Does This Restaurant Stock Live Up to the Hype?
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The restaurant sector is abuzz thus far in 2012, with several popular chains reporting strong performance and showing huge investment gains since the beginning of the year. Especially for restaurants with uniquely positioned niche strategies, including Buffalo Wild Wings (NASDAQ: BWLD), Chipotle (NYSE: CMG), and BJ’s Restaurants (NASDAQ: BJRI), there is no shortage of investor excitement.
BJRI investors, for instance, have enjoyed a more than 19% price appreciation since the beginning of January, which is an attractive continuation from its 150%+ gains since February 2010. At a recent price around $53/share (ttm P/E 54), however, the corporation is among the most expensive in the restaurant sector. At what point does extreme generosity become unwarranted excitement? Is BJRI worth the hype?
BJRI’s “casual plus” operating strategy is not new, but it has definitely caught on with the restaurant-going public. The corporation has grown sales at a 23% CAGR since Q4 2005, and has averaged same store sales increases of a healthy 3.6% between 2004 and 2010. Its fun to eat menu was also surprisingly unharmed by the recent economic downturn – sales increased by 18.3% in 2008 and 14.1% in 2009, and same store sales decreased by less than a percentage point in each year. The sustained performance is not just attributable to its moderately priced, large portioned menu items, but also to its extremely wide customer targeting initiative. With over 100 menu items, including gluten-free and vegetarian picks, BJRI is more attractive to a broad audience than more heavily focused competitors may be (Darden Restaurants’ (NYSE: DRI) Red Lobster, for instance).
Through advertising efforts the company has attempted to position itself as a unique entity in the restaurant space. Despite its offering of unique handcrafted beer, it’s “not a brew pub,” and although its high-energy restaurant locations are lined wall-to-wall with sports presenting TVs, it’s “not a sports bar.”
Although this positioning undoubtedly sounds good on paper – who doesn’t claim to present consumers with a unique offering? – does the strategy actually translate into a meaningful competitive advantage? Also, more importantly, whether or not the company maintains control of a significant competitive advantage, is it a worthwhile investment at current market valuations?
Upon closer analysis of BJRI, the classic popular company vs. good investment opportunity question arises.
There is undoubtedly no other metric more important to short term-focused investors than quarter-to-quarter top line growth. What some investors fail to think critically about is that revenue growth is but one of the many individual drivers to a firm’s overall profitability. BJRI’s historical operating performance offers a perfect example.
The corporation, largely through new restaurant construction and continuous same store sales growth, has grown revenues at a near 23% CAGR between Q4 2005 and Q3 2011. Over the same time period, BJRI’s profitability, as measured by return on net operating assets (RNOA, see footnote), has averaged a very mediocre 7.40%. Although profitability has improved from its late-2008-to-early-2009 trough levels, recent returns have plateaued at their historic 10% - 11% averages.
Sales in thousands
These average returns, which, depending on how one estimates the firm’s risk/reward profile, is arguably close to its cost of capital requirements. The inability to grow earnings well above the cost of capital charge is a common characteristic inherent in firms that do not enjoy significant, and sustainable, competitive advantages.
These effects are generally widespread in the food service industry. Not only is access to capital the only requirement for new entrants, but the industry is likely to be the most fragmented in the entire field of business – thousands of individual restaurant chains, as well as good old-fashioned home cooking, prevent very few firms from ever gaining a significant base of long lived captive customers.
Very few entities can defy the gravity-like effect of competition in the long run, in which excess returns are gradually diminished to levels that simply cover the corporation’s costs – the cost of running operations (buying and preparing raw materials for consumer consumption), the cost of borrowing (doesn’t apply to BJRI), and the cost of attracting shareholder investment.
The rare entities that do have the ability to not only sustain profitability levels above and beyond these costs, but continually grow them, almost always contain unbeatable competitive advantages marked by wide captive customer bases and significant economies of scale advantages. McDonald’s, for instance, returned more than 23% on its core assets over the past twelve months, and has sustained such impressive profitability for decades. This not only stems from the fast-food king’s ability to captivate millions of customers on a worldwide basis through targeted offerings (its local menu selections, for example), but also gains a significant boost from the sheer size of its operations. MCD’s nearly 33,000 restaurant system enjoys the benefits of shared advertising and logistics, as well as optimally managed variable costs through a level of bulk purchasing that will never be reached by smaller restaurant chains.
BJRI’s 116 restaurant system, which is spread among 13 different states, is not strategically organized to dominate local markets or reach a level of scaled operations to truly unlock meaningful profitability. The simple fact that competitors including Cheesecake Factory (NASDAQ: CAKE), Hops Grill and Brewery, and Uno Chicago Grill can operate on a similar platform and control any market share in the space shows that there is nothing inherently inimitable in BJRI’s strategy.
A company that can grow its top line yet maintain average profitability may present an attractive investment opportunity assuming that an investor can take advantage of an extremely inexpensive entry point. The problem with BJRI at its recent market price of $53/share is, however, that the stock is not being offered at such an inexpensive price.
The company is overvalued relatively:
- Trailing twelve month P/E and enterprise multiple of 54 and 20, respectively
- Average trailing twelve month P/E and enterprise multiple of ten key competitors of 23.23 and 11.75, respectively
- Competitors (MCD, PNRA, CMG, WEN, DENN, CBRL, BWLD, YUM, CAKE, DRI)
Such a disparity in market valuations implies that BJRI presents investors with a bigger bang for their investing bucks. If investors see companies as cash-producing machines and define returns as the cash yield they generate on their assets in place, then BJRI is currently the least attractive operator in the restaurant space:
- Methodology: each firm’s enterprise value, which factors their unique cash/debt positions, is put on a per-store basis (essentially what an investor at the current market price is paying for each restaurant location). The firm’s free cash flow generation over the past twelve months is compared to the locations’ purchase price.
- BJRI – FCF per restaurant $10,030, EV per restaurant $12,320,000, Yield = 0.08%
- DRI: 0.96%
- CMG: 2.29%
- PNRA: 3.15%
- WEN: 3.31%
- MCD: 4.00%
- DEN: 4.04%
- YUM: 4.13%
- CBRL: 5.10%
- CAKE: 6.50%
Especially in an industry that is marked by intense competition, the comparison of a company to its peers is of utmost importance – all facets of the business, including sales, margins, efficiency of operations (i.e. sales per square foot, sales per employee, same store sales growth, etc.), should be examined in unison to determine the most attractive operator on a long term basis.
However, without putting each of these metrics on a cost basis, as was accomplished in the calculations above, one cannot determine the true attractiveness of improvements in a business’ core operations. Despite continuously strong sales growth, same store sales increases, and margin expansion from late 2008 lows, the marginally profitable BJRI
Without a significant drop in price, or an equally large improvement in core operations (free cash flow generation, say), prospective investors are not getting the most bang for their buck in the restaurant sector.
*Footnote: Net Operating Assets = (Total Assets - Financial Assets) - (Total Liabilities - Financial Liabilities). Return on Net Operating Assets = Post Tax Operating Income / Net Operating Assets.
Motley Fool newsletter services recommend Buffalo Wild Wings and Chipotle Mexican Grill. The Motley Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill and Darden Restaurants. gibbstom13 has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.