Chipotle Valuation Surging to Dizzying Heights, Surpassing Amazon!

It should not be surprising that hiring a veteran restaurant executive to replace an inexperienced founder will have a material impact on the business and its stock. Chipotle Mexican Grill (CMG) is a classic example, as Steve Ells stepping aside for Brian Niccol (formerly of Taco Bell) has launched CMG’s shares into the stratosphere:

CMG’s customer traffic has rebounded (+2% in Q4 2018) after flat lining earlier in the year and material price increases (+4% in Q4 2018), which were sidestepped after the e coli incidents, have same store sales rising 6% and profits surging even faster. The current analyst consensus estimate has CMG earning $12 per share in 2019 on a mid single digit same store sales increase and 5% unit growth. Those figures would place CMG near the top of the sector.

As is often the case, the biggest issue is the magnitude of CMG’s recent stock gains. At more than $600 per share, CMG’s forward price-earnings ratio is a stunning 50x. Why a casual dining chain with 2,500 locations already should trade at such a valuation is hard to understand, unless one believes they are going to steal a lot of market share going forward from here. Many folks believe that will happen, but I am less excited.

To give readers a sense as to how nutty this CMG valuation appears to be, let’s compare it to Amazon (AMZN). I know AMZN is not a dining stock, but I find it to be an interesting comparison because they are both loved consumer brand stocks right now. Not only that, I would venture to guess that an investor poll would conclude that Amazon’s business is better than Chipotle’s and is likely to grow revenue and profits faster over the coming decade. And yet, today we can invest in Amazon at a cheaper valuation:

Looking at 2018 reported financial results, CMG trades at 31x EV/EBITDA, versus 28x for Amazon. I used EV/EBITDA to account for balance sheet items as well, but on a P/E basis the numbers are also similar: 50x for CMG and 59x for AMZN.

For those who are intrigued by Chipotle stock, I would simply point out that Amazon has long been a loved growth stock for which investors are often willing to pay sky-high valuations for. Today an argument can be made that CMG is more expensive and you would have a hard time finding people who expect CMG’s business to outperform AMZN in coming years.

If that’s true, either CMG is overvalued quite a bit, or AMZN is relatively cheap, or both. I would bet that AMZN outperforms from here. For those who like paired trades, being short CMG against an AMZN long looks interesting.

Biglari Holdings: Severely Mispriced Yet Again

I have not written about Biglari Holdings (BH) on this site since late 2014, but that does not mean the company has fallen off of my radar. While BH was once a prime long-term buy and hold candidate, it has become obvious over the years that the controlling shareholder and CEO, Sardar Biglari, not only prefers running an unconventional public company, but often does so at the detriment to its shareholders.

For those unfamiliar, the bulk of BH’s assets (and value) come from a 100% ownership of Steak N Shake and a large stake in two hedge funds run by Mr. Biglari, which are mostly comprised of shares in BH and Cracker Barrel (CBRL). The stock is volatile, sometimes trading quite low and other times approximating fair value for an unfocused conglomerate with little investor recourse.

Given a few too many unconventional moves (buying BH shares on the open market via the hedge funds and holding them for investment, as opposed to buying them at the corporate level and retiring the shares), I have largely been interested in BH in recent years as a trading vehicle — not a long-term investment — buying when the stock is clearly mispriced and selling when it approaches a more reasonable level.

Such an opportunity has once again presented itself after a late April move that resulted in shares of BH being divided into dual classes of stock; A shares and B shares, the former allowing Mr. Biglari to maintain control of the company, with the latter having no voting rights and serving as potential M&A currency.

Prior to the dual class issuance, BH stock was trading around $420 per share. Upon issuance of the new class A shares, the B shares should have fallen in price by roughly one-third according to the exchange ratio, which would have put them in the $280 range. And for a few days that ratio seemed to hold, but then a free fall began. Today BH “class B” fetches around $200 per share (I am focused on the non voting stock because the voting rights are meaningless considering that the CEO controls more than 50% of the votes).

So just how mispriced is this $200 piece of paper? Well, the total equity value at current prices is roughly $630 million. If we ignore the operating businesses (more than $800 million of annual revenue and by my guess, maybe $25M-$30M of EBITDA this year), BH shareholders own (indirectly via ownership of hedge fund LP interests) nearly 4.4 million shares of Cracker Barrel and nearly 1.3 million class B equivalent shares of Biglari Holdings. Since both are publicly traded, we can quickly assign a value to each, which cumulatively comes out to more than $950 million, or $305 per BH class B share. And yet BH class B’s trade for just $200 apiece. As you can see, something is off here.

