A Cannibal That Charlie Munger Would Love

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During a recent interview with The Motley Fool, Mohnish Pabrai shared some advice given to him by Charlie Munger. According to Pabrai, Munger mentioned cannibals -- companies repurchasing a significant amount of stock over time -- as a good source of investment returns.

One such company is CEC Entertainment (NYSE: CEC), the owner of Chuck E. Cheese restaurants. Since 2002, the company has reduced its share count from over 41 million to nearly 17 million shares outstanding. That's an incredible feat that is a testament to the company's free cash flow generation.

<img src="/media/images/user_13490/cec-shares-outstanding_large.png" />

Upon closer examination, the CEC story gets even more interesting. The company's net income has been falling since 2004, yet earnings per share has been rising dramatically. So now the picture is becoming more clear: CEC is a declining business that is able to grow earnings per share.

The company would not be able to maintain EPS growth if its business were rapidly deteriorating. The business is in decent shape, but it has slowly ceded to margin compression over the years. CEC's operating margin is higher than that of traditional restaurant chains Ruby Tuesday (NYSE: RT) and Frisch's Restaurants (NYSEMKT: FRS), but lower than that of McDonald's (NYSE: MCD) and other fast-food chains.

<img src="/media/images/user_13490/cec-op-margin_large.png" />

This is because Chuck E. Cheese is not a traditional restaurant. It's a restaurant and a children's entertainment complex. It competes against other local businesses that attract kids: putt putt golf, ice skating, neighborhood pool, and so forth. It's in the business of creating a fun atmosphere for kids, not for serving great food or competing with the likes of McDonald's.

Chuck E. Cheese has the advantage of being the only national chain in its niche. It has brand recognition and economies of scale in marketing. When little kids want to have a pizza party, they think of Chuck E. Cheese, not some local rip-off.


Valuing CEC is a little tricky since most of the value that accrues to shareholders comes in the form of share repurchases.

The company has generated ample free cash flow over the years, but I prefer to be conservative and use the lower pre-tax income figure. Pre-tax income declined from $134 million in 2004 to $91 million in 2007. Since then, pre-tax income has remained flat.

The company earned $4.67 per share before tax in 2011, up 6.5% from the prior year due to repurchases. Since then, the company has lowered its share count to a little over 17 million. If pre-tax income were to remain the same, the company will earn about $5.24 per share before tax in 2012. Even at a 7x multiple, the company would be worth $36.67 per share. But that assumes repurchases come to an end -- an unlikely scenario. If the repurchases over the next decade proceed at a similar rate as in the past, then the stock looks like a safe bet for capital appreciation.

Final Thoughts

The idea of a declining business growing earnings per share is counter intuitive, yet that is exactly what CEC Entertainment is doing. So I can see why Charlie Munger likes cannibals. Companies that consistently lower shares outstanding -- at a discount to intrinsic value -- are doing shareholders an enormous favor that leads to higher returns over time.

titans8904 has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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