First It Was Bricks and Mortar Clothing Stores, But Now The Manufacturers Are Dying Too?

Put me in the camp that thinks the death of bricks and mortar retail stores is being greatly exaggerated. It is true that e-commerce is here to stay, but people seem to forget that most of the online clothing and accessories shopping is done on store sites that have a physical presence. The notion that Amazon private label clothes are going to render great American brands useless seems a bit far-fetched to me. So yes, there are retail stocks out there that look mispriced to me, but today I want to point out something else going on in the market that seems odd to me; clothing manufacturers are falling in sympathy because their goods are stocked in the stores that investors feel will be closed.

So let me get this straight… we aren’t going to buy shirts, pants, shoes, and underwear in an actual store, in fact, we aren’t going to buy them at all?! Is the Internet going to make it such that we never leave the house and therefore won’t require clothing? We’ll just order a pizza from Domino’s by tweeting and chill on the couch watching Netflix?

When I see the stocks of companies like Ralph Lauren, PVH, UnderArmour, and VFC Corp trading at multi-year lows it makes me think that Wall Street is getting this all wrong. Some of these names are less well known; PVH sells Van Heusen, Tommy Hilfiger, Calvin Klein, Izod, and Speedo, while VF owns North Face, Lee, Wrangler, Timberland, and Vans, among others, but let’s be honest, these companies might see their distribution channels evolve but they aren’t going away.

Below are some charts of the names I am digging into. Long-term I bet there are some great investments in the sector.


Full Disclosure: Long RL and UA at the time of writing but positions may change at any time

The Downward Spiral of the Tech Hardware IPO: Are Acquisitions on the Horizon?

We see this happen so many times. A hot brand new technology hardware company with a cool new product decides to cash in via an IPO. All is good for a little while and then Wall Street’s expectations for growth become too ambitious as competition grows and the need to constant upgrade one’s device wanes. The company misses financial targets for a few quarters in a row and the stock goes from darling to laughingstock in short order. I think we can all agree that fitness band maker Fitbit (FIT) fits the bill. Here is the stock’s chart since the IPO in mid 2015:

Another obvious poster child for this phenomenon is GoPro (GPRO):

To me, it seems the only logical play is for these companies to be acquired by larger technology companies who can best harness the value and loyalty behind these solid brands to maximize their profit potential.

So why should a bigger tech player swoop in and take Fitbit and GoPro out of their misery? Quite simply, the public markets become broken for these young disappointments very quickly. Given the competitive landscape, it will be very hard for either of them to reaccelerate its business to the level that would be required for investors to warm back up to the story. As a result, the stocks are being valued extremely cheaply if you consider the value of the brand and the current user base. As a result, it should be a no-brainer for the big guys to snap up the small fries. This becomes especially true if we consider that the IPO markets have allowed these smaller players to amass large cash hoards.

Take Fitbit, for instance. At less than $6 per share, FIT current equity value is a meager $1.4 billion. The company’s finances are actually is very solid shape, with no debt and a projected $700 million of cash onhand as of year-end 2016. Net of cash, Wall Street is valuing the Fitbit brand and the more than $2 billion annual revenue base (2016 figure) that it brings are just $700 million. For a strategic acquirer, that price should be mouth-watering. Even offering a big premium of 50-100% to persuade current shareholders to sell would not impede value-creation from the deal. Offer $11 per share/$2.7 billion for FIT ($2 billion for the operating business plus cash onhand) and it is unlikely a company like Apple or Google would regret it.

GoPro would be an even cheaper purchase. At the current $8.75 share price, Wall Street thinks the company is worth just $1 billion (net of $200 million cash, no debt). Could Apple not add value to its company by paying $2 billion for GoPro, innovating the product line further, and integrating it into their existing user base around the globe?

So why have these deals not really happened? In some cases, large tech companies firmly believe they are superior to the upstarts. As a result, they prefer to challenge them with internal product development (me-too copycats) instead of merging and taking out one of their competitors. Apple is probably the most prominent company in this category, as they refuse to acquire any meaningful competitor. And yet, it is almost assured that their competitive positions would be stronger today has they bought companies like Netflix, Spotify, Pandora, etc. Instead, we read stories like the one recently that said that Apple is planning to go into the original content business. All I can do is roll my eyes.