Now, there are reasons why BH will unlikely ever trade for “full price” based on its assets. After all, many investors would immediately balk at a public stock that owns some companies outright, minority stakes in others through hedge funds, and chooses to buy up but not retire its own shares in the open market. There are other issues too, such as a large unrealized gain on the Cracker Barrel shares, which were acquired for less than $50 each (current price $160), and over $200 million of Steak N Shake debt outstanding.

Still, even if the negatives surrounding BH would result in the operating businesses being valued closer to zero than a more typical $25-$50 per class B share (which I believe they would fetch with a different owner), BH remains mispriced. If we exclude the BH shares owned by the company itself, the equity is valued at about $370 million. To put that into perspective, the Cracker Barrel stake alone is worth $700 million at the current market price, so maybe $600 million net of tax.

At a certain price it is hard to argue against taking a long position in a company that often sees its share price get out of tune with reality due to its unusual composition and low float (due to being small to begin with and having a majority owner). Count me as one who does not think the B shares should trade materially below the $300 level. The recent dual class restructuring has given the small investor a profit-making opportunity.

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

Somehow Food Companies Are No Longer Viewed as Stable, Defensive, Attractive Investments

For decades the consumer staples sector was viewed by investors as a stable and predictable cash flow generator with above-average dividend yields and below-average volatility. In particular, food companies like Kraft and Pepsi fit the bill, with brands that stood the test of time.

Lately, however, investor sentiment has shifted. While brand names continue to have loyal followers, younger consumers often prefer private label foods that come with lower prices and quality that is close enough to the branded alternative that they are more than adequate. I understand this view completely, as my family buys many store brand products from Safeway, Target, and Whole Foods.

So while the gap between store brands and global brands narrows, should food and beverage as a category be seen as no longer stable, predictable, and defensive? By the looks of the stock charts, as the tech sector powers the current bull market ever-higher, you would think that food is no longer a consumer staple. I say that because both private label and national brands are getting pummeled on Wall Street. I am baffled as to how that can be happening at the same time.

Should Kraft trade at 16x EBITDA these days? Probably not, given that they are set to cede market share over time. But there are other consumer brands that have fallen to levels that are truly cheap (as opposed to trading at a premium that may no longer be warranted).

One I like is J.M. Smucker (SJM), which has fallen from $140 to $100 over the last nine months or so. SJM owns brands such as Jif, Smucker’s, Crisco, Wesson, Folgers, Pillsbury, Hungry Jack, Milk Bone, and Kibbles ‘n Bits. While these brands will likely not grow market share in the future, they should continue to be cash cows for the company over the long-term. In the meantime, SJM has the scale and experience to launch brand extensions and new products that can resonate more with younger shoppers (examples being all natural, organic jam from Smucker’s or Natural Balance pet food). Today SJM shares trade for 15x normalized free cash flow (which I estimate to be $7 per share) and carry a dividend yield of over 3%. They look underpriced to me.

Perhaps more interesting is the fact that the world’s leading supplier of private label foods, Treehouse Foods (THS), has had one of the ugliest sell-offs lately that you will ever see from a multi-billion dollar a year category leader:

Treehouse counts each of the 50 largest food retailers as customers, with the top 10 accounting for more than half of the company’s $6 billion in annual revenue. If you want to place an investment bet on private label foods increasing market share over the coming 5-10 years, THS is your stock. Needless to say, it has been quite a headache in recent months (I have been building positions in the name throughout 2017).

Treehouse’s valuation makes J.M. Smucker look like nothing worth mentioning. Even after missing their own internal financial projections for most of 2017, I estimate that THS should book between $250 and $300 million of free cash flow this year. The current market value of the company is only $2.45 billion, which makes for a sub-10x free cash flow multiple. And that is for the largest private label food company out there. For comparion, over the last 10 years, THS shares have fetched an average of 16x free cash flow, which seems quite reasonable.

So we are in a weird moment in time where restaurant stocks are getting crushed (due to rising labor costs, a proliferation of home delivery services, and excess unit expansion in recent years), brand name food stocks are losing their once-premium valuations (due to private label encroachment), and the big private label supplier has seen its share price more than cut in half (due to management missteps after a large acquisition). Simply put, how can this all be rational at the same time?

