Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver

There is a long list of things to like about the restaurant sector from an investment perspective. Secular trends such as dual-income households have led many families away from frequent home-cooked meals around the dinner table. The busier we are, the more likely we will rely on restaurants of all shapes and sizes. Add in low gas prices and one would think restaurant stocks would be among the stock market’s best performing groups. And yet it has been quite the opposite lately.

I have always liked to invest in the sector, not only for the reasons above but also because it is relatively easy to understand and analyze. Chains often try to differentiate themselves, but the general recipe is the same for most. Suffice it to say I am finding so many bargains in the sector lately it is difficult to choose which ones should make the cut in a portfolio. Valuations are about as low as I have seen them since I began investing more than 20 years ago.

So why are these stocks having so much trouble with both secular and cyclical tailwinds? I think a big issue has been a very strong market appetite for well-known restaurant IPOs. Consider that there are more than 50 publicly traded restaurant stocks in the United States, and more than 20 of them have IPO’d since 2010. Just as these companies are having to compete for customers, they are also competing for investors’ capital. Given that restaurants are a small subset of the consumer sector, there is a finite amount of investment dollars being allocated to the group. With more and more options boarding the public market train, many are simply being discarded.

And despite low gas prices and a propensity to eat out or carry out meals, there are operational challenges all of these chains are facing. The biggest in my view is simply the sheer number of new locations being opened by restaurant chains generally. The number of food options these days can often be overwhelming. At some point it is reasonable to assume the U.S. is going to be facing an overbuilt restaurant sector, at which point many will start to see material declines foot traffic, sales, and profits.

That said, I firmly believe that there are many attractive investment opportunities within the restaurant space. Within the small cap arena there are many companies that offer a compelling business model and meager valuation. A great example is Kona Grill (KONA), a sit-down concept that will deliver over 20% unit growth in 2016 and end the year with 45 locations across the country. The company averages $4.5 million in annual unit revenue and 17-18% unit level profit margins, with a build-out cost of $3 million per location.

At the current $11 share price, which is down a stunning 50% from its 52-week high, the stock trades at a total market value ($127 million) below its $135 million replacement cost (note: replacement cost is how much money it would take to replicate the company’s assets if you started from scratch today). Throw in a long runway of future expansion potential and you have a very attractive long-term investment that Wall Street is completely ignoring. And there are many other bargains out there to be found if you look closely.

Kona Grill (KONA) – 2-Year Chart

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

Even With New E. Coli Cases, Chipotle Shares Not Yet Cheap

Shares of casual dining chain Chipotle Mexican Grill (CMG) have been hammered since reports of E. coli outbreaks across the country have caused a material decrease in customer traffic during the fourth quarter (double-digit same store sales declines have been confirmed by the company). After peaking at more than $750 in August, the stock now fetches a little more than $500 per share.

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This is definitely the kind of short-term sell-off I pay close attention to as a long-term, contrarian investor. History tells us that restaurants dealing with outbreaks like this see a drop in customer visits but eventually recover. Within a year or two, after the headline news has abated and the health issues rectified, people revert to their previous dining habits. With a perennially high valuation stock like Chipotle, a negative event like this can often be one of the only ways investors can get a bargain for their portfolio. So am I loading up on the shares at the current ~$520 price?

Not yet. Simply put, I don’t find the price extremely compelling, even after a 30% decline. Before the E. coli cases came about, Chipotle was having quite the year from a financial standpoint. Revenue was tracking at about $4.7 billion for 2015 (+15%) with operating cash flow approaching $800 million (about as high a profit margin as you will find in the industry). I estimate maintenance capital expenses for the company’s existing restaurants to be quite low (less than $100 million annually), so CMG’s existing units were on pace to produce free cash flow of $700 million per year before the outbreaks.

The problem for value investors like myself is that the stock’s valuation has gone from insanely high ($24 billion at the peak, or about 34 times free cash flow) to a lower level today (23.5 times free cash flow) which is still fairly high. Despite CMG’s growth outlook, I would have valued CMG at 20 times free cash flow before the recent drop (~$450 per share). Now that customer traffic has dropped more than 10% and will likely take at least a year to recover, I would want a discounted price to reflect the time it will take for the company to fix the problem once and for all and see visitors return to their normal habits. A 25% discount would mean a stock price in the 330’s. Accordingly, I do not think I will be bottom-fishing in CMG shares anytime soon. There are just too many other restaurant chains that I think are meaningfully more attractive from a valuation perspective.

