Are investors too chicken to buy Collins Foods Ltd?

Shares in Collins Foods Ltd (ASX: CKF), one of Australia’s largest KFC and Sizzler restaurant operators, have headed south recently. It wasn’t too long ago they traded above $5 apiece on the back of a solid interim report, but shares closed under $4 yesterday after trading as low as $3.50 each.

What’s going on?

First off, shares might have overshot their mark on the way up. As owner-operator, Collins has fairly low margin businesses, and once stores have matured, growth is dependent on same-store sales as well as new store openings. Although gross profit margins are solid, Collins has high fixed costs in the form of marketing, royalty, occupancy, admin, and restaurant related expenses which reduce overall profit margins substantially.

Thus, prices above $5 may have overestimated the business’ value.

While this could explain the initial fall from $5, this week’s decline could be best explained by media reports from the US regarding the ‘re-Colonel-ization’ of KFC’s chicken making processes. Reportedly, the quality of KFC’s chicken has dropped in recent years and US parent Yum! Brands has invested $185 million directly into the fried chicken brand, as well as $250 million in finance. A substantial amount will be spent on remodelling and upgrading equipment and processes.

But where does Collins Foods fit in?

Media reports published on 4 April coincided with a spike in volume and as much as a 15% decline in the value of Collins shares over the past two days. I’m putting 2 and x together and getting 4, but it seems plausible that investors could be worried Collins Foods will have to go through a similar expensive remodelling process. Investors could also be worried about a higher cost of sales as a result of the new processes.

Collins recently refinanced and expanded its debt facilities and has around $47 million in cash as well as $35 million of available debt headroom, plus an additional $14 million in a working capital facility (total of ~$96 million). It appears well funded to handle any potential challenges, although remodelling 170 restaurants wouldn’t be cheap.

Finger-lickin’ good

The plus side is that investors with an eye for value could find some in Collins. If we double the interim profit to approximate full-year earnings, Collins currently trades on a Price to Earnings (P/E) ratio of around 13, below the market average. Fast food shares like Collins and Retail Food Group Limited (ASX: RFG) occasionally take a hit from investor worries over national employment or wages, but fears of major declines are probably overblown.

KFC has outstanding brand recognition and is a market leader in the fried chicken space, and Collins Foods is worth a closer look after its recent falls.

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Motley Fool contributor Sean O'Neill owns shares of Retail Food Group Limited. The Motley Fool Australia owns shares of Retail Food Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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