Well, I am making a bet that things normalize over the longer term. I think it is fair to say that large, global food and beverage brands should no longer trade at premiums to the S&P 500, but I think any material discount is unwarranted as well. Dining out will continue to book huge sales figures overall, but profit margins are likely to permanently  compress, so valuation models need to factor in that likely reality. And as private label foods stand to gain market share over time, I cannot help but think Treehouse will fix their operational issues, grow free cash flow per share over the long-term, and once again fetch a more normal valuation (15-20x seems appropriate to me).

None of these outcomes will garner the attention from investors that an Amazon, Tesla, or a Netflix will, but if you care about valuation when investing your capital, we are talking about large multi-billion businesses that are here to stay and will generate fairly consistent profits for decades to come.

Full Disclosure: Long SJM and THS at the time of writing, but positions may change at any time

Restaurant Bubble? Shake Shack Has Two Locations at One Mall

Once seen as a very strong industry riding the secular trend of Americans moving away from cooking at home, the restaurant sector is starting to feel growing pains. With U.S. population growth slowing and immigration becoming more difficult, same-store traffic declines are backing restaurant companies into a corner. The choice is simple: continue to open new units faster than your customer base is growing spending on food, or admit to investors that the growth they have come to expect is over.

High-flying fast casual burger chain Shake Shack (SHAK) has made the decision that, despite dozens of burger places popping up everywhere across the country, the name of the game remains growth. In fact, despite having fewer than 85 locations in the U.S. as of June 30th, the company now has two units open at the bustling King of Prussia mall outside Philadelphia.

Some bulls on the company will likely reference the Starbucks phenomenon whereby that chain purposely opens locations near each other in order to reduce the size of waiting lines during busy peak times. But this is different. Shake Shack has told its investors that it sees room for 450 locations in the U.S. alone. If your ultimate goal is to build 9 locations in every state, it probably does not make a lot of sense to have two in the same mall.

The bigger point has large implications for the industry. As more and more big box anchor stores close their mall locations (Sears, JC Penney, Macy’s, etc), landlords are trying to fill the spaces fast. And with so many bricks and mortar retailers struggling to compete in the e-commerce world, restaurants are an easy way to fill space.

It should not be hard to see the problem with this plan in the long run. With minimal population growth and declining mall traffic, over time there will be less of a need for restaurants at these locations, not more. And yet the industry continues to grow seats far faster than consumer spending. We are seeing the result already; less traffic per location, and thus less revenue and falling profits.

Shake Shack might be able to get away with overbuilding for a while, mainly because the chain started in New York and is brand new to most consumers as they expand across the country. But five years from now we are likely to look back and see that it was silly to have two Shake Shacks at King of Prussia (assuming mall trends continue in a similar trajectory).

As a long-time investor in the restaurant space, the current landscape is challenging. On one hand, Wall Street is giving many companies (not Shake Shack) meager valuations due to falling customer traffic. On the other hand, if the industry continues to build new locations for the sake of growth (and not due to demand exceeding supply), it will make it hard for any chain to post impressive financial returns.

How should investors approach these dynamics? Well, it looks like the franchising route might be the best way to limit downside risk. While lower sales will impact royalty streams for the franchisor, fixed cost deleveraging will impact the bottom line far more severely, and that will sting the franchisee first and foremost.

Shake Shack management would argue otherwise. In fact, during their latest conference call they bragged about having a second unit at King of Prussia mall. Essentially, they argue that it was a wise move as long as they sell more burgers cumulatively with a second location. After all, if the demand is there, why not book the sales?

However, this assumes that the demand will be steady and/or rising over time. Once Shake Shack loses its “newness” and more competing chains invade their turf targeting the same customers, we could very well see demand for their burgers fall considerably. Enough that two locations make little sense.

Full Disclosure: No position in Shake Shack, but positions may change at any time

The Door Is Open For Somebody To Swoop In And Steal Whole Foods Market

It has been nearly three months since I wondered in writing whether anybody would step up and buy Whole Foods Market and a lot has happened since then. By now most people know that Amazon is in the driver’s seat with their $42 per share all-cash offer having been accepted by the WFM board of directors last month.

My assessment of the situation back in April was hit and miss. My estimate of fair value for the stock proved to be spot-on (“low 40’s”) but I dramatically underestimated Amazon’s interest in making a large acquisition. I pegged the odds of a deal at 40%, with the most likely buyers being a private equity firm or another grocery chain. Amazon must really like the idea of a Whole Foods combination, given that I do not believe it has ever offered $1 billion for another company, let alone the $13 billion Whole Foods will cost.