The second hurdle for these combinations is seller willingness to merge. From an emotional perspective, the board of GoPro would not have an easy time agreeing to sell the company for $15 or $20 when the stock price was $100 in 2014 and $60 in 2015. If they just come out with one more hit product the sky could be the limit! Same thing with Fitbit; we went public at $20 in 2015, how can we sell out for $10?

To me the playbook is obvious. Wall Street is telling you that your hyper growth days are over. The big guys have more resources and will slowly take your customers. For some reason, nobody realizes that combining forces is probably the best move for both sides in the long run. I will be interested to see if Fitbit and GoPro are public companies a year from now. Heck, maybe Steve Ballmer comes back to Microsoft and sees synergies with a Nokia/Surface/Fitbit/GoPro/X-Box product lineup (kidding, of course).


Cannibalization, Intense Competition Both Enormous Roadblocks for Chipotle Recovery

Shares of fast casual chain Chipotle Mexican Grill (CMG) are holding above $400 per share recently as investors cling to hopes that a full recovery is taking shape after e coli outbreaks halted the company’s impressive growth trajectory. Unfortunately for CMG bulls, the numbers do not seem to support that thesis.

Same-store sales have gotten back into positive territory in 2017, as the initial health issues from late 2015 are being lapped on the calendar, but overall sales volumes have not seen any improvement. Below are charts showing same-store sales (promising) and average unit volumes (illuminating) for CMG:


Even though same-store sales improved in Q4 2016 vs Q4 2015, total sales volumes continue to decline both year-over-year and sequentially. The year-over-year drops will likely continue for at least the first half of 2017, whereas the sequential declines will likely end very soon. The problem is that CMG is still planning to grow total units at a healthy clip (nearly 10% annually) and new units are only bringing in roughly $1.5 million each in annual revenue (~75% of mature units). This is most likely due to cannibalization from existing units, which limits volumes from new locations (proximity between units shrinks as more are opened).

Chipotle’s stock was a huge winner before the e coli issues due to lower build-out costs, high unit volumes, and profit margins that were the envy of peers. As the company continues to grow, the numbers will work against them and make it very difficult to regain their former financial glory ($2.5 million in average unit sales and four-wall margins of 27% at their peak). Without those kinds of metrics, the stock price looks richly priced at current levels with an equity market value well north of two times annual revenue. Buyer beware.

Full Disclosure: No position in CMG at the time of writing, but positions may change at any time

Beware of Seemingly Reasonable P/E’s on Growth Tech Companies

Pop Quiz:

Do all technology companies expense stock-based compensation in their financial statements? Perhaps more importantly, do sell-side analysts include such expenses in their quarterly earnings estimates, on which every quarterly report is judged by Wall Street?

Given that stock-based comp has been a hot button accounting issue for a couple of decades, and the chief accounting rule board (FASB) required GAAP financial statements to include such expenses way back in 2004, I suspect that most investors are not really paying attention to the issue anymore.

Since I am a value-oriented investor, most of my investments are outside of the high growth tech sector, where most of the stock-based compensation resides. Nonetheless, a few months ago I wanted to dig a little digging because I did not understand why market commentators in the financial media were seeming to understate the P/E ratio of the S&P 500. I have been closely watching S&P 500 index earnings for most of my career, so it struck me as puzzling when people on CNBC would claim something like “The S&P 500 trades at 17 times earnings, which is only modestly above historical averages.” In fact, the numbers I saw on the actual Standard and Poor’s web site showed the P/E to be more like 19 or 20x. Given that the historical average is around 15x, there is a big difference between 17x and 20x. So what the heck is going on?

It turns out that there is a large financial data aggregation company called FactSet, which supplies many investors with earnings data on the S&P 500. You can find their earnings data directly on their web site. After reading through it I realized that FactSet was showing higher earnings levels for the S&P 500 (which equates to lower P/E ratios by definition), and that is where the market commentators were getting their valuation information. For instance, the current FactSet report shows that calendar year 2016 earnings for the S&P 500 are projected at $119, which gives the index a trailing P/E of 19.3x. However, the S&P web site shows a figure of $109, which equates to a trailing P/E of 21.1x. Investing is hard enough, but now we can’t even agree on what earnings are? Maybe I’m making a big deal out of nothing, but this is frustrating.

