Description

Executive summary

Café de Coral is Hong Kong’s leading local fast-food operator, serving over 300,000 people daily. The company was hit hard by the COVID-19 pandemic but remained close to cash flow break-even and is not getting close to a full recovery. Hong Kong’s COVID-19 restrictions have been removed, and tourists are also returning. Assuming Café de Coral’s revenues/store revert to HK$17.5 million and the operating margin reaches the prior 8%, the stock will trade at a P/E of 7.8x. With a return to its pre-COVID 80% payout ratio, Café de Coral would be trading at a dividend yield of 10%. The fact that the controlling shareholder bought another US$1 million worth of shares a few months ago is a sign of confidence. 

Introduction

Café de Coral is Hong Kong’s largest fast-food chain after McDonald’s and the leader among the restaurant chains serving Hong Kong-style fare: rice dishes, noodles, roast goose, dim sum, sandwiches, etc. Its English name, “Café de Coral”, is a transliteration of the Cantonese words ”Dai Ga Lok”, which mean “All Happy Together”. 

In Overlook's Richard Lawrence’s book The Model, he described Café de Coral in the following way (quote from 2007): 

“The contrast between Café de Coral and McDonald’s in terms of ambience, cleanliness, and meal selection was huge. Over 22 lunch selections were available on the day of my visit, many of which vary day by day, enabling customers to order new dishes on a daily basis. CdeC’s outlet had a modern look, creative lighting, spacious seating, contemporary furniture, and flat screen TVs on the walls… 

One could not help but appreciate that CdeC was intimately in tune with the desires and culture of Hong Kong people. The feel was much closer to a restaurant serving interesting food than the fast-food outlet suggested by its prices.“

In other words, Café de Coral offers a Hong Kong casual dining experience at fast food prices. 

The company was founded by Lo Tang Seong and his brother Lo Hui Luk in 1968 to provide affordable meals to the Hong Kong working class. The same Lo family later started beverage producer Vitasoy and competitor Fairwood. They expanded quickly across Hong Kong and listed the entity in 1986. The company also tried to enter mainland China in 1992 but gave up its ambitions to grow nationally and is now focusing solely on the nearby Guangdong Province. 

Since 2016, the company has been run by “Peter” Lo Hoi Kwong, the son of one of the two founders. In early 2024, Peter announced that he would step back from the CEO position in favor of Piony Leung, who used to be in charge of Café de Coral’s Hong Kong business. But Peter will remain an Executive Director, and I don’t expect any major shift in the overall strategy or the company’s execution. 

Today, the company has 543 outlets in Hong Kong and mainland China, serving 300,000 people daily. The most popular concept is its namesake Café de Coral restaurant. But it also operates an institutional catering business focusing on schools, hospitals, etc. It has also developed or acquired several other restaurant concepts, such as Spaghetti House, Oliver’s Super Sandwiches, Mixian Sense and Shanghai Laolao. Fast food represents 79% of revenues, casual dining concepts 10% and their catering business most of the remainder. 

Within Hong Kong, Café de Coral targets office workers seeking affordable lunches. The average ticket size per customer is HK$40-50 per customer, about US$5-6 using today’s exchange rate. The company operates 172 stores with the Café de Coral brand name in Hong Kong, a market that’s become mature with growth in the low single digits. There’s competition from similarly named Fairwood and other restaurant operators such as Maxim’s. 

Growth has instead come from mainland China, where Cafe de Coral’s menu prices are significantly above the average fast-food restaurant. Today, it mostly targets Pearl River Delta cities such as Shenzhen, Foshan, Zhongshan, Zhuhai and Dongguan. Café de Coral has previously said it wanted to double the number of its mainland Chinese outlets within three years, implying an aggregate 10% yearly store count growth for the entire group on top of low-single-digit same-store sales. These numbers seem optimistic to me but reinforce that management continues to see growth potential in the mainland business. China segment margins have been high, but the return on equity has been dragged down by significant investments in its central food processing plants. 

Café de Coral has four central food processing plants: two in Hong Kong and two in nearby Guangdong province. These provide Café de Coral an edge against the competition: They ensure a consistent product with lower inventory requirements for the individual outlets, helping them save on rent. Centralized procurement also provides greater bargaining power in the purchasing of ingredients. The system also helps reduce waste. But the problem has been overinvestment: the central food processing plants in Hong Kong operate at decent utilization rates, but the mainland equivalents are operating at only 40%. 

The impact of COVID-19

Café de Coral grew its revenues consistently for almost 20 years until 2019. Then, it suffered from a series of unfortunate events:

First, Hong Kong suffered weak tourism following the anti-government protests in the summer of 2019. China cut off group travel to Hong Kong and discouraged individual travel. 

Second, in early 2020, Hong Kong suffered an outbreak of COVID-19. Its borders closed, causing tourism to grind to a halt. The city’s draconian zero-COVID policy forced restaurants to close early and limit the number of customers in each outlet. Café de Coral’s average revenue per store dropped from HK$18.3 million in FY2019 to HK$14.2 million at the bottom in FY2021. For the industry, Hong Kong’s total value of restaurant receipts fell 27% from the peak in 2018 to the bottom in 2022. Restaurant receipts remain about 11% below the peak in 4Q2018, partly due to still-weak tourism in Hong Kong. 

