Initiation of coverage Herfy Food Services Consumer | Saudi Arabia MENA research A safe play but valuation not compelling Neutral We like Herfy’s exposure to food consumption trends in Saudi Arabia, Target price (SAR) 91.0 its vertical integration, solid balance sheet, and strong FCF generation, Current price (SAR) 82.7 in our view Potential return 10.1% Valuation not compelling on 2011e multiples; stock trades in line with Bloomberg HERFY AB peers and market is pricing in a premium for superior profitability Reuters 6002.SE Initiate on Herfy with a Neutral rating and TP of SAR91.0/share MCap (SARm) 2,223 Herfy, a leading Saudi Arabian fast‐food chain à la McDonald’s, offers a MCap (USDm) 596 simple and straightforward exposure to strong food consumption trends Free float 30% in the kingdom. The company has over 170 branches and is targeting 20–25 Daily volume (USDm) 1.0 new openings per annum. Herfy also has a bakery division with a market Foreign own. limit N/A Foreign ownership N/A share of c7% and plans to open a new bakery facility in 2H11e with triple the capacity of the existing Riyadh bakery. We expect a revenue CAGR of Note: All prices as of 16 January 2011 11% (2010e–15e) driven by branch expansions and the new bakery facility. Price performance Vertical integration supports margins (nearly double peers) and reduces 84 the negative impact of food inflation. Herfy has a meat processing plant 82 80 with c70% of production meeting nearly all needs of its restaurants. Some 78 c30% of the bakeries’ output is also used internally. 76 74 72 Herfy has a solid balance sheet and strong free cash flow generation 70 capabilities, both of which support a strong DPO. Herfy has a net cash JASONDJ Herfy TASI position, negligible noncore investments, and limited working capital requirements (given the nature of its business). Like other Saudi retailers, it operates a leasing model with only 20 restaurants owned. The company pays dividends semiannually, and we assume a sustainable DPO of 70%. Valuation is not compelling on 2011e multiples following strong share price performance (outperforming TASI by 54% since IPO in January 2010). The stock is trading at a 2011e P/E of 16.2x, in line with peers relative to EPS growth. Market is justifiably pricing in a premium to account for Herfy’s superior profitability. Herfy trades at a 10% premium to McDonald’s, which has a similar growth profile and margins. The stock could nonetheless attract long‐term holders given its safe profile and sustainable growth, but we recommend waiting for a more lucrative entry point. 18 January 2011 We initiate coverage on Herfy Food Services with a Neutral rating and TP of Hatem Alaa, CFA SAR91.0/share, which offers 10% potential return to the current price. Key Senior Analyst catalysts are further gross margin improvements, lower SG&A/sales, store +202 3535 7354 yield improvements, a higher sustainable DPO, more vertical integration hatem.alaa@hc‐si.com efforts, and higher external sales of processed meat given its stellar margins. Menna El Hefnawy Key indicators (SAR) Analyst 2009a 2010e 2011e 2012e +202 3535 7360 EPS (clean) 4.24 4.47 5.10 5.82 menna.elhefnawy@hc‐si.com DPS 2.97 3.06 3.57 4.07 Source: Company data, AlembicHC Disclaimer: See page 29 Herfy Food Services Consumer | Saudi Arabia 18 January 2011 Herfy’s financial statements and ratios (SARm) 2009a 2010e 2011e 2012e 2013e 2014e Income statement Restaurants 404 459 516 568 624 680 Meat factories 13 17 19 22 24 26 Rusk factories 16 12 13 13 13 14 Bakeries 85 85 90 115 139 158 Revenue 518 574 639 718 800 878 Cost (324) (355) (394) (442) (492) (539) Gross profit 194 219 244 275 308 339 Gross margin 37.4% 38.2% 38.3% 38.4% 38.5% 38.6% SG&A expenses (49) (61) (67) (75) (83) (91) Management fees (4) (4) (4) (5) (5) (6) EBITDA 141 154 173 196 219 241 EBITDA margin 27.2% 26.9% 27.1% 27.3% 27.4% 27.5% Depreciation (27) (33) (35) (39) (42) (46) EBIT 113 121 138 157 177 195 Net interest expense (1.0) (0.5) (0.9) (0.4) (0.4) (0.3) Other income 5 4 4 5 5 6 Capital gains (loss) 0.3 0.2 ‐ ‐ ‐ ‐ Pre‐Zakat income 118 124 141 161 182 200 Zakat (3) (3) (4) (4) (5) (5) Net income 115 121 138 157 177 195 Net margin 22.1% 21.1% 21.6% 21.9% 22.1% 22.2% Balance sheet Cash and equivalents 20 61 54 69 87 107 Receivables and related party dues 20 25 31 38 45 53 Inventory 43 45 48 52 56 60 Other current assets 51 61 71 82 95 109 Total current assets 134 192 203 241 283 329 Net fixed assets 272 311 367 389 415 444 Other long‐term assets 4 4 4 4 4 4 Total long‐term assets 277 315 371 394 420 448 Total assets 411 507 574 634 702 777 Short‐term debt 9 7 12 12 12 7 Payables and related party dues 21 