Introduction to the Company
Pancake House, Inc. is a publicly listed company in the Philippine Stock Exchange. It is a Filipino-owned corporation, principally engaged in the development, operation and franchising of a casual dining chain of restaurants under the trade name “Pancake House”.
The consumer brand name has traditionally been associated with specialty pancakes and waffles and has likewise expanded to offer an array of popular international dishes such as spaghetti, tacos and chicken. The Company also owns and operates various restaurant brands directly or through its subsidiaries. These brands include “Dencio’s”, “Teriyaki Boy”, “Singkit”, “Sizzlin’ Pepper Steak” and “Le Coeur De France”. Total system-wide sales of the Group (total restaurant sales from the company-owned, joint venture and franchised stores) reached PHP 2. billion, translating to a compounded annual growth rate of 30% over a 3-year period. The Group opened 20 stores in 2007, including one (1) Pancake House outlet in Sunway Pyramid, Malaysia. The original Pancake House was established in 1970 by Milagros Basa, Leticia Zamora and Carmen Zaragosa. In 1974, Sta. Rosa Food Services Corporation and in 1978, Extrovert Corporation, were incorporated to hold ownership in succeeding Pancake House outlets. It successfully opened its first franchised outlet in Greenhills, San Juan in 1978.
On February 15, 2000, a new investor group led by Mr. Martin P. Lorenzo entered into an Asset Purchase Agreement with SRFSC and Extrovert for the acquisition of the “Pancake House” trade name and purchase of all of the latter’s operating assets. Pending the final purchase, a new team of management and employees was organized to take over the company-owned outlets of SRFSC and Extrovert. On March 1, 2000, the new investor group incorporated Pancake House, Inc. as the acquisition vehicle of the investor group, finalized the purchase of the operating assets. On December 15, 2000, Pancake House, Inc. as listed in the Philippine Stock Exchange. The total numbers of outlets of Pancake House as of the end of years 2000 up to 2007 and first quarter of 2008 are as follows: [pic] Since its incorporation, the Company has acquired and developed several brands in the market. The table below summarizes the details of the Company’s acquisitions, as well as the number of outlets of each restaurant chain.
The decrease in rentals and cost of land can be used as an opportunity to build stores cheaply.
Threats Industry Analysis Overview
Several brands compete in the casual dining segment of the food industry. For Pancake House, the specific competitors include Max’s restaurant, Barrio Fiesta, Kamay Kainan, Dulcinea, and Heaven and Eggs. Max’s restaurant has been in existence for more than 60 years. It has over 117 branches all around the Philippines and in the United States. Aside from its well known fried chicken, it serves a wide variety of Filipino dishes such as kare-kare, sinigang, crispy pata, and lechon kawali. It also offers combo meals and snacks. Max’s also provides catering and function services for wedding and other occasions.
Aside from Max’s, Barrio Fiesta and Kamay Kainan also serves traditional Filipino dishes. La Dulcinea Restaurant was first established in 1963 in Ermita Manila. It offers Spanish food specifically targeting the AB market. The restaurant popularized the Spanish snack Churros con Chocolate. Dulcinea has now 10 outlets around Metro Manila. In 2005, it reported gross revenue of PHP140 million. However, net income was negative at PHP 9. 1 million, raising doubt about the company’s ability to continue its operation. Heaven and Eggs, the new entrant in the industry, only started its operation in May 2005.
It offers international dishes. It presently has 5 branches in Metro Manila located in Tomas Morato, Eastwood City, Fort Bonifacio Global City, and Glorietta 4, and Trinoma.
Industry Structure (Based On Product Offerings)
The branded / unbranded restaurant industry comprises of the following major specialities:
1. Traditional Filipino restaurants
2. Japanese speciality restaurants
3. Chinese speciality restaurants
4. Italian/Continental speciality restaurants
5. Other/World cuisine restaurants The restaurant business is exceedingly competitive and comprises of restaurants catering to various specialities.
Five Forces Analysis
Competitive Rivalry (High)
Since the industry is liberalized with multiple established players, there is very high degree of competitive rivalry in the industry. This has led to the reduction in costs across product categories and has reduced the profitability margins of all the players. In some cases, it has also led to the establishment of specialty niches. Bargaining Power of Suppliers (Low) Since the raw materials for this industry are predominantly commodities, the bargaining power of suppliers is very low. Further, with increased fragmentation in supply, the suppliers are forced to compete amongst themselves rendering any threat from them nonexistent.
Bargaining Power over Buyers (Medium)
The buyers consist of end users/retail consumers and, in some cases, other institutions. Since, the industry is competitive; the firms do not have much bargaining power over the buyers. However, for some well-known restaurants, there is limited leverage available with the companies.
Threat of Substitutes (High)
Many of the services offered by restaurant chains are freely substitutable with each other. Hence, there is a significant threat from substitutes.
Entry of New Players (High)
With very low barriers to entry, the entry of new players is not only possible but happens on a daily basis. Thus, established chains rely on a pool of loyal customers to help them overcome this threat. Based on the sovereign rating of a country, a default spread is calculated based on historical default rates of similarly rated entities.