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

Whole Foods Market: 2015 Update

It has now been about 18 months since I began accumulating shares of Whole Foods Market (WFM) in the high 30’s. Since that time the stock briefly had a huge move back into the 50’s before losing steam again. Same-store sales have decelerated but my investment thesis remains unchanged; just because competitors are copying WFM’s model and seeing success does not mean that the company cannot continue to be the leader in the healthy food space. Investors were not pleased with WFM’s quarterly earnings report last night, but the stock is finding some support around $30 and might be forming a bottom.

So how bad are things really? Well, if you only look at the stock you might conclude the company is all but dead. For instance, traditional supermarket chain Kroger (KR) now fetches a higher relative valuation (cash flow multiple) than WFM, despite the fact that they have more than 2,600 stores nationwide compared with 431 for Whole Foods. Yes, investors think Kroger will deliver better financial results going forward. I don’t suggest taking that bet.

The financial media has concluded that WFM’s troubles are due to people shunning their stores for the likes of Wal-Mart, Target, Costco, and smaller, regional WFM copycats since all of those places now sell organic food. While this may be true to some extent (especially with local WFM wannabe stores — not many Whole Foods shoppers frequent their neighborhood Wal-Mart), there are other explanations that are ignored because they are not as obvious and do not make for interesting headlines.

A big one is the fact that Whole Foods is cannibalizing itself by continuing to open new stores at a rapid pace (32 in the just-completed fiscal year). In Seattle, where I live, there are now 7 Whole Foods stores, with several more in development. Over the last 6 years WFM has increased their store count by 50%. As soon as a new store opens that is 10 minutes away, people are going to stop traveling to the one that is 20 or 30 minutes away.

Interestingly, the company provides information about its store performance based on the age of the store. If the media was 100% right and people were simply switching from Whole Foods to Target or Kroger, sales at all WFM stores would suffer equally. But look at the data for fiscal year 2015:

Store Age       SSS

<5 years         +7.6%

5-11 years       +1.5%

>11 years        +1.1%

ALL                 +2.5%

The older the store, the worse the sales growth. This makes sense, right? If there has been a store in your neighborhood for a decade, chances are you will already be shopping there if you are at all interested in doing so. It’s very hard to boost sales at older stores, especially considering that Whole Foods stores already sell far more food per square foot of space than any other grocer.

And when they open new stores those stores do well for many years, at the expense of the older stores. Existing WFM shoppers will migrate to the closer location (hurting older store sales) and shoppers that had no interest in driving longer distances just to shop there might check it out now that it is more convenient to do so.

Notice that none of this has anything to do with the fact that Safeway now sells Annie’s fruit snacks.

Accordingly, the investment thesis for WFM must incorporate the fact that growing same store sales for the company’s existing base of 431 stores is going to be very hard. In fact, I am assuming that they cannot post sales gains above inflation, which implies flat traffic growth for all stores after they have been open for a few years. So why invest?

First of all, the company has 431 stores vs over 2,600 for Kroger, so it is entirely plausible that Whole Foods ultimately reaches their 1,200 store goal in the U.S. And secondly, the company’s stores are massively profitable even if sales do not grow. For all of the heat the company has gotten lately, fiscal 2015 same store sales actually grew 2.5% and operating cash flow totaled more than $1.1 billion. That’s more than $2.6 million of cash flow per store. For comparison, Kroger does about $1.6 million per store, and their stores are bigger.

At $30 per share, Whole Foods stock trades at less than 8 times EBITDA and less than 14 times existing store free cash flow, both below their less impressive competitors. Such a price would only be justified if the company had minimal growth ahead of it.

Lastly, I cannot conclude without commenting on some of the odd analyst questions from last night’s quarterly conference call. More specifically, the investment community is criticizing the company’s decision to borrow money (they have never had any debt before) to buy back stock aggressively over the next few quarters.

Normally, companies are mocked for buying back stock as it hits all-time highs and then halting the purchases when things turn sour. Despite the fact that WFM did not start buying back any stock until last year (after it dropped dramatically) and now is accelerating those purchases (as it is hitting levels not seen since 2011), everyone just seems to want to pile on. Here is the first question from the conference call:

“Thanks for taking my question. So my one question has to do with share buybacks. I just wanted to understand the rationale for taking on debt and buying back shares right now maybe instead of waiting until maybe comp trends stabilized. So if you could maybe help us with your thought process.”