Today Whole Foods released its merger documents in preparation for the shareholder vote and the tidbits we learned were quite interesting. Specifically, four private equity firms and two grocery competitors reached out to the company, in addition to Amazon’s interest. Perhaps not surprisingly, Whole Foods focused on a deal with Amazon and never actually opened up the bidding to other interested parties. I suspect this is mainly because the company’s founder and CEO wants to keep his job and Jeff Bezos will let him.

In terms of where this deal heads from here, it was also noteworthy that Amazon’s initial offer was $41 per share and when Whole Foods countered at $45 Bezos and Co. made a best and final offer of $42. This is interesting because not only were they not really interested in increasing their bid, they also insisted that WFM keep quiet about the negotiations. Amazon even insisted on multiple occasions that they would walk away immediately if the deal was leaked or if other buyers were allowed to join the bidding.

Such a negotiating strategy clearly worked, but it does open up the possibility that a last minute competing bid could emerge. Imagine you are at a private equity firm, or another grocery chain who would be interested in partnering with PE to help fund a bid. Assuming you liked the idea of grabbing Whole Foods, the main reason not to would be the fact that Amazon has deep pockets and would likely be able to prevail most easily in a bidding war. But after reading the details of how this deal came about, it appears that Amazon might not be willing to raise their bid above $42 per share. In that case, as little as $43 or $44 might steal WFM away. You can bet that Jana Partners, the hedge fund whose 8% stake fueled the most recent takeover talk in the first place, would support taking the best offer possible.

Whole Foods stock closed today right at $42.00 per share, so there does not appear to be a high degree of confidence that another bid is coming. That may be true, but all it takes is one interested party who decided to take a shot at it. It could be a very quick turn of events (and relatively easy) if a single bid over $42 prompted Amazon to walk. I won’t bother placing odds on this happening given that I didn’t think Amazon would bid in the first place, but I don’t think it is a stretch to say that the details we learned today could sway another party who has been pondering making a higher offer. After all, they were never really allowed to bid in the first place.

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

Will Anybody Step Up And Buy Whole Foods Market?

Activist hedge fund Jana Partners has amassed an 8% stake in Whole Foods Market (WFM) and is urging them to work harder harnessing strategies to maximize operational efficiencies and also test the waters in terms of possible takeover interest. I have been a fan of the company for a long time, and of the stock ever since it cratered into the 30’s several years back. The original investment thesis hinged on long-term square footage growth (8-10% annually) but the company has now decided to slow new location development. As a result, we are now left with more of a cash cow business with minimal growth (same store sales have been falling 2-3% for over a year).

The stock recently traded in the high 20’s (too low for even a slower growth outlook) and Jana seems to have timed their purchases very well during February, March, and April at prices of between $28 and $32 each. Even without a buyout I believe WFM stock would be fairly valued in the low 40’s (far lower than I would have said when they had a stated objective of reaching 1,200 stores (versus less than 500 today). Wall Street does not agree, as even with the Jana-related bump the stock fetches $34 per share.

The easiest way for WFM to realize a more fair price would be to find a buyer, but the company would be a big target ($11 billion market value at current prices). As a shareholder, I would not be thrilled with anything less than a $13.5 billion acquisition price. But who would acquire WFM?

The press reports that Amazon contemplated an offer last year seems odd. They simply prefer to build businesses internally. With no track record of large M&A deals, the odds that Jeff Bezos would all of the sudden offer eleven figures for WFM seems remote.

The second possibility would be a strategic buyer, as in one of WFM’s grocery store competitors such as Kroger or Albertson’s. One could make the argument either way on this line of thinking. The traditional stores have been successful recently copying the WFM product offering, which has resulted in negative comps for the organic pioneer, so they really don’t need to buy WFM. On the other hand, one less competitor means less pricing pressure industry-wide, which could be attractive in such a cut throat market like grocery retailing. I could understand both sides of the coin very easily.

The last option in my view would be a private equity buyer. This makes the most sense from a financial point of view, as PE could use debt to fund much of the acquisition cost without endangering the company (WFM’s balance sheet is pristine). Other grocery store chains have far more leverage which limits their ability to borrow more money. I suspect banks would allow a near-term leverage ratio of up to 5x for a Whole Foods leveraged buyout, which would equate to roughly $6 billion of debt financing and $7 billion of equity capital (assuming a purchase price of $13 billion).