Since this default risk is for debt, the equity default risk is estimated by adjusting this by a factor equal to the relative volatility of equity markets in the country with respect to the debt markets. Generally, this factor is taken to be 1. 5 for emerging markets (assuming that equity markets are about 50% more volatile than debt markets). The historical premium for mature markets of approximately 5% is added to the country risk premium get the total risk premium. Based on the Sovereign rating of B1 (Moody’s) for Philippines, the adjusted default spread is 650 bps. Thus, Country Risk Premium for Philippines = 6. 5% * 1. = 9. 75%
Thus, Total Risk Premium for Philippines = 9. 75% + 5% = 14. 75% = Rm- Rf Beta Though it appears that PCKH is like a conglomerate of chains of restaurants, the core business is only one i. e. restaurants. Also, industry betas of speciality restaurant chains are not available, thus to avoid a large error in the estimation of beta, the industry beta of the restaurant business is taken as the base. Beta obtained by the industry comparables method = 0. 38 Ke = Rf + Beta*(Rm- Rf) Hence, Cost of Equity = 5. 621% + 0. 38 * 14. 75% = 11. 23% Now, from the company’s annual report, its pre tax marginal cost of funding is 7. 5%. Thus taking this to be the marginal cost of debt Kd, we have: Thus, Kd = 6. 7%
To calculate the available free cash flows for the company, pro forma financial statements have been forecasted. The steps which have been followed are as follows: Pro forma Profit and Loss Statement
Assumption 1: Analyzing the current Macroeconomic Indicators and based on the Industry Analysis, it has been estimated that even though the company has been growing at an annual compounded rate of over 16% for the past five years, the company’s growth for the next fiver years would be slower than this mainly because of the current recessionary phase in the economy. However, a growth rate of close to 12% will be sustained in the near future. Although a moderate slowdown is anticipated, this is expected to happen over the course of the next 5 years. Thereafter, a perpetual growth rate of 4% has been assumed for the company.
During the sensitivity analysis, all these growth rates have been tweaked so that a clearer picture of the stability of the valuation emerges. Assumption 2: The costs in nominal terms have been assumed to keep pace with inflation and also remain in line with industry trends over the course of the valuation period. The EBIDTA margin has been assumed to decline slightly from the current 6% to 5% over the next 5 years This is based on the assumption that COGS for the company would remain stable at around 80% and selling expenses would also be stable at 15% of revenues.
Assumption 4: Depreciation is projected as fixed percentage of Gross block. From year 6 onwards, depreciation is assumed to equal to the CapEx. Assumption 5: Tax rate is assumed to be 32%, which is the applicable statutory tax rate for the company. Pro forma Balance Sheet Assumption 1: Share Capital remains constant and retained earnings of each year is added to reserves. Assumption 2: Deferred Tax and Unsecured Loans are assumed to remain constant as forecasting them is difficult and they are not operational level issues. Assumption 3: Using the above Source of Funds has been calculated.
Assumption 4: Cash has been used as the plug-in variable during forecasting. This also helps identify mistakes in the forecasted Balance sheet in case it becomes negative. Assumption 5: CapEx is taken as the average of past 3 years. Assumption 6: All leases have been capitalized at the pre-tax cost of debt. Lease rentals have been removed from the operating expenses and capitalized at the pre-tax cost of debt and added to the long-term viability of the company. Assumption 7: From the ending value of the Gross Block the Accumulated Depreciation is subtracted to get the Net Block for the year.
Assumption 8: Capital WIP & Investments are forecasted to remain unchanged. Assumption 9: Assuming stable Account Payable and receivable Days, Inventory turnover days and Cash conversion cycle, the current assets and liabilities have been estimated. Assumption 10: Using assumptions 1 – 9, the value of the plug variable “Cash & Bank Balance” is calculated. Proforma Cash Flow Statement Step 1: Find out the Cash flow from Operations using the PBT, Depreciations, Change in Working Capital, Change in Current Liabilities & Provisions and Direct Taxes
Step 2: Find out the cash flow from Investment which mainly comprises of Purchase of fixed asset or CapEx Step 3: Cash flow from financing activities include Dividend payments & Interest payment Step 4: Using Cash flow from Operations, Cash Flow from Investing & Cash flow from Financing find out the Net increase in Cash & Cash Equivalent. This when added to the cash at the beginning of the year gives the cash at the end of the year. Step 5: The cash at the end of the year can be cross-checked to that on the Balance sheet. DCF using FCFF Step 1: The sales from FY09 to FY13 are projected using inputs from Pro forma Profit & Loss statement.
Step 2: EBIT for FY09 to FY13 is projected, recurring other income is added to it. Step 3: The Tax effective @ 32% is subtracted from the above. To this Depreciation is added and CapEx and change in Working Capital are subtracted. This gives Free Cash Flow to the Firm. Step 4: Estimate the terminal value using FY13 FCFF and the terminal growth rate. Step 5: Calculate the Present value of FY09-FY13 FCFF and Terminal Value. To this value we add Cash and subtract Debt to get the Present Value of Equity. Step 6: Divide the PV of Equity Holding by a number of outstanding shares to get the Value per share of PCKH.
Sensitivity Analysis The DCF model is known to be highly sensitive to terminal growth rates and the Weighted Average Cost of Capital. To overcome some of the uncertainty in valuation because of this, sensitivity analysis has been done to see the possible range of intrinsic (DCF) value of the company for different values of WACC and the terminal growth rate.
