Jamie Rollo – ‘Costa Coffee is not underperforming compared with its peers’: Morgan Stanley leisure analyst Jamie Rollo has argued Whitbread-owned Costa Coffee is not underperforming compared with its peers. Rollo said: “We often get asked whether Costa Coffee is ‘over-earning’. Whitbread’s coffee chain had a relatively tough year last year, with like-for-like sales growth slowing to 2%, Ebit margins falling 80 basis points, and Ebit up only 5% – sharp slowdowns from previous years. External pressures from competition and weak high-street footfall are self-evident, but what is less certain is how much was self-inflicted from historical underinvestment. Its closest coffee shop competitors, Starbucks and Caffe Nero, and its food-led competitors, Greggs, Pret A Manger and EAT all publish UK accounts, and we have compared the businesses, after making a few adjustments and assumptions. We conclude, first, the issues facing Costa are not specific to it, as all operators saw slowing like-for-like sales and weaker profit growth last year; and second, that Costa’s economics do not appear to be particularly superior to those of its competitors. This may be scant consolation given the external pressures continuing to bite, but it does suggest Costa’s downside risk is less than expected if its unit economics do not have to be rebased to its peers’ level.

Store count and openings: Costa opened 184 net new stores in the UK last year, to reach circa 2,220 there, a growth rate of 9%. The company plans to open a similar number of stores this year, and targets 3,000 stores in the UK. Starbucks opened a net 52 stores in the UK last year, to reach circa 880 there, a growth rate of 6%. Caffe Nero opened a net 31 stores last year, to reach circa 615 in the UK, a growth rate of 5%. It sees potential for at least 750 in the UK, and since its year-end acquired the 45-site Harris & Hoole business. Costa is therefore adding over double the number of new stores of its closest two competitors – an impressive growth rate. Among the food-led operators, Greggs is the closest comparable to Costa in terms of size, with 1,764 stores at the end of 2016, up a net 66 (+4%). Pret A Manger ended 2016 with 329 stores, up a net 26 (+9%). EAT opened six new stores in its last fiscal year to reach 100 outlets.

Sales per store: Costa’s average sales per store are about £540,000 across both its equity and franchised stores, or £595,000 for its equity stores. Starbucks’ average sales per store are roughly £760,000 across its equity stores (it does not give system sales so we cannot calculate its franchised stores, but the business is mainly equity stores). Caffe Nero’s sales per store are about £435,000. This puts Costa squarely in the middle of its coffee-shop peers, and does not suggest its stores are ‘over-earning’, though we note its peers have a bigger London mix (eg Costa circa 20% of stores in London versus Starbucks and Nero circa 30%). Greggs’ average sales per store are a comparable £517,000. Sales per store is significantly higher for Pret A Manger and EAT at £1.9m and £1.0m, respectively, reflecting the higher average spend per head in a food outlet.

Like-for-like sales growth: All three coffee chains reported like-for-like sales growth in the 1% to 2% range last year. For Costa, this was the low end of its 2% to 3% guidance and a slowdown from the 3% reported the prior year and 5% to 6% for the five years prior to that. For Starbucks UK, this was a slowdown from the 4% the prior year and 6% the year prior to that, and like Costa it blamed economic and geopolitical headwinds (though not competition). Caffe Nero’s 2.2% was very similar to its previous few years though the low end of its 2% to 4% target. These figures suggest that Costa’s slowdown is not out of line with the general market and that it is not underperforming. The food-led chains reported stronger like-for-like sales, although still slower than in the previous year. Greggs’ like-for-like sales were up 4.2% for 2016 versus 4.7% in the previous year. Pret A Manger’s like-for-like sales were 4.8% versus 7.5% in the previous year, although this covers the whole group, which is not all UK.

Margins: Store-level Ebitdar margins are pretty similar for the three coffee chains at 41% to 43%. Rents are also similar for the three companies at 15% to 17% of sales. Ebitda margins thus range from 24% to 28%, with Costa and Nero similar and Starbucks slightly higher, likely reflecting its superior unit sales. Post central overhead Costa’s Ebitda margins are slightly higher than Starbucks and Caffe Nero, likely reflecting its superior scale across the UK. Ebit margins are 10% to 11% for all three coffee companies, and not dissimilar to the food-led stores, with Greggs at 9% and Pret at 10%. EAT loses money.

Profit per store: Unit profits vary widely, in line with the unit sales variance. For the coffee chains, Starbucks UK generates £220,000 Ebitdar per store, Costa £201,000 , and Nero £145,000, again putting Costa in the middle. Among the food-led stores, Greggs is at £99,000, EAT at £216,000 and Pret at £484,000. Post rent, Ebitda per store is similar for Costa and Starbucks at circa £100,000, with Nero lower at £72,000 and Greggs at £71,000. Pret makes £281,000 Ebitda per store while EAT is only at £37,000. Within the coffee chains, adjusted Ebit per store for company-operated stores is the highest for Starbucks UK at £76,000, followed by £62,000 for Costa Coffee and £42,000 for Caffe Nero. This also does not suggest Costa is particularly over-earning in its stores.

Return on capital employed: Costa’s return on capital employed dropped from 50% to 45% last year, and we estimate this would be 37% excluding its franchise operation (to be comparable with peers that are mostly or wholly company operated). Starbucks’ return on capital employed dropped from 60% to 35%, and Nero’s return on capital employed dropped from 38% to 33%. This suggests a similar return on capital employed for the coffee chains, though on a declining trajectory. The food-led outlets had lower returns, with Greggs at 26% and Pret at 17%.

We think Costa could be an interesting turnaround story, and the implied multiple is only about 5.5 times Ebitda. The company has not kept up with the pace of development in technology or changing consumer tastes, and arguably been overly focused on expansion. It is in the process of adding ovens to its stores so it has been rolling out new hot food ranges this year, and will also launch new healthier/fresher food ranges, all segments where it is under-represented. It also recently extended its coffee range through new initiatives in the Cortado product, and has just launched cold brew and new single-origin blends. A new till system is being installed this year, enabling faster service, differential pricing, and new functionality to provide the platform pay and collect to be rolled out. It is also enhancing its app. We think these are all fairly easy wins that should help offset pressure on its high street stores, which account for about 40% of stores and where footfall is arguably in structural decline. It will continue to add circa 200 new stores per year, focusing on new formats such as drive-thrus and Pronto. Costa Express (self-service machines) is also growing rapidly. We assume 1.5% like-for-like sales for Costa Coffee this year and a 100 basis points margin drop in our forecasts, broadly in line with guidance, and think Costa could prove a surprising turnaround, which could bring both upgrades and a re-rating. This could be material given that Whitbread shares trade at a 30% discount to their sum of the parts proxy, with an implied 5.5 times Ebitda multiple currently being applied to Costa Coffee if we strip out the hotels business at 10.5 times.”