The logical question I needed to answer was what accounted for the gap in earnings tallies. If earnings really were 9% above the level I thought, my view of the S&P 500’s valuation would undoubtedly change. I was shocked when I learned the answer.

It turns out that FactSet’s earnings data does not represent the actual earnings reported by the companies comprising the S&P 500, which is what the figures on the S&P web site show. Instead, FactSet uses the reported earnings that match up most closely with the Wall Street’s analysts’ quarterly forecasts. Put another way, if the analyst community excludes certain items from their earnings estimates, FactSet will adjust a company’s actual reported earnings to reflect those adjustments (for an apples to apples comparison to the Wall Street estimate) and those earnings figure are used when they tell the investment community what the earnings for the index actually are. If this sounds bizarre to you, it should.

Having followed the market for my entire adult life (and all my teenage years too), I immediately knew what accounted for much of the gap between these earnings estimates. Most technology companies still to this day report non-GAAP earnings results right along side GAAP figures in their earnings reports. For reasons I don’t understand (since the issue of whether stock compensation is an actual expense was resolved years ago), the analyst community excludes these expenses in their numbers, so when a tech company reports earnings, the non-GAAP number is comparable to the analyst estimate. As such, the non-GAAP number is incorporated into FactSet’s data. So whenever a stock market commentator quotes the FactSet’s version of the index’s P/E ratio, they are inherently ignoring billions of dollars of employee compensation that is being paid out in shares instead of cash.

To illustrate this point, Consider Google/Alphabet’s fourth quarter earnings report from last night. The analyst estimate was $9.44 per share and Google reported $9.36 per share. So today’s media headlines say that the company “missed estimates.” If you read the financial statements carefully you will see that Google’s GAAP earnings were actually $7.56 per share. The non-GAAP earnings figure, which is the ones that is reported on because that is how the analysts do their projections, was a stunning 24% higher than the actual earnings under GAAP accounting rules.

You can probably guess why there was such a large gap. During the fourth quarter alone, Google incurred stock-based compensation expense of… $1.846 billion! Multiply that by four and Google’s run-rate for stock compensation is $7.4 billion per year! That is $7.4 billion of actual expenses that are being excluded from FactSet’s earnings tally, and that is just from one company (albeit a big one) in the S&P 500 index.

So how does this impact investment decisions? Well, there are many people that look at Google and see an $850 stock price and $34.40 earnings for 2016 and conclude that the stock is quite reasonably priced given the company’s growth rate, at less than 25 times trailing earnings (850/34.40=24.7). Of course, the actual P/E is 30.5x because when you add back stock-based comp Google’s earnings per share decline from $34.40 to $27.85.

The valuation differentials get even larger when you consider younger, smaller technology companies because these firms seem to be addicted to stock-based compensation. Google pays out a lot in stock, but even that $7.4 billion figure is only 7% of the company’s revenue. Paying out 7% of sales as stock compensation is indeed a very large figure, but other tech companies dole out far more.

I looked at some other fairly large ($5-50 billion market values) tech firms and the numbers are staggering. During the first three quarters of calendar 2016, (CRM) paid out 9% of revenue in SBC, but that seemed quite low compared with some others. Zillow (ZG): 13%. ServiceNow (NOW): 23%. Workday (WDAY): 24%. Twitter (TWTR): 26%. Can you believe that some tech companies pay a quarter of revenue in stock-based compensation? Not total compensation, just the stock portion!

Importantly for investors, these companies are getting very large valuations on Wall Street. In fact, those five tech companies have current equity market values that cumulatively exceed $100 billion. I wonder if investors might view them a little less favorably if they realized they might be less profitable than the appear on the surface.

For me, the takeaway from all of this is that all investors should dig deeper into valuations in general. Don’t just take figure you hear on CNBC or read in press releases as gospel. Just because a web site says a company has earnings of X or a P/E ratio of Y does not mean there isn’t more to the story.

Dow 20,000: Just A Number

How about that? Dow 20,000! What a hugely important milestone! Right? Well, not really.

Sure it will make for a good front page story in USA Today tomorrow, and those few humans who are still needed on the trading floor of the New York Stock Exchange (they’ve been largely replaced by machines) will unpack the Dow 20K hats for sure, but Dow 20,000 is no more important than Dow 18,763.

