EUR 21.76 For Business Accounts Only

Short-term pressures ahead, remain Neutral

Stimulating demand, but at the expense of margins. Herfy’s restaurant sales picked up in October, post the launch of a more-affordable menu (SAR4–14/sandwich vs. avg. of SAR14). Herfy offered these promotions on weak 9M17 traffic (revenue ↓2% y-o-y on 33 more branches), which will affect margins negatively, in our view. We cut 2018-21e EBITDA margins and restaurant yields by an average 2.1pp and 9%, respectively, on delay in maturity of branch additions and margin recovery. We remain Neutral on a 21% lower 12M TP of SAR49/share, as we believe Herfy’s efforts to enhance efficiencies are unlikely to pay-off in the short-run and fully mitigate 2018 cost pressures. Herfy trades on a warranted discount to peers (2018e EV/EBITDA of 12x vs. 13.9x) given our 2017-19e muted EPS growth outlook (2.7% vs. peers’ 10.7%).

Reversal in yields key watch factor. Pressure on restaurant yields is not easing, dropping 11% y-o-y in 9M17 vs. 4.3% in 2016, as expansions continue (22 new branches y-t-d) with the majority of additions are standalones. We expect this to sustain into 2018, albeit at a lower rate of c5%, on weaker demand post the VAT implementation. We believe recovery in yields (+1.1% p.a. over 2018-22e) should stem from maturity of high-yielding standalones, which take a longer time to reach full potential (18–24 months vs. 12–18 for other formats).

Management’s efforts yet to be tested. Herfy aims to raise operational efficiency by rationalising costs to mitigate cost pressures ahead, as expat fees and subsidy cuts materialise. We, nonetheless, expect the pressure on EBIT margins to sustain into 2018 and normalise at new, lower, levels (18.5% vs. 19.5% in 2016), pending signs these efforts pay-off, especially as Herfy refrains from raising prices and is inclined to offer promotions. Downside risks stem from: i) losing government support, currently in the form of custom tariffs’ waiver (8% for beef and 20% for poultry) and fixed wheat prices, and ii) enforcing full Saudisation on Herfy’s mall branches (c30% of total, we estimate an additional cost of cSAR15mn in 2018).

M&A plans do not excite us. We do not view M&A as positive at this stage; it would be better if focus centers on improving branch productivity and efficiencies, particularly as little synergies are possible given Herfy’s current wide reach. Herfy targets opening at least 25 branches p.a. (2018 budget has yet to be finalised), reaching 500 branches in 5–7 years, while we assume 20 branches p.a.