Guzman y Gomez Defying Consumer Squeeze

Small Caps | Oct 15 2024

Mexican food chain Guzman y Gomez initially confounded the critics when it took off to an astronomical valuation, but brokers have since come to appreciate what's on offer.

-Guzman y Gomez explodes onto the fast food scene
-Healthy food at a higher price point
-Ambitious store growth goals
-Opinion remains split on valuation

By Greg Peel

Guzman y Gomez ((GYG)) opened its first Mexican fast food store in trendy Newtown, Sydney, in 2006. Newtown has in the past had a reputation as a graveyard for fast food chains. McDonalds opened there, then closed.

Guzman y Gomez is still in Newtown. Guzman y Gomez now has 210 stores; 185 in Australia and the rest spread across Japan, Singapore and the US. Guzman y Gomez must be doing something right.

The company's operations and performance have proved a bright spot in a difficult industry, Ord Minnett noted earlier this month, resilient in the face of pressures in the broader economy and consumer constraints.

Feedback from players in the broader fast-food industry, or quick service restaurants (QSR) as the sector likes to be referred to, suggests current trading conditions are tough, with sales growth hard to come by as strained consumers choose cheaper-value options and margins are being squeezed by persistent cost inflation. Securing the best-located real estate for medium and longer-term store expansion also remains a challenge.

Guzman y Gomez offers familiar Mexican dishes at a higher price point than burger and chicken joints. Ord Minnett sees the company's positioning as the "healthier" fast food choice largely compensating for its price disadvantage. According to the company, "Clean is the new healthy".

"Clean", in the context, does not just mean they wash the lettuce. The food, according to the website, has no added preservatives, artificial flavours, colours, or unacceptable additives.

Guzman y Gomez IPO'd in June at $22 but shot up to $30 on listing. By mid-September the stock was at $40. The listing price had analysts shaking their heads. The fact the stock only rose thereafter was mind-boggling. QSRs do not attract that sort of over-the-top PE ratio.

Hard to Stomach?

Ord Minnett initiated coverage of Guzman y Gomez in mid-June, ahead of listing, with no rating and a $15 target price, compared to the IPO price of $22.

The broker viewed the company as a relatively small operator in a highly fragmented market and forecast the company could grow the store network three-fold over the next ten years. But despite impressive growth to date, Ord Minnett pointed to returns on investment below the cost of capital. The broker saw more value in Collins Food ((CKF)) (KFC, Taco Bell) and Domino's Pizza ((DMP)).

Since Ord Minnett's early scepticism, more initiations followed, but not until July and August when brokers had given the operation more scrutiny.

Morgans anticipated significant long-term growth potential, with earnings to benefit from strong operating leverage. This broker initiated coverage with an Add rating and $30.80 target, noting near-term forecasts were broadly in line with prospectus estimates.

Morgan Staney opened with Overweight and a $31.80 target, highlighting several positives including: a unique offering that resonates with consumers; strong unit economics; and the ability to scale via a capital-light franchisee model. Volume growth will drive operational leverage, according to Morgan Stanley, and provide a significant tailwind to margins and profitability over the next three to five years.

On UBS' assessment, Guzman y Gomez offers attractive operational and financial attributes, featuring a large store network, total addressable market and quick new-store payback. Post the share price performance since the June IPO, UBS initiated coverage with a Neutral rating seeing the risk reward as more balanced against its $31.00 target.

By late August, Morgans had downgraded to Hold from Add, but lifted its target to $37.70 from $30.80.

The company had revealed a robust start to FY25, with its sales growth for the first seven weeks ahead of guidance. Morgans noted the comparables Guzman y Gomez has to cycle would also get easier. Morgans believes the company can continue to perform well through FY25 with possible index inclusions, sell-downs to increase liquidity, strong quarterly sales updates and an inevitable earnings upgrade.

But share price appreciation was the issue. Nevertheless, Guzman y Gomez has since been included in the ASX200.

Goldman Sachs initiated coverage early this month. This broker is cautiously optimistic on the QSR outlook now that consumer sentiment is trending positively and as interest rate expectations and recent tax cuts are now being factored in. Recent elevated population growth and a forecast return to growth in real disposable income and consumption are other factors behind Goldman's positive thesis.

Goldman Sachs opened with a Sell rating, suggesting the long-term store expansion goal appears overstated and due to an overblown valuation.

Ay Caramba

The index inclusion, and the company's first quarter trading update earlier this month, have been responsible for share price appreciation, Ord Minnett suggests. At some point, this broker had moved from "No Rating" to Hold, and had lifted its target from an early $15.00 to $27.70. White-labeling research from Morningstar had been traded-in for wholesale securities analysis conducted by Barrenjoey.

On the first quarter results, Ord Minnett (Barrenjoey) lifted again, to $41.00.

Guzman y Gomez reported first quarter same store sales growth of 8.7%, above consensus and prospectus forecasts. For weeks 8-13, comparative sales growth accelerated to 10.2%, up from 7.4% in the first seven weeks. According to management, the uptick was due a strong delivery performance and successful execution of the "Clean is the New Healthy" campaign.

Furthermore, customer demand for value menu items such as the $12 Chicken Mini Meal provided a boost.

Group sales rose 20.7% against 32.8% in the first quarter last year with five new store openings and management reconfirming the FY25 target of 31 new restaurants. The apparent slowdown is shrugged off by brokers given the faster pace of new store openings a year ago.

While management expects the company to meet FY25 prospectus guidance, consensus is optimistic guidance will be beaten.

UBS had downgraded its rating to Sell from Hold, and was unmoved by the strong result. All the good news is already well and truly in the share price, the broker argues. UBS lifted its target from $35.00, which had earlier been $31.00, to $37.00.

Wilsons chimed in with an Overweight rating and $41.14 target.