Investors salivate over Cafe de Coral

IT is not so much of an over-statement to suggest Hong Kong's fast-food sector is suffering from indigestion due to increased competition, sluggish sales growth and rising costs. But despite the negative factors, Cafe de Coral managing director Michael Chan Yue-kwong has much to smile about these days. The company has announced record profits and turnover for the year ended March 31 and saw its first syndicated loan over-subscribed by 135 per cent, helping it raise $300 million for expansion over the next three years. So what has got consumers and investors salivating over Cafe de Coral, the largest fast-food retailer in Hong Kong? Mr Chan points to the quality of its food and its attractive balance sheet, which sports a strong cash flow and only $500 million in short-and long-term debt. While profit and turnover growth might not match last year's lofty heights, when increases of more than 30 per cent were posted, Mr Chan said both figures had jumped 20 per cent in the first quarter. The growth was impressive considering latest government statistics showing fast-food sales in the first quarter up only nine per cent. Growth is negative when inflation is taken into account. Nevertheless, Cafe de Coral does have its critics who believe higher costs and tougher competition from rivals such as McDonald's, Fairwood and Maxim's cloud prospects. Sun Hung Kai Securities analyst Dora Cheuk said rising labour and rental costs would put Cafe de Coral under increasing pressure as the fast-food market became more saturated. ''They have to expand into China to maintain their high growth,'' she said, adding that the stock, which closed on Friday at $5.25, was rated a hold because of a hefty price-earnings multiple of 18.1. In a recent research report, SG Warburg Securities analyst Alexandra Mackesy said Cafe de Coral's profit growth over the next three years would depend on the expansion of its Hong Kong operations. Ms Mackesy said this expansion would have to carefully monitored because higher labour and rental costs and intense competition would see pre-tax margins shrink to 10.8 per cent in fiscal 1994 from 11 per cent in fiscal 1993. It was unlikely that Cafe de Coral's 24 to 25 per cent share of Hong Kong's $5.6 billion fast-food market would climb, she said. Cafe de Coral plans to use most of the $300 million loan to buy stores in order to cut spiralling rental costs, which are hitting the bottom line of Hong Kong's major retailers. Mr Chan said six locations were acquired in the past months for between $20 million and $30 million each. The company now owned 20 locations and aimed to own 20 per cent of all outlets, he said. Ms Mackesy estimated that Cafe de Coral's rental costs accounted for 14 per cent of turnover compared with 10 per cent two years ago. Cafe de Coral has reduced labour costs with a central processing plant in Sha Tin, which has allowed it to increase production but not its workforce. Although there were more than 1,300 fast-food restaurants in Hong Kong, Mr Chan said there was room for growth because fast food accounted for only 12.8 of total eat-out sales compared with 20 per cent in Japan and 40 per cent in the United States. The company's aggressive expansion would continue in fiscal 1994 with 18 Cafe de Coral outlets, two to three Ah Yee Leng Tong units and three to five Spaghetti House restaurants slated to open, he said. While market expansion could absorb some of the growth, Mr Chan said Cafe de Coral was also counting on stealing market share from major rivals such as Fairwood and Maxim's and the large number of family-owned businesses. In the early 1990s, Cafe de Coral saw diversification into other restaurant concepts as a promising strategy. The Spaghetti House and Ah Yee Leng Tong chains were acquired in 1991 and 1990, respectively. However, growth has been slow due to intense competition for sites. Only one Spaghetti House was opened last year instead of the three to four planned. Ah Yee Leng Tong, serving Chinese food, participates in the second-slowest growing restaurant sector. Mr Chan defended the track records of both chains, saying they were specialty restaurants which did not have the formula to penetrate the housing estate market. Rather, growth would be limited to tourism and business areas where higher-margin businesses could carve out a niche, he said. Like most fast-food players, Cafe de Coral has high hopes for China and plans to spend $200 million to open 50 restaurants there by 1997. It now operates four restaurants in Shenzhen, Guangzhou and Foshan, with another seven scheduled to open in Beijing (near Tiananmen Square), Shanghai, Shenzhen, Zhuhai and Xiamen within the next six months. Mr Chan said the initial foray had been a tremendous success with customer traffic similar to Cafe de Coral's 10 busiest outlets in Hong Kong. While each store generates an operating profit within three months, they are not expected to produce a return on capital for 18 to 24 months because of the heavy investment required. Since the outlets in China are 8,000 to 10,000 sq ft - double the size of those in Hong Kong - construction costs are about $4 million. They operate their own kitchens rather than using a central processing plant. One of the key components to Cafe de Coral's plans for southern China and Hong Kong is a 15,000 sq ft processing plant in Guangzhou, scheduled to start operation by year-end. The pilot project plant is important because it will allow the company to pay for raw materials and labour in yuan and export some of its production to Hong Kong to generate Hong Kong dollars. Mr Chan said this could allow the Sha Tin processing plant to eventually become a distribution centre. Cafe de Coral imported about 30 per cent of its food materials from Hong Kong because they were unavailable in China, which had tariffs of 10 to 40 per cent. There is also the problem of higher prices for local raw materials as a result of China's problem with inflation. Mr Chan said Cafe de Coral would explore expansion into other Southeast Asian countries if it could link up with a strong franchisee.