33 42 52 63 75 Dividends payable 20 42 48 55 62 68 Other current liabilities 32 35 39 43 48 54 Total current liabilities 82 116 140 161 185 204 Long‐term debt 9 31 31 20 8 2 Other long‐term liabilities 22 25 27 30 33 37 Total long‐term liabilities 32 56 58 50 41 38 Total liabilities 114 172 198 211 226 242 Shareholders' equity 296 335 376 423 476 535 Total liabilities and shareholders' equity 411 507 574 634 702 777 Source: Herfy, AlembicHC 2 Herfy Food Services Consumer | Saudi Arabia 18 January 2011 Herfy’s financial statements and ratios (continued) (SARm) 2009a 2010e 2011e 2012e 2013e 2014e Cash flow statement Operating cash flow before working capital 139 155 174 196 220 242 Change in working capital 5 (0) (4) (4) (5) (5) Operating cash flows 144 154 170 192 215 237 CAPEX (85) (72) (91) (61) (68) (75) Other investments 12 1 ‐ ‐ ‐ ‐ Investing cash flows (72) (71) (91) (61) (68) (75) Change in debt (12) 19 5 (12) (12) (12) Dividends paid (60) (61) (91) (103) (117) (130) Other (1) (1) (1) (0) (0) (0) Financing cash flows (73) (42) (87) (115) (129) (142) Change in cash (1) 41 (8) 16 18 20 Key financial ratios Net debt/equity 0.0x ‐0.1x 0.0x ‐0.1x ‐0.1x ‐0.2x Net debt/EBITDA 0.0x ‐0.2x ‐0.1x ‐0.2x ‐0.3x ‐0.4x ROAA 29.9% 26.3% 25.5% 26.0% 26.5% 26.4% ROAE 41.0% 38.3% 38.7% 39.3% 39.4% 38.6% ROIC 37.4% 33.0% 33.8% 35.5% 36.5% 36.4% Key price ratios EV/EBITDA 15.8x 14.3x 12.8x 11.2x 9.9x 8.8x P/E 19.5x 18.5x 16.2x 14.2x 12.6x 11.4x P/BV 7.5x 6.7x 5.9x 5.3x 4.7x 4.2x Dividend yield 3.6% 3.7% 4.3% 4.9% 5.5% 6.1% FCF yield 2.6% 3.5% 3.3% 5.6% 6.3% 7.0% P/S 1.2x 1.0x 0.9x 0.8x 0.7x 0.7x Source: AlembicHC 3 Herfy Food Services Consumer | Saudi Arabia 18 January 2011 Investment case We like Herfy’s (1) straightforward exposure to strong food consumption trends in Saudi Arabia, (2) vertical integration, (3) solid balance sheet (net cash position and negligible noncore investments), (4) strong FCF generation (low working capital requirements and a leasing model), and (5) high DPO (c70%) But valuation is not very compelling on 2011e multiples given strong share price performance; stock is trading in line with peers on P/E relative to EPS growth, and market appears to be pricing in Herfy’s superior profitability, in our view Initiate coverage on Herfy with a Neutral rating and TP of SAR91.0/share (10% potential return) Key attractions (1) Offers straightforward exposure to Saudi Arabia’s solid food consumption trends Herfy mainly operates a leading fast‐food chain in Saudi Arabia with over 170 restaurants (80% of 9M10 revenue and c65% located in the central province) that are similar to McDonald’s and is targeting 20–25 store openings per annum.e Th company also produces baked goods (17% of 9M10 revenue) and processed meat (3% of 9M10 revenue). It is thus well positioned to benefit from Saudi Arabia’s sturdy food consumption trends given the sustainable growth and relatively high food spending, in our view (see “Supportive top‐down dynamics” section for details). We expect revenue to grow at a CAGR (2010e–15e) of 11% and net income at 12% driven by new branches and bakery expansions (a new bakery facility will be completed in Riyadh in 2H11e with a capacity triple that of the existing Riyadh facility). Restaurants will remain the largest segment, contributing c79% to revenue over our forecast horizon. We conservatively assume that store yields will stabilize at current levels, making them a key upside risk to our numbers. Store yields have improved at a CAGR (2006–09) of 9% driven by promotions and store layout enhancements (drive‐throughs, family sections, etc.). 4 Herfy Food Services Consumer | Saudi Arabia 18 January 2011 Herfy’s historical and forecasted revenue Herfy’s historical and forecasted net income 1,000 947 30% 250 60% 878 900 211 24% 800 48% 195 22% 25% 50% 800 718 200 177 700 639 157 20% 40% 16% 574 138 600 150 30% 518 121 500 466 11% 15% 115 30% 12% 375 11% 400 324 12% 100 18% 91 26% 11% 10% 10% 20% 300 62 14% 8% 47 200 50 10% 5% 14% 12% 10% 8% 100 6% 0 0% 0 0% 2006a 2007a 2008a 2009a 2010e 2011e 2012e 2013e 2014e 2015e 2006a 2007a 2008a 2009a 2010e 2011e 2012e 2013e 2014e 2015e Revenue (SARm) y‐o‐y growth Net income (SARm) y‐o‐y growth Source: Herfy, AlembicHC Source: Herfy, AlembicHC Revenue contribution by segment (9M10) Net income contribution by segment (9M10) Bakeries 11% Bakeries 15% Rusk factories 2% Rusk factories 2% Meat Meat factories factories 3% 14% Restaurants Restaurants 80% 73% Source: Herfy, AlembicHC Source: Herfy, AlembicHC (2) Vertical integration supports margins Herfy is vertically integrated, which strengthens margins and reduces the unfavorable impact of food inflation.