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Next time you walk through a shopping precinct, check the number of fast-food outlets. Then ask how many are franchised and if they serve gourmet food. Chances are, you’ll see at least one or more of Grill’d, Nandos, Salsas, Crust, Pie Face, or Schnitz.

Australia’s love of higher-priced fast food is great for Retail Food Group (RFG), owner of gourmet pizza chains Crust and Pizza Capers. Even perennial sharemarket star Domino’s Pizza Enterprises (DMP) is capitalising on the gourmet trend with more upmarket treats.

Retail Food Group (RFG)

Chart: Share price over the year to versus ASX200 (XJO)

Domino’s Pizza Enterprises (DMP)

Chart: Share price over the year to versus ASX200 (XJO)

Gourmet fast-food chains such as burger outlet Grill’d have found a lucrative niche between traditional low-priced takeaway food and pricier restaurants. A stronger in-store dining experience has helped Grill’d, Nandos and others charge around $20 for a meal and a drink.

The demand for gourmet takeaways led to RFG acquiring Crust Gourmet Pizza Bars, a trailblazer in upmarket pizzas, and the smaller Pizza Capers in 2012. The combined businesses were worth a quarter of RFG’s underlying earnings (EBITDA) in its latest half-year earnings report.

The acquisitions could be a company-maker. Business forecaster IBISWorld estimates the pizza restaurant and takeaway industry will have $3.5 billion in revenue in 2013-14. Strong demand for gourmet pizzas and healthier options will underpin the industry’s growth.

RFG is at the epicentre of powerful trends. Demand for fast food will keep rising as the population grows and people eat out more. And as the obsesity epidemic worsens, healthier fast-food options such as gourmet pizzas will be in higher demand.

Add to that Australia’s love affair with franchises – we are among the most franchised countries on the planet – and RFG is clearly in a sweet spot. Even a patchy economy seems to have had little effect on demand for lower-priced treats from its franchise systems.

Although the long-term fast-food fundamentals are promising, the question is valuation. Some commentators compare RFG with the much larger Domino’s and argue it is undervalued. Why buy Domino’s when you get pizza exposure through RFG that is more targeted at the gourmet end, and is not as aggressively valued by the market?

Care is needed with simplistic comparisons. For one thing, RFG comes with a lot more than pizza. It owns the Donut King, Michel’s Patisserie, Brumby’s Bakery, bb’s Café and Esquires Coffee Houses, and The Coffee Guy franchises. It also roasts more than 1.35 million kilograms of coffee annually – a lucrative business.

Also, RFG makes most of its revenue in Australia and Zealand. Domino’s makes 36 per cent of revenue in Australia/NZ; 26 per cent in Europe; and almost 37 per cent from its recently acquired Japanese operation, which is having early success based on latest results.

Domino’s and RFG have different business models and strategies. Domino’s has done a stellar job taking its core strength to offshore markets. RGF has become a multi-franchise system that relies mostly on Trans-Tasman markets. Domino’s strategy has more long-term potential, and RFG is more defensive because it does not rely on a single franchise system.

Domino’s has outperformed RFG. Its return on equity (ROE) was 29 per cent in FY13 and has risen strongly since 2007. RFG had a 13.3 per cent ROE in FY13, according to Morningstar – the fifth consecutive annual decline, thanks to increases in shareholder equity in that period.

The market has recognised Domino’s strong performance with a five-year average annual total shareholder return (growth and dividends) of 48 per cent and a $1.66-billion market capitalisation -making it among the best-performed small cap stocks in years. RFG has returned 27 per cent annually over five years and is capitalised at $579 million.

Domino’s and RFG have at least one thing in common: they are still overvalued, even after recent price falls.

As so often happens, the market has got ahead of itself with valuations for Domino’s and RFG. That does not mean both stocks should be ignored. Rather, that value investors need to be patient and wait for better value. With both stocks priced for perfection, it would not take much for their valuations to retreat if earnings disappoint.

RFG looks the pick of the two stocks at current prices. It is a larger business than many realise: 1401 franchised outlets and long-established systems such as Donut King. Try finding a shopping centre without at least one of RFG’s franchise systems.

RFG has found its groove after a few hiccups. Its failed attempted to acquire Oaks Hotels and Resorts in May 2011 spooked some analysts because it would have been a significant divergence from its franchise strategy.

