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WING: Company Overview (2017 10-K)

Wingstop is a Dallas, Texas based operator and franchisor of a global chain of restaurants specializing in fresh, boldly-flavored, cooked-to-order chicken wings, fries and sides.  At the end of 2017, its 1133 store system (23 US company, 1004 US franchised, 106 International franchised) generated sales of $1,087M in the year.  With its primary (“center of plate’) focus on wings flavored with 11 sauce options and the mantra “Wings, fries, sides, repeat,” it aims to distinguish itself from competitors also offering wings, but as an add-on item or a complement to a bar or to sports entertainment. The sauce options (fresh, hand-applied and tossed, range from mild to hot and spicy to savory to sweet, and have names such as Atomic, Mango Habanero, Cajun, Original Hot, Louisiana Rub, Mild, Hickory Smoked BBQ, Lemon Pepper, Garlic Parmesan, Hawaiian and Teriyaki) accommodate a wide latitude of tastes.  Wings, fries and sides constitute 92% of sales.  Fries are hand-cut and also freshly prepared, as are sides which include dips, coleslaw, bourbon baked beans, potato salad and freshly-baked yeast rolls.  The company requires franchisees to purchase all restaurant operating products (chicken, equipment, signage, cleaning supplies etc.) in accordance with its specifications and from approved vendors.  It negotiates regional or national contracts for chicken (~70% of all purchases) and other commodities.  It has contracted with distributor Sygma Network, Inc. as a single source for purchase and delivery of all food and packaged items. The company receives vendor rebates based on system-wide volume purchases (~6% revenues).

As a public company only since June 2015, WING’s financial record is fairly limited, but what is available is strong.  In the 5 years from 2013-2017 comps averaged 7.25% (driven primarily by transactions), 36.1% cumulatively, which, coupled with very strong unit growth (12-15%/yr.), has driven domestic system-wide sales up 98%. It is worth noting that domestic AUVs have been almost exactly flat in the last three years, at $1.1M, no doubt affected by the large number of new locations that open at lower volumes and mature over the first several years. It should also be pointed out that the impressive 5 yr. gain in same store sales was driven early in that period. The last three years’ domestic systemwide SSS have slowed from +7.9% in 2015, to +3.2% in 2016 and +2.6% in 2017. On the positive side: Int’l same store sales were up 9.9% in ’17. Also, domestically, Q4’17 was the strongest quarter of the year, up 5.2%, and that momentum has apparently continued into Q1’18.

In the same five year period, WING’s revenues (royalties & fees and company store sales) grew from $59.0M to $105.6M (up 78.9%), driving net income from $7.5M to 27.3M (up 264%) and adjusted EBITDA from $19.5M to $41.5M (up 113%).  As an asset-light, highly franchised enterprise, ROA in 2017 was an admirable 23.6%.  WING’s debt to trailing EBITDA, as noted below, is now over 5x, at the top of the targeted range after the recent special dividend, and in line with other publicly held pure franchisors.

The company plans to sustain its strong comp performance largely through expanding and refining its advertising strategy and enhancing its digital tools to manage operations and to mine data in support of its advertising initiatives.  In early 2016 the franchisees voted to allocate 75% of its advertising spend to a national platform (vs. its previous 25% national, 75% regional allocation).  The program aims to leverage scale to more efficiently purchase media and to achieve broader reach for its brand awareness initiatives, particularly in smaller and newer markets.  It is also aiming to expand brand awareness using social media to communicate with its key customers: 18-24 male millennials and 24-34 millennial parents (particularly moms).  In 2016 the TV campaign was waged in 10 domestic markets covering about 60% of the system, and in 2017 the campaign expanded to 26 weeks in all domestic markets.

These brand awareness initiatives are supported by WING’s technology initiatives.  With its 75% take-out rate, WING sees significant potential in enhancing on-line ordering through its digital platform. In 17Q4 22.7% of sales were made online, up from 19.7% a year earlier. The company only has to look at Domino’s Pizza to see the potential.  DPZ, also 98% franchised and also mostly take-out (or delivery in DPZ’s case), processes over 50% of its orders online and is rapidly expanding the range of devices on which it can process them. This facility has proven an important ticket builder, especially since on-line orders generate higher tickets, an incremental $5 in WING’s case.  Also, a new POS system integrated with its digital platform directs on-line orders straight to the kitchen. About a year ago, it launched voice-activated ordering with menu item customization with Amazon Alexa technology (An illustrative order: “Alexa, ask Wingstop to order an 8 piece classic wing combo with lemon pepper, fries and ranch.”).  During 2017 a delivery service was tested in Las Vegas (with 5 co. and 5 franchised locations) using Door Dash as third party provider. There was an approximate 10% lift in sales, mostly incremental, and with a $5 higher ticket than usual. Rollout of delivery into additional markets will take place during 2018 and  2019. The unit level economics described below have undoubtedly been the driver of the near doubling of store count (almost all franchised) in the past 5 years, and the impressive domestic pipeline of 450 new franchised unit commitments (80% from existing franchisees).  There is an additional backlog of 584 international locations. The company believes it can grow to 2,500 domestic units, about half from building out existing markets and half from new markets, and has not put a number on the obviously attractive international potential.