When the Dow Jones Industrial Average is this high, we actually would expect new milestones to be reached on a very regular basis. An average stock market year (+10%) would actually see us break through another 1,000 point level every six months. Even if we stretch the milestone interval to 5,000 points, it will only take two and a half years on average.

In fact, it only took 18 years from 10,000 to 20,000. That might sound like a long time for the index to double (it’s only a 4% average return during that time), but that period includes the massive dot-com market collapse of 2000-2002, as well as the Great Recession of 2008-2009.

Here is a calendar breakdown of Dow Jones milestones:

As you can see, every milestone from Dow 3,000 through Dow 20,000 has occurred since the 1990’s. Dow 1,000 — now that was a milestone… it took 76 years from the index’s creation in 1896 for it to pierce the 1,000 level!

Also of note is how the Dow itself has become less and less relevant over time for investors. Most of us use the S&P 500 index since it represents more broadly diversified group of public companies, versus just 30 for the Dow. This is also because the S&P 500 is value-weighted, meaning that a company worth $10 billion comprised twice as much of the index as a $5 billion company.

The Dow, on the other hand, is share price-weighted. So while Bank of America (market value $235 billion) is ~2.5 times larger than Goldman Sachs (market value ~$95 billion), it actually makes up far less of the Dow’s composition than Goldman does. In fact, BofA’s share price is only 1/10th that of Goldman, so a $1 increase in GS stock (which is a gain of 0.4%) adds the same amount of points to the Dow as a $1 increase in BofA stock (a gain of 4%) does. It’s really a bizarre methodology.

Despite all of that, I’m glad we are getting 20K out of the way so we can stop hearing about it. That is, of course, until we hit Dow 25K, which history suggests is most likely to happen in just a few years.


Healthcare Stocks Look Poised To Rebound In 2017

Please excuse the technical difficulties this site has experienced lately. After some adjustments everything should be back up and running smoothly. As such, I am hopeful that posting frequency will pick up a bit this year.

Perhaps one of the more surprising stock market trends post-election has been the relative inability for the healthcare sector to get back on track after taking a beating during the campaign season. With government deregulation on the way, as well as a bipartisan bill having passed Congress late in 2016 that will serve to loosen the FDA drug approval process, rational minds might have expected healthcare stocks to stage a large rally, much has been the case with banking stocks (same thesis; rolling back the regulations put in place post-recession).

We have seen a bit of a pickup in recent days, but after an initial one-day surge on November 9th, healthcare stocks have been lagging generally. I fully expect that 2017 will be a much better year for the sector. Abusive drug price increases will surely still get the attention on lawmakers, but that practice should come to somewhat of a halt now that the industry has seen what can happen to the likes of Valeant (VRX).

While investors will have to temper their growth rate expectations for pharmaceutical-related companies, the fundamental demand story should remain intact longer term. The strong companies should have no trouble churning out consistent sales and strong cash flow. Doing so will prove to investors just how resilient the industry can be, and should result in more normal valuations for most players in the sector.

To give you an example of how strange some of the price action has been in these names, consider one that I have been accumulating recently, both personally and for clients: CVS Health (CVS). This leading healthcare name has seen its share price take a stunning downward turn, from over $100 to as low as $70 per share. It’s hovering around $80 currently.

CVS is not some small drug company with a few products that has grown by dramatically increasing prices. We are talking about a blue-chip franchise with leading positions in both retail drugstores and pharmacy benefit management. The historical record of shareholder value creation is impressive. From a long-term demographic perspective, CVS stands to benefit greatly from drug innovations and an aging population.

And yet somehow the stock is currently fetching just 14 times annual earnings, a whopping 30% discount to the S&P 500 index. With overall valuations in the market in the upper band of the historically normal range, CVS looks like quite a bargain, even as the sector has been a focal point for criticism. While stocks like this have hurt investor performance lately, myself included, I see little reason to think 2017 cannot be the start of a healing process for an excellent American company like CVS Health.