I was shocked at this question. Whole Foods has no debt, more than a half a billion of cash in the bank and stores that generate over $1 billion of cash flow per year, so they are in pristine financial shape. The stock is hitting 4-year lows and trades at a discount to traditional supermarkets despite being far better in terms of sales and profits. And the analyst wants them to wait until business gets better before buying back stock?

It should be obvious why they are doing this. Because they know if they can improve the business at all going forward the stock is going to go up a lot. Buy low, sell high, right? In fact, if they took Oppenheimer’s advice and waited until the stock was $50 before doing any repurchases, they would probably get mocked for doing so. This just tells me how negative the sentiment is for Whole Foods Market right now.

I may have been early last year with the stock in the $37 area, but since I invest with a five year horizon I am happy to average down and wait for the water to warm up. Right now the company is getting absolutely no credit for what they have built, how successful it continues to be even today, or any future growth opportunities that exist. It is the epitomy of a contrarian, long-term investment.

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

As Expected, Anheuser-Busch InBev Makes A Big Move Targeting SABMiller

The timing of my last post in June about the odds of Anheuser Busch InBev (BUD) making a big splash in the M&A market was pretty good it turns out. BUD has made a formal approach to SABMiller and I would peg the odds of a deal at no less than 75%, conservatively. While BUD’s slow pace was baffling to me, in hindsight it appears maybe they were waiting for a global stock market correction to help them offer a big premium. Opening with an offer of $65 per share when SAB stock was at $60 would look a bit insulting. With the stock at $47 before today’s announcement, it would get the two sides talking for sure.

Even after major anti-trust concessions such as the sale of SAB’s 50% stake in the Miller Coors joint venture, BUD investors would be material winners if the two beer giants combine. The InBev playbook has always been about lean operational excellence and BUD’s EBITDA margins are well ahead of SAB’s (the gap is more than 10 percentage points, even after subtracting the U.S. operations). After a few years of deal integration the SAB business would likely have similar margins to legacy BUD, which would mean EBITDA accretion of a couple billion dollars. Apply a 13 multiple to that and you get about 15% accretion for BUD shareholders. My fair value estimate for BUD pre-deal is in the high 130’s, which would likely get pushed over $150 after a successful SAB integration.

We could be looking at 2018-2019 as far as a timeline is concerned for such an integration, but given the shaky global economy right now, the risk-reward for BUD investors was very solid before today’s announcement and the numbers would only improve if a deal gets done. As a result, I am not a seller of BUD here and would not be opposed to opportunistic buying depending on how negotiations go. I’ll post an update digging into the deal specifics if one is agreed to over the next couple of months.

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

Noodles and Company Update: I’m Turning Bullish

My first post about casual dining chain Noodles and Company (NDLS) was on the company’s IPO day in June 2013. Fast casual restaurants were very hot and NDLS took advantage of that with a very well-timed initial public offering at $18 per share. That first day the stock doubled and I tried to caution people that the valuation made little sense, despite the company’s growth prospects (link: Noodles and Company IPO Doubles in Price, Already Overvalued After One Day).

The stock continued to soar for a little while, peaking at $51.97 a month after the IPO, but it has been an ugly downhill slide ever since. In August 2014 I wrote a follow-up post as the stock dipped below $20, highlighting that I thought it was still too high, but situations like it are worth monitoring (link: Noodles and Company Falls Back to Earth, Still Not A Bargain). The reason is because many of these companies are profitable and growing and therefore are not bad investments, provided the price is right.

In the case of NDLS, the stock hit a new low of $11.37 on Friday and can be had today for $12 and change. That is down 75% from its high and nearly 1/3 below the original IPO price of $18 per share. So is it finally a bargain? I think so. At current prices the company trades at less than 1 times annual revenue. Add in solid cash flow generation from existing units and a lot of room to grow the restaurant base over time (unit growth is currently above 10% annually) and I think the stock is quite undervalued. Earnings per share are often depressed on an accounting basis when companies are growing quickly as capital expenditures for building new units flow through the income statement, so cash flow is really the most crucial metric for NDLS. On that basis the numbers look very good.

I estimate that the company’s existing unit base alone is worth approximately $19 per share, so it trades at quite a discount right now in my view. And that does not even include a $35 million stock repurchase plan that the company has authorized and indicated they plan on completing by year-end. It may have taken more than two years since the IPO, but paying attention to the company could very well pay off for those who have been patient.

