Conclusion: Hardly different from our Conclusion in May ’17
The more things change, the more they remain the same. The biggest difference is that CHUY trades closer to $20 today than $30 twenty months ago. The operating results in the interim have justified our May’17 conclusion. CHUY is statistically cheaper today, but the prospects have not improved, especially in light of a macro environment that is clearly weakening and a still challenging competitive situation. The best hope for a higher stock price (other than a “meltup” in the general equity market) would be interest by private equity investors. However, we don’t believe these company stores could be easily franchised, which is often the appeal for “asset light” driven private equity players. Secondarily, the real estate is entirely leased, removing the potential liquidity from a sale/leaseback. The balance sheet is debt free but the store level returns have slipped on existing stores, and results at the newest openings are “mixed”, possibly on the low side. We therefore wouldn’t bet on private equity providing a premium to the current 20x ’19 earnings and almost 13x trailing EBITDA.
In May of ’17 we said:
“While the details of operating performance provided above could be considered “sobering”, management of CHUY can be commended for an excellent record of growth, maintenance of a strong balance sheet, and continued opportunities for unit expansion and earnings growth. Almost all of the variables described above are typical of almost all operators in the restaurant industry. Sluggish traffic trends (especially for full service dine-in locations), higher labor costs, commodity costs that have probably seen their best levels, competitive pressures, and occupancy expenses that continue to edge higher are not a happy combination. This is more a commentary on the current headwinds affecting even the better managed restaurant companies.”
Source of Revenues
Chuy’s Holdings, Inc. is a steadily growing Austin, Texas-based full-service restaurant chain featuring freshly-prepared Mexican and Tex-Mex fare. As of Q3’18 it operated 98 stores in mostly suburban locations in 19 states, two more opened early in Q4, with about 35% in its home state and the remainder throughout the southeastern states, Virginia suburbs of Washington DC, Ohio and Indiana. The company, until a year or so ago, targeted 20% annual growth, making the jump from a regional chain to a national one while admittedly encountering challenges in entering some secondary markets in 2015.
The company’s menu offers endless taco chips and salsa and items with irreverent names, generous portions and value prices. The following price point indications are a mix of a presentation after Q2’18 and Q3’18. Favorites have included “Big as Yo’ Face” Burrito” ($8.69-$10.49) or “Chicka-Chicka Boom-Boom” ($10.69) which are 2 of only 10 items priced over $10. The other 40 items are less than $10 and the average ticket (including 18.3% alcohol) was $15.03 in Q3’18, which is one of the lowest of its competitive set. For example, as of Q2, a typical CHUY’s “Big as Yo Face” Burrito Oven-Roasted Chicken which includes a side of rice and beans and unlimited complimentary chips and salsa sells for $9.99, comparing favorably with Chipotle’s $6.85 chicken burrito plus an order of chips and salsa for $2.05 for a total of $8.90.
Operational Model & Unit Level Economics
The company prides itself on the un-chainlike look of its stores with the slogan “If you’ve seen one Chuy’s, you’ve seen one Chuy’s.” The flexible prototype is suitable for a wide range of sites including conversions. The only standard feature of the design is the kitchen which is strictly identical in every location. Despite the variances in store design, the stores in the comp base as of Q2’18 (the last time fully described) averaged close to 8.8K square feet in size generating AUV’s of $4.4K and unit-level EBITDA margins of 18.7%. These historical results are materially higher than the conservatively targeted model, which calls for targeted EBITDA margin of 15.0-16.5%s by the third year, by which time the company model calls for AUV’s growing to $3.75M. At this possibly conservative stated level of performance, targeted cash-on-cash return on the average new unit cash investment of $2.1M in a leased location net of landlord allowance ($2M) plus our estimate(100k), of pre-opening expense, would be 27-29%. Currently, on the comp stores, for an average cash investment of $2.3M, the actual cash-on-cash returns, at 18.7% store level EBITDA, calculates to 35.9%. Obviously, if the future results move closer to the Company’s conservative targets, the margins would be contracting materially. The difficult competitive environment is not helping at the moment, but we have sufficient respect for this management team that we viewed their model as “theoretical”, and results could exceed expectations if and when industry conditions improve.
Company History and Strategy
Until 16Q4 CHUY’s comps were positive for 25 consecutive quarters. During this stretch, it outperformed the industry by about 240bps on average as measured by Knapp-Track. This was true even in 2014-2015 when the company struggled as it entered new secondary markets, and, importantly, the company’s comps averaged about 2.6% driven by a healthy balance of traffic and price. It is noteworthy that despite the relatively robust comps and store-level performance, operating margins were somewhat uneven during that period. Similarly, the company’s ROIC has averaged less than 10% in the last 5 years. The variability is partly explained by poorly performing stores in newly penetrated secondary markets in 2014-2015. Management addressed this challenge in 2015 by slowing new store growth from a 20%+ pace to 12% and backfilling new markets to achieve area efficiencies. Operating margins, which had fallen as low as 6.5%, recovered to 8.4% by 16Q1. However, the company has finally succumbed to the restaurant industry malaise. Comps steadily weakened before going negative 1.1% in 16Q4 (on – 2.4% traffic offset by +1.3% price) and that YTY decline in comps and traffic has continued through Q3’18.
