Will McDonald's South and West franchisee, Westlife, opt for a pan-India presence?

Shares of Westlife Development, the McDonald’s franchisee for western and southern India, gained seven per cent on Tuesday, on expectation it could be the front runner to add the northern and eastern parts of the franchise to its existing operations. McDonald’s on Monday terminated its agreement with Connaught Plaza Restaurants (CPRL), which was operating in the two regions under a joint venture (JV).

In a note on Tuesday, CLSA said a pan-India presence would bring scale benefits for Westlife, while McDonald’s would swiftly regain its lost ground, given the ongoing dispute with the existing partners, impacting its brand and quality of service. A quick resolution would be in the company’s interest, and a delay would benefit competitors such as Domino’s, Pizza Hut and KFC.

If it were to get the franchise rights, the key advantage for Westlife would be an opportunity to diversify into newer markets and scaling up from the current levels, said an analyst.

Economies of scale would benefit the top line and help keep costs down. Given their record of growing the franchise in the southern and western part of the country, Westlife would be the obvious first choice to run the other two regions before McDonald’s considers someone else, said an analyst at a domestic brokerage. From 166 restaurants in the June quarter of 2013, Westlife now has 261.

While there is a possibility of Westlife getting the northern and eastern regions, analysts believe the dispute might drag on for six-eight months. Further, valuations could also be a hurdle as CPRL, according to reports, is asking for a valuation similar to listed entity Westlife.

Analysts say valuations upwards of Rs 3,000 crore would mean Westlife, which has little free cash flows, would have to take a loan or dilute equity to fund the purchase. Westlife ended FY17 with a loss of Rs 12 crore. How it structures its deal, if one comes about, with McDonald’s will be critical.

However, the company is looking at improving its profitability, both from the revenue as well as on the costs front. This includes adding 25-30 stores per year and reaching a sales target of $1 billion by 2022, from the current $145 million.

To increase its return on investment, the company has cut capex on new stores by 25-30 per cent over the past four years to Rs 2.2-2.3 crore per store. This is expected to help it post an operating profit margin of 15 per cent, from the FY17 level of five per cent.

While the company posted a net profit in the June quarter, it will achieve net profit on a full-year basis in FY18. Analysts say at 40 times its FY20 earnings the stock is richly valued.