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

With M&A Booming, Anheuser-Busch InBev Likely Plotting Its Next Big Move

Through the first half of 2015, the volume of announced merger and acquisition activity is on a record-breaking pace (the data go back 35 years). While using dollar volume is a bit misleading without adjusting for inflation (ever wonder, like me, why movie theater box office receipts are based on ticket sales dollars rather than actual attendance?), there is no question that M&A is booming right now. And yet, one of my favorite acquisition-hungry companies, Anheuser-Busch InBev (BUD), has been very quiet. It has been two years since BUD spent $20 billion to lock up 100% of Grupo Modelo. This market environment (low interest rates and lots of synergistic corporate deal-making) would seem to fit right into BUD’s business model.

Over the years rumors have surfaced about their possible interest in Pepsi’s beverage business, as well as SABMiller’s non-US beer business, and either of those deals would clearly be a boon for investors (but I am not picky — anytime hugely accretive deal would be a welcomed development). I am hopeful that over the next 6-12 months BUD makes a splash in the M&A market. The recently announced merger of Heinz and Kraft might indicate that a BUD deal is not far off. 3G Capital, the private equity company behind the Heinz deal, has also been instrumental in creating the behemoth that has become Anheuser-Busch InBev over the years. Now that the Kraft deal has been struck, I am hoping BUD is next on the to-do list.

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

Which Company Is More Valuable: Shake Shack or Red Robin?

shaklogo

rrgb

I wanted to follow-up my post about the Shake Shack (SHAK) IPO because I think the stock is presenting an interesting opportunity on the short side (finding shares to borrow is another story completely). Sometimes investors use paired trades – shorting one stock and going long another in order to bet on the valuation differential – to reduce their risk and still bet against a highly valued stock.

First, let me give a quick recap of Shake Shack today, post-IPO. At $45 per share the company’s equity is valued at $1.6 billion. This is for a company that had 63 restaurants open at the end of their most recently reported quarter, with more than half (32) franchised. The 31 units they own average $5 million in sales annually, but that figure will decline over time because the company’s focus on Manhattan (where each unit does more than $7 million per year in sales) will dissipate over time as Shake Shack goes national.

The key for investors is a tidbit included in the company’s IPO prospectus; over the long term Shake Shack sees room for 450 owned units in the U.S. with average unit volumes of $3 million per year and 20% four-wall margins. With less than three dozen U.S. locations today, you can see that it will probably take two decades to reach their 450-unit goal.

So why is that data crucial for investors? Well, consider that in 2014 fellow burger chain Red Robin (RRGB) operated 408 restaurants in the U.S. and each one averaged $3 million in sales. Furthermore, the average company-owned Red Robin had a four-wall margin of 21.4%. In addition, Red Robin plans to open 20 new units in the U.S. in 2015, so by the end of this year the company will have 428 units averaging $3 million in annual sales at a 21% profit margin. Essentially, Red Robin is today what Shake Shack will be in 20 years.

You probably see where I am headed with this. Red Robin’s current equity market value at around $80 per share is only $1.14 billion, compared with Shake Shack at $1.6 billion. How on earth can Shake Shack be worth more today than Red Robin? It can’t be, at least in any rational world (yes, I know, the stock market is not always rational).

By The Numbers:

Red Robin: 408 owned units, 99 franchised units, $1.14 billion equity value

Shake Shack: 31 owned units, 32 franchised units, $1.60 billion equity value

Bold investors can short Shake Shack by itself and hope the market comes around to realize the current share price is irrational sometime soon. Less bold investors can short Shake Shack and pair it with a long investment in Red Robin. As long as the valuation differential between the two converges over time, the trade will make money. Count me as one who does not think Shake Shake can maintain a 50% equity valuation premium to Red Robin over the long term. In the short term, though, anything is possible (as we see today).

Note: Shorting Shake Shack is difficult right now since it is a newly public company, but as time passes it will be easier to find shares to borrow (my broker, for instance, does not have any shares available as of now).

Full Disclosure: No positions at the time of writing but positions may change at any time

Shake Shack: Another Predictably Overvalued Consumer IPO

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Shares of burger chain Shake Shack (SHAK) are soaring more than 130% today to $48 on their first day of trading, after pricing at $21 per share. With 36 million outstanding shares, the company (which owns 21 restaurants and franchises another 19) is worth a whopping $1.75 billion. That equates to $83 million per owned restaurant. With the average unit volume for an owned location being $5 million, of which $1.25 million is profit, you should be able to see the wacky pricing for the shares pretty clearly. This is not surprising, though, given how much fanfare consumer brand IPOs have been generating in recent years.