The performance of new stores is an important analytical parameter. The Company provides us with revenues from all stores and the total operating store/weeks. It also provides the store-weeks for non-comp stores, so analysts can track the annualized performance of the newest stores versus the chain average. At year end ’16 it appeared that the newest stores were annualizing at about $4.1 million, versus $4.58M for comp stores and $4.43 for all stores. The company pointed out then that the $4.1M was down only 4.8% from 2014, but the trend has continued, even if at a slow pace. As of Q1’18, the trailing twelve months for comp stores slipped modestly further, to $4.411M (down 3.4%, traffic declining more than that, allowing for price increases over that 21 month period. Furthermore, the performance of the newest stores in 2018 is “mixed”, discussed further under recent developments, below.
Going forward, the company’s slower store development plan is the largest change in strategy. The company has slowed its unit growth from the 20% historical level, to 11 units in 2017 on a base of 80, for a growth rate of 13.7%. As of the end of Q3’18, 7 new units have opened out of a planned 9 for 2018, the last 2 opened in early Q4, which represents 10% unit growth. Development in 2019 will slow further to 5-7 new restaurants. Management typically has been less clear on the trajectory of margins other than targeting G&A growth at half the rate of revenue growth, which, assuming revenue growth consistent with store growth. In the past, this implied net earnings growth of 25%-26%, but that expectation has obviously been scaled back.
Other than the development plans and margin focus described above, current broad initiatives include a new partnership with a national-level marketing firm, more intense attention to off premise sales such as catering, online ordering and delivery, and integration of a new labor management system.
At the end of Q3’18 CHUY continued to have no debt and its $25M credit facility (expandable to $50M) remained untapped. While free cash flow will likely be sufficient to fund virtually all the new store development without tapping the credit line, the remaining $28M stock purchase authorization, if exercised in the next twelve months, could require a modest amount of debt.
In the nearly 5 years since its July 27, 2012 IPO at $17.17, CHUY’s stock has been as high as $43/share, in late 2013 and early 2014, but has retreated during the last several years from the mid-30s down to the present level, no doubt affected by the flattening of the previous growth in EPS. There is no dividend, and a large stock purchase programs has not been part of the financial strategy, though a $30M authorization was announced in October, 2017. During the first nine months of 2018, 65,000 shares were bought for $1.6M, none during Q3, leaving $28.4M under this plan.
Recent Developments (Per Q3’18 earnings release and conference call)
Operating results in Q3’18 continued to be lackluster, though far from disastrous. Comps were up 0.5% on a calendar basis but down 0.4% on a fiscal reporting basis. There was a one week shift between “calendar” and “fiscal” reporting YTY, with a 13 week quarter involved, but an explanation of the timing difference is “above my pay grade”, perhaps not yours. Let’s just call the comps “flat”. More importantly, the comps were negatively affected by the wettest September on record in the core Texas market, reducing patio sales by 18%.
EBITDA restaurant margin for Q3 was 14.0%, vs, 15.9% in ’17. Results were negatively influenced by higher labor, higher insurance, delivery charges, increased marketing expenses and occupancy expense. Benefits came from lower commodity costs and less training expense for new managers. G&A was flat in dollar terms, 40 bp better as a percentage of sales. There was an income tax benefit of $1.6M vs. an expense of $1.0M in ’17. The GAAP results showed a net loss of $0.44/share vs. $0.19/share profit, but Adjusted Net Income was $0.20 vs. $0.19. Two new restaurants opened in the quarter, two more early in Q4, completing the year’s expansion plan with 100 locations in total.
Guidance was adjusted downward: Net Income/Sh. goes to $0.88-$0.92, vs. $1.09-$1.13 previously. Comps in ’18 will be flat vs. 1.0% previously. Pre-opening expenses will be $4.3-$4.4M vs. $4.4-4.8M previously. G&A, taxes, new units, shares outstanding, and capex were also revised modestly downward. There was no formal guidance provided for ’19.
The conference call provided further discussion about the unusually bad weather in Texas, the new marketing effort with increased social media and mobile usage. Online ordering using Olo is being expanded to all restaurants, now represents 8-10% of all to-go orders, and is a stepping stone for a new loyalty program. As indicated, 5-7 new restaurants are planned in ’19, the slower growth allowing for greater focus on the existing fleet. Pricing in the quarter was 1.5-2%, cost of sales was down 110 bp to 25.6% with favorable produce and chicken pricing, but this benefit will moderate in Q4 as beef, tomato and avocado cost is higher. Labor cost was up 180 bp to 37% as a result of higher wage rates and new store inefficiencies, with labor inflation amounting to 3-3.5% for all of ’18. Other Store Operating expenses increased 50 bp to 14.8%, due to delivery charges (14% increase in to-go sales), occupancy expenses (up 60 bp to 7.6%, from new stores and lease extensions). There was a non-cash impairment charge of $11M after taxes relating to six restaurants.
During the Q&A, the performance of new restaurants was discussed, a “mixed result in Chicago, two a little bit lower than expected and one doing more than expected….Miami, one that we’re very disappointed in, one we’re very excited about and one is in the middle. Overall..a little bit lower from our expectation.” The cadence of sales during the quarter was discussed, inconclusive other than the weather impact, a weather break and sales improvement finally in early November.
Margins were discussed, in terms of possible improvement, and 2.5-3.5% of sales improvement is necessary for margins to stabilize. The loyalty program could help but it is too early to quantify. Pricing will once again be in the 1.5-2.0% range. Importantly, sales away from the rains in Texas and the southeast were better, but obviously not enough to overcome the core market weakness. Marketing expense has traditionally been light, inching up to 1.0-1.1%, and could go higher by about 20 bp if the new programs seem to be helping.
Conclusion: Provided at beginning of this article