Trump Stock Market Rally Staring Down Formidable Opponent: Valuation

With the U.S. stock market having rallied 5% since Election Day, many investors are very enthusiastic about President-Elect Trump’s clear agenda of filling his Cabinet with wealthy business people who will be tasked with creating an optimal business environment for American companies. Slashing regulations, cutting corporate tax rates, and incentivizing profits earned overseas to be repatriated back to the U.S. will certainly put a jolt into Corporate America. Perhaps even more crucial to the recent stock market rally is the fact that infrastructure spending and corporate tax cuts are likely to be funded with additional borrowings by the federal government. As a result, we have seen a steep increase in interest rates over the last month, which has led many traders to sell bonds and reallocate that capital into stocks.

But after that asset reallocation is over, then what? Count me as skeptical that this market rally will continue for the next four years. I see two main headwinds that are likely to creep into the picture beginning in 2017; lofty legislative expectations for the Republican-controlled Congress and elevated stock market valuations.

First, there is likely to be a gap between what legislation is actually passed in 2017 and the “best-case scenario” that stocks seem to be banking on today. Dreams of a $1 trillion infrastructure spending program coupled with large personal tax cuts, as well as a reduction in the corporate tax rate from 35% all the way down to 15%, will cost a lot of money. As in trillions of dollars. Where does this money come from?

President Obama has been able to reduce the federal government’s annual budget deficit by more than 50% since he took office, but the U.S. is still spending more than half a trillion dollars more each year than it is bringing in from taxes. There are likely many Republicans who are concerned enough about our country’s finances that they would be unwilling to vote for a material increase in the budget deficit. In that scenario, $1 trillion of spend on infrastructure spending does not work. Corporate tax rates fall to 20-25% instead of 15%, and large personal tax cuts become quite small (remember George W Bush’s $300 per person tax cut in 2001?). A more subdued legislative result would limit the rush of cash into personal and corporate pockets that many are hoping for. Simply put, expectations might be too high.

Even more concerning for the stock market are current valuations. Right now the S&P 500 index trades for roughly 20.5 times estimated earnings for calendar year 2016. The average trailing 12 month price-earnings multiple over the last 50 years is 16 times. Market bulls are quick to point out that interest rates are sitting at below average levels, so stocks deserve to trade at above-average prices. That may be true, but interest rates are on the rise and over the last five years, as interest rates reached record low levels, the S&P 500 index traded between 15 and 20 times trailing earnings. As interest rates rise, stock valuation multiples should go down, not up.

This chart shows year-end price-earnings ratios for the S&P 500 index going back more than 50 years. To smooth out the downward volatility seen during recessions, I used “peak earnings” (highest ever recorded) as opposed to “current earnings” (trailing 12 months). The consensus for 2016 earnings is to get within ~3% of the profit peak, which was in 2014 before oil’s big drop.

Simply put, price-earnings ratios are likely to trend downward over the next few years. In order for stock prices to continue their march higher, corporate profits would really need to grow quickly. If legislative action on that front disappoints in 2017, the current market optimism could very well die down quickly. Normally, Trump’s election could very well have marked the beginning of a prolonged bull market in stocks, due to his desire to put business leaders in powerful positions (the underlying assumption being that these folks will be more friendly to business than any other constituency). The big headwind to that theory this time around is that during President Obama’s two terms in office, the Dow Jones Industrial Average has soared from below 8,000 to over 19,000. As a result, the old adage that “trees don’t grow to the sky” seems particularly relevant, no matter the legislative agenda.

That is not to say that markets are going to reverse course and move dramatically lower. I think a more likely outcome is that P/E ratios move from 20-21x to 16-18x and corporate profits grow at a 5-10% annual clip. In that scenario (7.5% annual profit growth and a 17x P/E), the S&P 500 index in four years would be trading around 2,475, or roughly 10% above current levels. Not a terrible outcome, but hardly robust either.

This Is How Amazon Will Become America’s Most Valuable Company

In 2014 I invested in (AMZN), much to the bewilderment of many of my clients. Even though the stock had fallen from more than $400 to below $300 per share, the consensus view was that the company was a money-losing unfocused endeavor that prioritized innovation over financial considerations. In many minds, there was no way to justify Amazon’s market value, so $280 per share was pretty much just as crazy as $400 per share.

Fast forward 30 months and Amazon shares trade in the mid 700’s. The company is reporting GAAP profits and still growing 20% per year. Prior skeptics missed several things, but at the core they did not account for the fact that Amazon sees no boundaries in terms of areas in which it will compete. The company was losing money in the accounting world, but in reality certain businesses were making money and those profits were being used to subsidize growth initiatives in other areas, some of which would fail and others that would succeed but not turn a profit on their own until years later.