The biggest hurdle for private equity is that $7 billion equity requirement. That is a very large deal for one company to take on alone. More likely a consortium of PE firms could get together and pitch in $2-3 billion each. I have no doubt that many firms are taking a look at this type of option.

All in all, a buyout of WFM is possible, but not probable, in my view. The price tag would be high in absolute terms and there is enough concern about the company’s competitive position that pulling the trigger on a deal might be tough for most of the parties that do in fact kick the tires. If I were setting the odds, I would say there is a 60% chance WFM stays public, a 25% chance private equity makes a play, a 15% chance another chain bulks up its store base, and a <1% chance Amazon is serious about a deal.

Full Disclosure: Long shares of Whole Foods Market and Amazon at the time of writing, but positions may change at any time

Freshii: Can This Recent Restaurant IPO Deliver Despite High Expectations?

Just when I thought the restaurant sector was dead on Wall Street, we see that fast casual, Canadian-born Freshii (FRII.TO) has pulled off an impressive IPO, offering shares recently at $11.50 each (CAD). With the stock near $14, Freshii’s market value is approaching $430 million (CAD). Adjusting these figures into a U.S. dollar equivalent, FRII stock fetches around $10.25 with a total equity value of $320 million.

Today the company reported 2016 revenue of $16.1 million and EBITDA of $3.7 million (both in USD). Based on those numbers, it would appear that Freshii shares are quite overvalued, but there are reasons that many investors are impressed with the company.

When I reviewed the IPO prospectus, what jumped out at me was the extraordinarily low unit build-out cost ($260,000). For a 99%-franchised fast casual chain, such a low initial investment requirement will make it relatively easy for the company to grow quickly. While average unit sales in 2016 were only $468,000 per location, a reasonable 10% margin would net franchisees a mid teens return on investment (including the initial franchise fee).

I recently visited the lone Freshii location here in Seattle and I was impressed with the food offerings. The average entree price point is pretty much in-line with the fast casual industry ($7.50) and seems especially reasonable given the quality and healthy nature of the food.

On the surface, the Freshii concept appears to be well suited for rapid growth, especially in younger, more health conscious urban areas. But when we look at the stock, it already reflects very high expectations. Freshii collects a 6% royalty on gross sales and system-wide revenue in 2016 was $96 million. If we assume that the company can earn industry-leading margins due to its high franchise percentage, EBITDA at maturity could rise to the mid 40’s in percentage of revenue terms.

Freshii predicts total units will surpass 800 by the end of 2019, which would bring in upwards of $25 million in annual recurring royalty revenue, and possibly ~$11 million of EBITDA. Accordingly, based on expected 2019 profits, Freshii stock currently trades at roughly 30x EBITDA. Yikes.

In addition to valuation, a big concern for investors should be Freshii’s limited operating history coupled with a lightning fast expansion plan. Just three years ago Freshii had 70 locations globally. Today that figure is around 300, with more than 150 new opening planned for 2017. To reach the company’s 2019 goal, new units would need to accelerate to around 200 per year in both 2018 and 2019.

Can a small company like this grow that quickly without running into any roadblocks? Will the next 500 units perform as well as the first 300 locations? These are risks that are real and should not be ignored.

Of course, if Freshii becomes the next Subway investors stand to do very well. It will be interesting to see how well the company can deliver against the hype (the founder and CEO, Matthew Corrin, is only 35 years old).

I have not figured out if there is a certain price at which point I would be interested in initiating a position in the company. What I do know is that the current price is a little bizarre (~$1 million per opened location, despite the fact that the build-out cost is just $260,000 and Freshii doesn’t actually own the location).

I will probably want to see how new units perform for a little while before I nail down a possible entry point. After all, the company is set to increase its unit base by 150% between 2015 and 2017. Moving at that rate could very well give investors buying opportunities (read: volatility) along the way. Regardless, Freshii is one fresh restaurant idea to watch.

