accompanying heavy promotional campaign will give the company good traction. Sunny Agrawal, analyst at Aditya Birla Money, sums up in a report: “We believe that the strategy of JFW to expand aggressively during a downturn and spend money behind brand-building and back-end infrastructure is a step in the right direction. Moderation in same-store sales growth is a temporary blip and Jubilant has a very robust brand and business model, which has immense potential to tap the opportunity in the rapidly growing organised QSR industry.”

No longer hungry

Consumer appetite has taken a knock following an increase in prices

The QSR industry in India is estimated at ₹13,000 crore as on 2013 and is expected to clock 20% CAGR over 2013-208. Jubilant currently has a 72% market share of the pizza home-delivery segment and 17% in the food services segment (Dunkin’ Donuts). So, even with increased competition, there is ample room for all players to grow. Offering an explanation about what went wrong with Jubilant and what is being done to remedy that, Kaul says, “We conducted a survey to find out where we were lacking and found that the emotional connect with all our brands was strong and customers still gave all our products a thumbs-up.” 

 Long-term gains?

Even though the company is doing everything that it can do to tide over the downturn and contain costs, a recovery in the economy and a revival in consumer spending will be crucial for some of these steps to really start contributing to growth. Says Jubilant’s CFO Ravi S Gupta, “There is a causality between GDP growth and discretionary spending; GDP is currently at 5% levels. Till 2011, unemployment was at 15% and we believe that it has come down further since then. Hence, because of a lack of spending power, discretionary spending has come down and affected our numbers.”

Just like others, the management too believes a cut in interest rates will spur growth and bring consumers back to pizzas. Not surprising, Jubilant is looking to open 150 new stores for Dominos every year. Gupta adds that most of Jubilant’s stores are profitable in the first month of operations and all stores have a payback of less than three years. “While rental costs have gone up, by opening more stores we are creating incremental profitability for our investors. As long as we can generate incremental return over the cost of the capital, we are doing fine.” 

Analysts also reckon that this is a short-term phenomenon and since the structural drivers of growth are in place, the company should do well in the long run. Manish Poddar, research analyst at Motilal Oswal, says, “Aggressive expansion in the past three years is yet to bear fruit as revenue productivity of new stores is 30-40% lower than that of mature stores. But recovery in same-store sales can drive operating leverage.”

Leaving a bad taste

A slowdown in topline growth has been accompanied by a much longer dip in profitability in recent quarters

Seconds Pritesh Chheda, analyst at Emkay Global Financial services, “There is a chance that with the base effect kicking in and inflation being somewhat controlled in relation to consumer income, same-store sales should revive in the third quarter of this financial year. By FY16, we should definitely see a sharp revival in same-store sales.” He adds, “This is a small, under-penetrated category. So it needs to grow at least at the FMCG growth rate of 15%, which is a bare minimum that the same-store sales growth should be at. The interim slowdown is the only problem for Jubilant. The franchisee is good, the business canvas is large, the company is aggressive and a huge opportunity exists.” More importantly, Chheda believes that once growth kicks in, for every 1% increase in same-store sales growth, there will be a 3% increase in earnings. “Based on operating cash flows of 3%, this growth should go up to 10%, with every possibility of touching 20%, which will lead to a 40% earnings upgrade. In that case, the stock will automatically become cheap,” adds Chheda.

Most analysts are betting on a revival to have a huge impact on earnings because of the base effect and Jubilant’s growing size. This premise is also based on the assumption that its margins and return ratios, which are currently looking depressed, will start to look better, and that will help in justifying its valuations. However, that day is still quite far away. In the near term, since the stock is trading at a PE of 46 times its estimated FY15 earnings, there is a possibility of a correction. In other words, this stock is difficult to digest at the moment.