Unit Level Economics

The company has designed a simple, efficient and profitable restaurant operating model which has proven attractive to franchisees despite an increase in the royalty rate from 5% to 6% on new unit agreements since mid-2014. The domestic restaurants are a relatively small 1,700 sq.ft., due to their high (75%) take-out volume, and generate about $1.1M on average (or $647/sq.ft). The prototype’s operational simplicity is a factor in the low labor costs (23.4% at company stores averaging $1.7M per unit).  The company discloses the cash outlay for a new leased unit at approximately $370,000 (excluding pre-opening expenses). It estimates new units generate $820K in year 1 and $890K in year 2, by which time cash-on-cash returns on new franchised units range from 35%-40% (or 31% to 36% including our pre-opening estimate of $46K), implying an EBITDA range of $130K-$148K, or EBITDA margins of 15%-17%. Subsequent revenue growth to the 2017 domestic store average of $1.1M would generate a cash-on-cash return of about 50%.   An even more aspirational target is achieving the performance of company stores with their 2017 AUV’s of $1,712K & potential store-level EBITDA margins of about 17% (net of 6% royalty rate & vendor rebates).  This has undoubtedly been the driver of the near doubling of store count in the past 5 years, and the impressive domestic pipeline of 450 new franchised unit commitments (80% from existing franchisees).  There is an additional backlog of 584 international locations. The company believes it can grow to 2,500 domestic units, about half from building out existing markets and half from new markets. There is obviously substantial additional potential abroad.

Shareholder Returns

The stock has performed admirably since its IPO at $19.00 in mid-2015, more than doubling and now selling close to the all time high. In addition, this asset light franchisor has returned its free cash flow ($180M so far) to shareholders with special dividends of $2.90/sh in mid ’16 and $3.17/sh paid in early ’18. A regular quarterly cash dividend of $.07/share was also established during Q3’17, and this payout is targeted at 40% of free cash flow.

WING: Current Developments  (17Q4 Conf. Call)

The Company completed 2017 with impressive 13.5% unit growth, now spread over  30 different states and eight international markets, including Mexico, Singapore, the Phillipines, Indonesia, the United Arab Emirates, Columbia and Malaysia. The rate of unit growth in 2017 may well continue the recent trend but management has guided to a presumably conservative 10%+ for 2018. With over 1000 in the domestic and int’l combined development pipeline, suffice to say that there is ample opportunity for continued long term unit growth.

Same store sales in Q4 were the best of the year, up 5.2%, against modestly positive 1% in Q4’16. Management indicated that the momentum has continued into early Q1’18, which compares against an even easier -1.1% in Q1’17. Management pointed out that they are especially proud of the Q4’17 performance, with adjusted EBITDA up 18.9%, considering the very high volatility in chicken wing prices, which peaked in Q3, declining into Q1’18 and the continuation of higher labor costs. Total cost of sales in Q4 at company operated locations (including all store level operating expenses) declined 160 bp to 74.5%. For all of ’17, Cost of sales was up 370 bp to 77.5%, so Q4 was a dramatic improvement.

Since there are only 21 company operated locations (after purchasing 2 franchised locations), corporate growth is dependent on franchise unit growth and the sales of the franchise system. Commodity costs (chicken wings primarily) are obviously a system wide issue and have returned to more normal levels. Labor costs continue to be a concern industry wide, but WING locations have below average labor costs than most restaurant industry competitors, so franchisees should not be overly burdened. Rents, which are going up industry wide, are less of a concern here since locations (with access to lower to middle income consumers) are not usually in the same trade areas (for lower to middle income consumers) where most of their competitors want to be.

In terms of operating initiatives, delivery has been expanded to Austin and Chicago, which have seen sales lift in the mid to high single digit range, largely incremental, just as in Las Vegas. Advertising dollars are expanding with the growth of the system and the company continues to invest in its digital presence. From a balance sheet standpoint, a new $250M credit facility was completed in Q1’18, at an interest rate of 90-day LIBOR plus 275 basis points. On a pro forma basis, the net debt to trailing 12 month EBITDA is about 5.4x, which is, after the recent special dividend, predictably at the top of their borrowing inclination.

Management guided to EBITDA growth in 2017 of 13-15%, leveraging slightly the expected unit growth of 10% “plus”. Same store sales are expected to be up low single digits. Earnings per share are expected to be about $0.75 with 29.6M shares fully diluted. The tax rate is expected to be reduced by about 1500 bp. The $0.75 estimate for ’18 compares to $0.69 in ’17, adjusted for new revenue recognition rules governing up front franchise fees and advertising fund contributions.

Aside from the obvious challenge of successfully developing over 110 locations (or more), and supporting the existing 1100 locations, the company continues to develop its on-line ordering platform, obviously a major competitive asset. Importantly, growth in the national advertising campaign provides the possibility of regaining the substantial comp growth of a couple of years ago. There will not be additional marketing expense for franchisees, but the funds previously spent in local markets will be re-allocated to the national TV program. 100% TV coverage of the domestic store base in 2017 will be followed by heavier weighting in 2018.