The work-from-home trend caused office workers to eat at home rather than in restaurants. Hong Kong MTR ridership dropped about 50% from 2018 to the COVID bottom and remains around 10% below the pre-COVID level. But like in many other Asian cities, working from home is not as prevalent as say in the United States. The average living space per capita in Hong Kong is only 16 square meters - far lower than America’s 77 square meters per capita. In my personal view, most office workers will eventually be forced back to their desks, though it could take a few years. 

Third, in 2020, the Hong Kong government introduced a new National Security Law, that weakened its legal system and took away some of the freedom that citizens once had. Roughly 410,000 people have left Hong Kong since then, equivalent to roughly 5.5% of the population. However, it’s hard to distinguish whether some of this net migration was due to the zero-COVID policy with many possibly choosing to weather out the pandemic outside of Hong Kong. A positive sign is that since 2023, net migration to Hong Kong has actually turned positive. And the government has another powerful lever: allowing for greater immigration from mainland China. There is no shortage of mainland Chinese who want to move to Hong Kong to provide a better life for their families. Salaries in Hong Kong remain higher than in mainland China. 

In the past ten years, Café de Coral’s margins have contracted. Part of the reason is the company’s lower revenue/outlet. Another reason is the low utilization of Café de Coral’s mainland food processing plants, two of which were built in the 2011-13 era. While the pre-COVID margin was around 8-9%, on my estimates they can probably reach above 10% margins once Café de Coral’s central food processing plants reach full utilization. 

Café de Coral’s future

Hong Kong gave up its zero-COVID policy in late 2022, with no restrictions on either individuals or on the operation of restaurants. Further, the Hong Kong-mainland China border has been open since January 2023. Tourism has now returned to 4 million arrivals per month, which is roughly 2/3 of the level experienced before the anti-government protests began in mid-2019. 

Café de Coral’s aggregate revenues have already recovered to their pre-pandemic level. But the revenue/store of HK$15.9 million remains 13% below the peak in 2018. I believe this number will gradually improve as tourism, net migration, and a return to offices continue to trend in the right direction. 

Café de Coral’s recent guidance for FY2024 revenues is positive: 

“While more time is required for a full economic recovery, the Group remains cautiously optimistic regarding performance and prospects in the second half of the year.”

Its margin guidance has also been positive: 

“The Group remains on track to improve its profit margins and believes the Hong Kong business is well positioned to take advantage of economic recovery in the market.”

Competitor Fairwood is guiding positively as well, which I believe reflects positive industry dynamics:  

“Hong Kong’s F&B and retail markets are gradually improving as the economy gains momentum… With business having been steady over the past six months, the Group is anticipating a solid second half ahead… The immediate outlook is highly positive.”

In the last interim report, Café de Coral’s operating margins reached 6.2%. I believe that operating margins will eventually get closer to 8% as 1) leases get repriced lower 2) Hong Kong employers require workers to come back to the office 3) net migration continues to reverse 4) food price inflation challenges are dealt with through higher menu prices. While it is plausible that mainland tourism to Hong Kong will never fully recover, I still think that margins will mean-revert over the medium term. If industry margins remain low for an extended period of time, then many of Hong Kong’s restaurants will simply go out of business. 

At 5% store count growth per year and HK$17.5 million in revenues per store with an aggregate 8% margin, you’ll be looking at a 2025e EPS of HK$1.06 and a P/E ratio of 7.8x. Historically, the stock has traded closer to a P/E of 20x. Asian peers such as MK Restaurants and Yum China trade closer to 20x as well. 

Café de Coral has typically paid out about 80% of its earnings as dividends, which in the above scenario would lead to a dividend yield of 10%. 

Finally, controlling shareholder Lo Tak Shing purchased US$2 million worth of shares in Café de Coral in 2021 and another US$1 million in September 2023. And the options issued in the recent employee stock option program have an exercise price of HK$14.9, roughly 80% above the current share price. 

Risks

The broader Lo family (not Peter Lo) owns Vitasoy, a company targeted by Beijing for being pro-Hong Kong independence. After a Vitasoy employee killed a Hong Kong policeman, its sales in mainland China suffered, and the company turned to loss-making. Now, the connection between Vitasoy and Café de Coral is tenuous. Hong Kong citizens tend to consider Café de Coral pro-Beijing if anything. But it's a fact that in China, political risks are ever-present and difficult to understand as an outsider. 

Higher food prices can hurt short-term margins, as they did in FY2022. 

Minimum wage hikes can have short-term impacts on margins, as happened several times during the 2010s. 

There’s always a risk that Café de Coral’s mainland expansion turns into tears, as it’s done for many other Hong Kong restaurant operators, including Fairwood. 

Food safety scandals can also erupt, though they have been rare for Café de Coral in the past. 

Note that I do not include operating leases in my calculation of enterprise value, and that the quoted EBIT is after subtracting said leases. 

Catalyst

FY2023 earnings release in June 2024. 

Greater tourist arrivals to Hong Kong. 

More aggressive store openings in mainland China.