We often hear growth investors focusing on a company’s total addressable market, or “TAM,” when trying to figure out how high a stock could go over a 5 or 10 year period when growth is more important to management than short-term profitability. Many Amazon investors try to gauge the company’s TAM by looking at the total retail market, and assuming e-commerce ultimately represents X percent of retail spending, and Amazon gets Y percent of that e-commerce market. That method of analysis would work for most companies, but not Amazon. The problem is that it implied that we know what categories will have an e-commerce component and that the e-commerce penetration of each category will remain somewhat consistent (such that we can predict what it will be).

Why is that problematic? Watch this video, unveiled today by Amazon:

You see, Amazon is not a traditional company. It is creating new businesses that don’t exist and it is re-imagining business models, like the convenience store. There is really no way to know what businesses Amazon will get into in the future. All we really know is that they are more willing than any other company on Earth to venture into something new that may or may not seem to make sense. This is why I believe within the next five years Amazon will become the most valuable U.S. company. There is nothing stopping them from growing because they never limit themselves.

The “Amazon Go” store you saw in the video (see the related Seattle Times article here) will open in 2017 in Seattle, about 10 miles from my house. I will eagerly await its arrival and share my initial experience when it opens. As for the stock, as the price warrants I will reduce my position over time (I already have sold some), but it is probably the only stock I have ever owned that I will continue to hold at least some of my shares almost no matter how high it goes. As long as I cannot predict where Amazon’s growth will take it in the future, it will be hard for me to confidently say the company is overvalued.

Full Disclosure: Long shares of Amazon at the time of writing, but positions may change at any time.

2016 Election: Thoughts The Day After

It is reasonable to expect that the financial markets will see an increase in volatility over the coming months as folks try to decipher exactly how a Trump presidency will look, feel, and sound. I thought I would share some initial thoughts, both on the election result and how U.S. policy might evolve in 2017.

  • The conventional wisdom as people digest the election results is likely to be that Trump had a unique ability to connect with a set of voters that might not have been regular voters in past cycles and were sick and tired of the political status quo (high turnout), whereas Clinton had a last name and a resume that defined that very persona (low turnout). I doubt it will get much airtime, but it turns out that only one of those scenarios played out. Below is a summary of the popular vote totals from the last four elections. I think it is quite striking and explains the result this year.popvote
  • From a business and financial market perspective, there are several issues that are likely to be addressed in 2017 now that Republicans will control the executive and legislative branches of government. They have both positive and negative aspects, which means that the exact details will be very important. Several come immediately to mind:
    • Overseas cash repatriation
    • Corporate tax reductions
    • Personal income tax reductions
    • Infrastructure spending
  • In every case, the core question will be how/if the tax cuts/spending increases are paid for
  • If not, more borrowing will increase the deficit and debt, which would exacerbate an existing problem
  • If they are paid for, it will be important to see which segment of the country takes the brunt of the cuts. We have seen in the past that cutting services for the working class to pay for lower taxes for the wealthy and corporations doesn’t work so well, so the ideal scenario would be relatively equal benefits for everyone
  • Bringing foreign cash back to the U.S. should be a no-brainer no matter your political affiliation. There is no doubt that it benefits the wealthy more than others, but it makes no sense for trillions of dollars to be idling in foreign bank accounts in perpetuity
  • Lower corporate taxes would definitely boost the stock market and it would be a very rational response. Again, the key is how they would be paid for (if at all) and whether cuts elsewhere would offset the benefits. Again, wealthier people have more assets invested in the markets, but higher stock prices help the value of retirement accounts no matter the size
  • Starting in 2017 it should be abundantly clear what the priorities of the new administration are and how they will approach legislating them. Only then will we have a sense for whether economic optimism is warranted or not.

Have We Finally Reached Restaurant Saturation?

I have been an avid long-term investor in the restaurant space for nearly two decades. I think my first food investment was Panera Bread Company (PNRA), which I was very familiar with due to my undergraduate years in St. Louis. St. Louis Bread Co was acquired by Au Bon Pain in 1993 and about five years later they decided to divest all of their other restaurant concepts in order to focus on rebranding the local favorite “Bread Co” into a dominant national chain called Panera. To this day the company’s St. Louis locations retain the original name.

