Just Plain Chicken

By Chad Henage - August 1, 2012 | Tickers: BWLD, CMG, DRI, YUM | 0 Comments

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I have to say in the case of Buffalo Wild Wings (NASDAQ: BWLD), I wasn't terribly surprised to see the stock sell off after reporting earnings. The challenge in this market is that any company that disappoints investors is going to be sold no questions asked. I remember not all that long ago, Buffalo Wild Wings was the “redheaded stepchild” in my eyes to Chipotle (NYSE: CMG). It seemed like everyone wanted to buy Chipotle stock, while Buffalo Wild Wings stayed undervalued. However, a few good quarters of earnings reports caused Buffalo Wild Wings to run up also, and now both companies have met the same fate.

The big difference between the two companies, even today, is, they both are expected to have very similar growth in the future, yet Buffalo Wild Wings still sells for a relative 30% discount to Chipotle's current valuation. This likely has to do with the fact that Buffalo Wild Wings is a much smaller company, and less well known. The biggest challenge the company currently faces is their reliance on chicken wings. At this point, as the price of chicken wings increases, the company's earnings decrease by a similar amount. However, the price of this commodity is likely to vary, and over time the company will both benefit and be hurt by this cost input. Longer-term however, the company's future looks bright.

With revenue increasing nearly 30% and same-store sales up more than 5%, if the story ended there investors would be very pleased. The problem is, chicken wing prices increased and that hurt the company's margin, leading to an earnings increase of just 9.3%. Prior to this earnings report, the stock sold for over 27 times forward earnings, and apparently a 9.3% increase is not going to cut it. There are two issues that appear to be hurting the company's results. The first is, the company does not yet have the size to leverage their fixed costs across a greater base. You can see this in the amount of free cash flow that the company generates based on $1 of sales. I use this measure on a regular basis to compare companies in the same industry. Since free cash flow is less manipulated than earnings per share, it gives investors a better picture of a company's true return generating capabilities. Besides Chipotle, the company also competes against other restaurateurs, such as Yum Brands (NYSE: YUM) and Darden Restaurants (NYSE: DRI). Yum Brands of course operates the popular Taco Bell, Pizza Hut, and KFC chains. Darden offers a more traditional restaurant experience with their Red Lobster, Olive Garden, and Longhorn Steakhouse concepts. Since consumers have the choice of going with any of the above restaurants, Buffalo Wild Wings needs to effectively compete across the board. Let's look at how the company compares when it comes to free cash flow and gross margin: 

As you can see, Buffalo Wild Wings generates less free cash flow for each $1 of sales than its competition. In addition, while Chipotle had a tough quarter and this led to a lower gross margin percentage, Buffalo Wild Wings normally would rank on the bottom in gross margin as well. This should tell investors that there is both a current challenge, and a long-term opportunity. As the company gets larger it should be able to leverage its cost against a greater base, and thus create better free cash flow and a higher gross margin over time. While these two measures are something to keep an eye on, the company's growth plans appear to be on track.

In the company's 2012 outlook, the company reaffirmed their plans to open 70 new company-owned and franchised locations before the end of the year. With just 18 open so far, this leaves the majority to be opened in the final two quarters. This is likely the reason that the company said, “we should achieve net earnings growth between 15% and 20% for 2012.” In addition, the company recently signed two international franchise agreements. One agreement calls for 22 locations in the Middle East, and the other agreement calls for four new locations in Puerto Rico. It's likely to be years before Buffalo Wild Wings would even saturate the US market. However, if the company continues to sign international franchise agreements, this could give a boost to the overall growth rate. If the company's growth rate speeds up, Buffalo Wild Wings could potentially challenge Chipotle as one of the fastest growing public restaurant chains.

The differentiating factor between Buffalo Wild Wings and its competition is expected growth. More established chains such as Yum Brands and Darden Restaurants are expected to grow between 12% and 14% over the next few years. Chipotle is expected to grow at nearly 22%, versus Buffalo Wild Wings' 20% growth rate. With 819 total restaurants at the beginning of the year, and 70 new openings planned, this means 8.55% new restaurant growth. Since the company's same-store sales have been positive as well, overall top line growth should stay impressive. With a growing store base, the company can realize cost efficiencies that would push earnings per share along at a fast pace. In fact, you could easily make the argument that Buffalo Wild Wings is a better value than the widely talked about Chipotle. The company has nearly the same growth rate, and yet sells for a relative 30% discount. Since the company is also a smaller concept, its growth should be somewhat easier to maintain. I would suggest investors add Buffalo Wild Wings to their Watchlist, to keep up with developments.

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