Eagle Eyes: KFC

KFC is the franchise holder of Kentucky Fried Chicken restaurant chain in Malaysia, Singapore and Brunei. With over 350 outlets, it is the largest fast food restaurant chain in Malaysia. It is almost a fully integrated player with its poultry division involved in breeding and hatching operations, poultry processing as well as feed milling operations. It also owns the Ayamas retail outlets and Rasa Ayamas restaurants. KFC also sells processed chicken products under the Ayamas brand.

KFC's ancillary division produces buns, coleslaw and salad to KFC and Pizza Hut restaurants. The Life sauces used in its restaurants, which are also sold to the public, is another of its operation. Although it may seem to be involved in a whole range of operations, it is the KFC restaurant operations that contribute a major chunk of its profits at about 80%.

KFC restaurants can be regarded as a fast growing yet resilient business. The rising standard of living means that more and more can afford meals at KFC. In developed countries, fast food restaurants like KFC offer food for almost the cheapest price compared to other restaurants as labour cost increases. In Malaysia, this holds true for tourist destinations such as Genting Highland, where KFC is one of the cheapest food outlets and hence, is often fully packed with customers.

Despite its strong growth potential, KFC is also expected to be a resilient business given the fact that it operates in the food sector. Demand for essentials such as consumer products in the low to medium range are unlikely to be affected badly in the event of an economic downturn. This is the reason why consumer stocks with strong brands like NESTLE and YHS are afforded a high PE of 15-20x.

KFC was at the centre of a shareholding tussle in the past 1-2 years but it has since been resolved. KULIM, through QSR, seems to have gained control of the company. In fact, it has tried to increase its stake in KFC by making an offer for the remaining shares in KFC for $4.94. This has proved to be unsuccessful as few accepted the offer. With KFC trading above $4.94 for quite some time, the offer is destined to fail.

Although KFC has performed well in the last 2 years, it seems that the shareholding tussle and MGO by QSR has dampened investors' interest in the company. Earnings have been growing at a steady pace over the year and with an expected strong fourth quarter, EPS for the year would be estimated to be about 50c. Based on its share price of $5, KFC is trading at a PE of 10x. Does it reflect the true value of the company?

There is no doubt that KFC is a cash cow as its business involves cash over the counter. Over the last 7 quarters, KFC has used its strong cash flow to pare down its debt impressively. Net debt has declined from $230m in the first quarter of 2005 to just $57m by the third quarter of 2006. KFC could possibly increase its profits by about 5% next year simply by paring down its debt as the lower finance cost will be reflected in its profits.

Barring any unforeseen circumstances, KFC should grow by about 10% next year. Rating it at a conservative PE of 13x based on 2007 EPS of 55c will give it a target price of $7.15, which is an upside of about 40%. Downside would be limited by the $4.94 offer by QSR. In other words, there should be only one direction for KFC's share price. Its strong brand, exceptional cash flow and improving balance sheet should ensure its sustainable growth for many years to come. BUY

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