So why do I favor solid investment stories in this sector? Here are some of the most important reasons:

  1. The business model is easy to understand and analyze.
  2. The secular trend of less cooking at home and more dining out (or carry-out) is well established
  3. It is very easy for investors to research how the units operate and sample the product
  4. Smaller chains have a large runway for growth if they decide to expand from regional to national players
  5. Private equity type transactions are common in the industry, which gives investors comparable terms to use for valuation

In recent years, however, the space has gotten very crowded. Many companies have gone public and in order to attract growth investors have promised impressive annual unit growth (10%+ per year in many cases). And there are a slew of smaller, private companies that have major growth plans. Consider two examples that I have encountered in recent years in the Pacific Northwest; MOD Pizza and Little Big Burger.

MOD was founded here in Seattle in 2008 and by 2014 had over 30 locations. After opening up the chain to franchisees, growth accelerated and there are more than 150 units today.

Little Big Burger was founded in Portland in 2010 and after only five years and 10 locations was sold to a largest restaurant operator for $6 million. The company now has plans to open at least 10 units in the Seattle area. Just what we need… another burger place!

We are seeing this all across the country. Rapid expansion of fast casual restaurants in the sandwich, pizza, burger, taco, and burrito spaces, among others. And it’s not just the larger players, but smaller concepts too that seem to yearn to play with the big boys. And so now we are facing what appears to be a restaurant buildout unlike anything we have ever seen. But with a population growing at less than 1% annually, and income growth relatively muted, how on earth can we support all of these places? It should certainly be a concern for investors.

And we have seen Wall Street adjust their willingness to assign premium values to publicly traded restaurant stocks. Fast growing concepts used to trade for 10-15x EV/EBITDA on the public markets, versus about 8x for more well known, mature brands (a crummy brand would fetch just 6x). We seem to now have a situation where most stocks in the industry are shifting down to that 8x number. The market is basically saying “we have too many units already, so either you won’t open at the rate you are planning, or if you do your profits per unit will go down.” Higher minimum wages across the country don’t help either.

So what are investors to do? I don’t think the restaurant space is “uninvestable” by any means, but we need to be more selective about the chains we allocate capital to, and also more strict in our valuation criteria. For instance, I am an investor in Kona Grill (KONA). The full service, sit-down chain will end 2016 with 45 locations across the country. For the third year in a row they are growing their unit base by 20%, which has traditionally afforded it a premium valuation. But recently sentiment has shifted. Below is a 2-year chart for KONA shares:


Fortunately, KONA has a lot of good things going for it. First, the CEO is the largest shareholder. Second, their concept is relatively unique and their units are doing well. Third, they are small enough to grow quickly if they want to (the company recently conducted a third party analysis which found a market opportunity of nearly 300 units in the U.S. alone, though give the content of this post, perhaps that number should be taken with a grain of salt).

As a result, management has publicly indicated that since Wall Street is no longer rewarding 20% annual unit growth, they are going to scale back their expansion plans. Since the CEO owns so much stock, he will likely turn his capital allocation attention to share repurchases. While growth-focused investors likely soured on the stock upon hearing this news (and sold, contributing to recent price declines), I actually applaud the move. With the stock trading at roughly 70% of projected 2016 revenue, retiring existing shares is an excellent use of capital. Coupled with unit growth of, say, 5%, shareholder value creation should follow.

And that is an important point. Since valuations have come down across the board for public restaurant stocks, future gains will be predicated on not only existing unit performance but also on capital allocation. Those companies that opt for share repurchases when their stocks are cheap (and debt repayment if they are not) and tweak their expansion plans based on competitive conditions (as opposed to the rigid plans they have laid out to investors in the past) are likely to be much better performers.

All in all, a lot is changing in the sector, both on the ground and in the financial markets. Recent months have not been kind to stock prices as valuations have dropped considerably, but there definitely attractive investment opportunities if you find proven concepts with management teams that are nimble and change course if conditions warrant. Count KONA as one of those that I believe fits that mold, despite poor recent stock action.

Full Disclosure: Long shares of KONA at the time of writing, but positions may change at any time