Even if you consider that the company plans to open 10 units a year in the U.S. and let international franchisees open even more overseas, it is impossible to justify a $1.75 billion valuation for a company with a total of 40 units open globally. As a result, I suggest you visit the company’s locations rather than invest in the stock at current prices. As we have seen with other consumer IPOs such as The Container Store (TCS), Potbelly Sandwich Works (PBPB), and Noodles and Company (NDLS), it is not uncommon for these IPOs to come back down to earth over time, so definitely monitor the situation if you are tempted to invest in SHAK today, but try to hold off for now.

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

Investors in Biglari Holdings Now Getting Core Steak ‘n Shake Business for Free

It has been a while since I last wrote about Biglari Holdings (BH) and their efforts to diversify into a holding company far bigger than just the core Steak ‘n Shake restaurant operations. BH has acquired a 20% stake in Cracker Barrel (CBRL), as well as purchased Maxim magazine, First Guard Insurance, and Western Sizzlin outright. Accounting for a recently completed rights offering that raised $86 million, BH has around $200 million of cash and no holding company debt (the Steak ‘n Shake subsidiary does have debt of $220 million). An update seems in order now that BH shares are trading for $330 each, for an equity market value of $680 million.

Why? Well, the valuation seems off, to put it mildly. At the current quote of $103 per share, BH’s Cracker Barrel stake is worth $488 million. Add in a net cash position of approximately $200 million and you quickly realize that buyers of BH today are getting Steak ‘n Shake (a business with more than $700 million of annual sales) for free, as well as all of the company’s other assets. To give you an idea of how ridiculous this is, consider that the Steak ‘n Shake generated annual free cash flow of $60 million in 2010 and 2011 (that figure has come down in recent years as CEO Sardar Biglari has invested a lot of capital into accelerating Steak ‘n Shake’s franchising business globally). As such, it is not a stretch to value Steak ‘n Shake equity at multiple hundreds of millions of dollars (accounting for its debt load). Getting that business for free is a big deal on a percentage basis considering that BH’s total equity capitalization is currently valued at less than $700 million by the market.

I am not the only investor who sees value in BH shares. Och-Ziff Capital Management (OZM) recently filed a 13G disclosing an 8% passive stake in the company, and that filing was made when the stock was trading over $400 per share. It will be interesting to see if they increase their stake at current prices. Accordingly, you may not be surprised to learn that BH is currently my largest equity holding.

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

Noodles & Company Falls Back To Earth, Still Not A Bargain

About 14 months ago fast casual restaurant chain Noodles and Company (NDLS) had one of the most successful initial public offerings of the year, more than doubling on its first day of trading from an offer price of $18 per share. That very day I warned how overvalued the stock was at its then-$36 price. Investors trampled over each other to buy the shares for a few more days (the stock peaked at $51.97 on its third day of trading) and then reality slowly began to set in. Paying more than 40 times cash flow for NDLS, or any stock for that matter, is a very dangerous proposition.

After several quarters in the public spotlight, many recent high-flying IPOs have crashed and burned. Most are in the retail space, such as The Container Store (TCS) or Zulily (ZU). Amazingly, even after huge drops, most of these stocks are not yet bargains. Circling back to Noodles & Company, which is trading below $20 per share today after reporting lackluster earnings last night, the stock still trades at about 15 times cash flow (enterprise value of more than $600 million for a company that booked EBITDA of about $20 million during the first half of 2014). That price is still on the high side of fair, even if you believe in the growth story and think NDLS will succeed in continuing to grow its unit base by double digits annually for many years to come. I’m not a huge fan of the company to begin with, so a 15 multiple is not even in the ballpark for me to consider it as an investment, despite the fact that I have favored growth stories in the restaurant area for a very long time.

For bargain hunters, it certainly makes sense to watch these recent IPOs as they crater back to earth. However, be careful not to jump at something just because it is down 50% or more from its peak. NDLS is a perfect example of a stock that is down a ton (62% in the past year) but is still not cheap. You really need the valuation to be favorable to justify bottom fishing in recent IPOs. Some of them went so far above a reasonable price right out of the gate that a price drop alone puts them in the “less expensive” category, as opposed to “undervalued.”

Full Disclosure: No positions in NDLSTCS, or ZU at the time of writing, but positions may change at any time