RFG rallied from about $2.50 in mid-2012 to as high as $4.87 this year (it is now $4) as the market embraced its pizza acquisition strategy and the improving fortunes at its other franchises. Sales for low-priced treats such as donuts and coffee were reasonably defensive in a soft economy.

About 21 per cent of RFG’s underlying earnings (EBITDA) came from Donut King in first-half FY14. Michel’s Patisserie contributed 26 per cent; Brumbies added 20 per cent; the pizza chains quickly contributed a quarter of earnings; and the other businesses added 7 per cent.

Store numbers and earnings contributions are evenly spread across RFG’s four main divisions, meaning it is less exposed to a poor performance from one franchise system. More franchise systems, outlets, and revenue lines are helping RFG diversify and improve earnings quality.

RFG is ramping up growth. It raised $53 million an oversubscribed placement in October at $4.30 a share to fund its next evolution. It had net growth of 27 outlets in first-half FY14 and commissioned 79 outlets, of which 49 are for the pizza businesses.

RFG’s strategy essentially has three prongs. First, expand the pizza business rapidly through new store openings and create a strong growth engine within RFG. So far, so good.

Second, reinvigorate and expand the older franchise systems. For all the talk about pizza, RFG has plenty of upside from reinventing the Donut King, Michel Patisserie and Brumby’s Bakeries systems, which arguably had become a little tired in the past few years.

RFG’s grandly named “Project Evolution” is a smart move. It involves innovating chains such as Donut King by creating standalone stores with a different in-store experience to buying a quick cinnamon donut and coffee at a shopping centre.

Drive-through Donut Kings with children’s playgrounds; Michel’s Patisseries with much more of a European feel; Brumby’s Bakeries that play on Australian heritage and traditional baking methods; and hole-in-the-wall coffee shops are key initiatives.

This is clever retail innovation and a sign that RFG is capable of disrupting markets; taking existing concepts into new markets; and finding incremental gains in the older businesses. The early results suggest this innovation is being supported by good management execution.

Project Evolution could lift price points for RFG franchises and improve the all-important average transaction value per customer. As Grill’d, Nandos and Salsas have shown, improve the in-store experience and food quality, and customers will pay up and return more often. Also, higher-margin, exciting outlets are a lure for potential franchisees in a crowded market.

The third part of RFG’s strategy is scale. More franchise outlets means better bargaining power with shopping centres for prime locations, and improved economies of scale and capacity to create, develop or acquire other franchising systems. A bigger network also allows RFG to run more of its lucrative coffee business through the franchise systems.

Pilot stores have been launched and 18 full-format Project Evolution stores are to be commissioned in the second half of FY14. Another 71 Donut King, Michel’s and Brumby’s outlets are being refurbished.

Strong growth in the pizza business should keep earnings growth ticking over as RFG reinvests in the older franchise systems.

RFG announced 7.7 per cent year-on-year revenue growth to $64.6 million for first-half FY14, and an 18 per cent rise in net profit to $17.3 million. The dividend payout ratio increased from 76 per cent to 83 per cent, giving a 10.75 cent interim dividend per share.

Net debt in first-half FY14 was $49.5 million, for a lower-risk gearing ratio of 14 per cent. RFG’s long-term debt in FY13 was $108.9 million. Strong cash flow and part of the proceeds from equity capital raising were used to repay borrowings.

Consequently, equity issuance has climbed from 108 million shares in FY12 to 144 million in first-half FY14. High share issuance can be drag on ROE and dilute existing shareholders.

Still, the power of franchise systems, when they work, is high free cash flow, low corporate overheads, and more of each dollar of sales going to the bottom line. RFG had a cash-flow conversion to EBITDA of 88 per cent in first-half FY14.

In its latest result, RFG said it was “premature” to lift guidance of around 15 per cent full-year increase in net profit. That view makes sense as RFG reinvests heavily for the future. So ROE could track sideways or only edge higher as funds are reinvested from growth.

The market, however, is counting on RFG to grow rapidly in the next few years, judging by its valuation. RFG won’t deliver the supreme growth (pardon the pun) the market is counting on from the pizza division alone. A bigger growth phase may still be a year or two away as the promising Project Evolution adds to growth.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at May 7, 2014.

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