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

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

An Inside Look at the New Whole Foods Market Concept: 365 By Whole Foods

As more and more people have adopted a healthier diet, natural and organic specialty grocery stores like Whole Foods Market (WFM) are finding that competition is catching on to the trend. What was once labeled a small, hippie niche of the food market is now going mainstream. Products from companies like Annie’s, once able to set stores like Whole Foods apart, can now be found almost anywhere. As a result, WFM is finding that it can retain its loyal customer base that is willing to pay a little more for higher quality ingredient standards, locally sourced products, and a wonderful in-store experience, but it is getting harder to find new customers. Many people are perfectly happy with their traditional stores and not very eager to pay any more than they have to for groceries. The result is that WFM remains a profit-generating machine, but sales per store have plateaued. The stock has also reversed course, currently trading for $28 per share, down about 50% over the last 18 months.

The company continues to open new flagship stores across the country, as there continues to be a significant amount of demand for the original concept. But in order to try and expand their reach across even more customer types, WFM has created the “365 By Whole Foods” store to grow alongside the core store brand. The country’s third “365” store recently opened in Bellevue, WA, not too far from my home in Seattle and I decided to go check it out. The company has said the goal was a smaller store with fewer SKUs, focusing on cheaper items (lots of generic store branded items) and lots of automation in order to keep development and operating costs low (which further allows them to be more aggressive on price). Here are some photos of what I found:

This location actually an anchor store in Bellevue Square mall, occupying what used to be a JC Penney. During mall hours, you can access the store directly via escalator.
This location is actually an anchor store in Bellevue Square Mall, occupying what used to be a JC Penney. During mall hours, you can access the store directly via escalator.


Modern design interior but not a lot of fancy fixtures. Probably costs a lot less to build out than a flagship WFM store.
Modern design interior but not a lot of fancy fixtures. Probably costs a lot less to build out than a flagship WFM store.


Rather than run their own in-store restaurant, 365 locations will partner with local chefs to bring in fast casual dining options.
Rather than run their own in-store restaurant, 365 locations will partner with local chefs to bring in fast casual dining options.


Same goes for the coffee counter... outsourced to a local Seattle company.
Same goes for the coffee counter… outsourced to a local Seattle company.


With the goal of lowering costs, digital signage was very prevalent, including all of the pricing labels. You need less staff if you don't need humans updating prices all the time.
With the goal of lowering costs, digital signage was very prevalent, including all of the pricing labels. You need less staff if you don’t need humans updating prices all the time.


Automation is a trend. Here is a do-it-yourself tea kiosk.
Automation is a trend. Here is a do-it-yourself tea kiosk.


Weigh your own produce. Saves time at checkout and you don't get any surprises  on cost.
Weigh your own produce. Saves time at checkout and you don’t get any surprises on cost.


Whole Foods is known for their prepared foods and it is a huge money-maker for them (more than 10% of sales). Again, rather than not knowing how much your container will cost (priced by weight at regular WFM stores), now there is flat rate pricing.
Whole Foods is known for their prepared foods and it is a huge money-maker for them (more than 10% of sales). Rather than not knowing how much your container will cost (priced by weight at regular WFM stores), at 365 there is flat rate pricing.


WFM will sell some fast casual meals itself. Order and pay at the kiosk and it is sent to the kitchen for preparation.
WFM will sell some fast casual meals itself. Make your selections and pay at the kiosk and your order is sent to the kitchen for preparation.


I picked up my tacos at the back of the store when they were ready (computer monitors show your order's progress).
I picked up my tacos at the back of the store when they were ready (computer monitors show your order’s progress).


Craft beer is as hot in the Pacific Northwest as anywhere. No shortage of local brews to choose form.
Craft beer is as hot in the Pacific Northwest as anywhere. No shortage of local brews to choose from.


Interesting idea here; digital signage promoting the products on the aisles of the end caps. WFM makes money on advertising as well as actual sales. Smart.
Interesting idea here; digital signage promoting the products on the aisle end caps. WFM makes money on advertising as well as actual sales. Smart.


Overall, I was very impressed with the 365 store. Will it cannibalize regular WFM stores? Probably some, if they are close by. Will some people be attracted to the prices which skew to the lower end and are competitive with places like Target or Safeway? I think so. Will WFM see a strong return on investment on this store format? I certainly think so. The big question is how many stores like this the market can support and what others do in response. I am not sure anyone can pinpoint those answers at this point, but good for them for trying to address a clear hole in their store offering.

In the meantime, WFM stock is extremely attractive at $28 per share, in my view. At 7x EV/EBITDA and a history of opening stores that trounce the competition in terms of sales per square foot and profitability, I suspect WFM’s future remains bright and that the business will continue to be a cash cow. The stock price today does not really reflect such a viewpoint, hence my optimism.

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