All posts by Roger Lipton

SEMI-MONTHLY FISCAL/MONETARY UPDATE – ECONOMIC, SOCIAL, POLITICAL, MONETARY WORLDS ARE IN HOLDING PATTERN, BUT THE BEAT GOES ON !!

SEMI-MONTHLY FISCAL/MONETARY UPDATE – ECONOMIC, SOCIAL, POLITICAL, MONETARY WORLDS ARE IN HOLDING PATTERN, BUT THE BEAT GOES ON !!

The USA is the most powerful nation on earth. The holding pattern we are in before the new administration takes control, as well as the Covid-19 vaccines become widely distributed, has affected the world we live in, on many levels.

At the moment In the capital markets: The stock market chooses to look across the valley, flirting with an all time high as this is written. Traders have lightened up on their gold bullion positions, since a “safe haven” is not considered as necessary. Gold mining stocks have retraced virtually their entire gains since the first of the year. The reasoning in a nutshelll: (1) A new, more comforting, US administration is about to take office (2) Vaccines are on the way (3) There is no alternative to investing in the equity markets (TINA) since interest rates are so low.

Meanwhile: The facts of life include the following discussion points. Take them under consideration, with the cautionary overview that it is very difficult not to be seduced by the madness of crowds. 

With that preface:

The central banks around the world continue to stand by, prepared to accommodate further when necessary, which will no doubt be the case, though the form it takes is a bit more uncertain. Overall,  the basic situation has not changed, in terms of (1) Negative interest rate debt, which is at an all time high (2) The current deficits and cumulative debt are at record levels (3) Most asset classes have been bid to record levels (4) Governments around the world are searching for sources of funds, and the public will pay (5) Gold is underpriced, the gold mining stocks even more so.

NEGATIVE INTEREST RATES

The total worldwide sovereign debt now selling at negative interest rates has just hit a record of $17 trillion. China, for the first time, recently sold negative yielding debt. Major trading nations compete with each other to raise capital so the fact that German five year bonds sell with a negative .74% yield allowed the Chinese to provide an attractively higher yield at a negative 0.15% on their five year paper. The Chinese issuance was part of a package that yielded a barely positive 0.318% for ten years and 0.665% for fifteen years.

People…this kind of situation has not happened in recorded history, and is not good.

THE DEBT AND THE DEFICITS

As we have written before, the addict needs an increasingly large “hit” to maintain the “high”, though hardly anyone would say that the worldwide economic situation is rocking and rolling (i.e.”high”) While common wisdom these days is that the economy was strong before Covid-19 hit, US GDP  (up about 2.5% in calendar ’19) was forecast, before the Covid-19,  to grow only about 1.5% in Q1, clearly rolling over. The chart below shows vividly how large the stimulus, worldwide, has been, to get us through the pandemic, compared to the last crisis.

People….there has to be a hangover after this fiscal/monetary party.

MOST ASSET CLASSES ARE AT RECORD HIGHS

Ben Bernanke, Fed Chairman ten years ago, made it clear that his Fed’s objective was to support asset prices, which in turn would hopefully create a trickle down wealth effect for the broad economy. Janet Yellen, and now Jerome Powell have continued in the same vein. Moreover the mandate has evolved, as described by Powell, to achieve a “symmetrical” two percent inflation rate (tolerating above 2% for a while) and, most recently, economic growth that will benefit all segments of the economy, clearly targeting the wealth gap. This policy, echoed by central banks worldwide, has produced negligible interest rates of fixed income securities (all the way out to thirty years),  supporting the stock market because TINA (there is no alternative). The chart just below shows vividly how US equities (the S&P 500, ex financials) are selling at 49x free cash flow, almost 50% higher than at the top of the dotcom bubble.

People…..safe to say we are closer to a top than a bottom.

GOVERNMENTS NEED HELP, AND IT’S ON THE WAY, FROM US !!

First, we should understand that the minimal, or even negative, interest rates, are a form of wealth transfer. Fixed income security holders earn nothing, losing ground to even minimal inflation, and the government benefits from negligible interest cost on Treasury securities.

Additionally, though President-elect Biden publicly dances around the subject, it is clear that tax rates in the US will go up under his administration. It won’t be close to filling the cash flow gap but will be designed as acceptable to the public while the can (cash flow gap) gets kicked down the road. There has been a lot of discussion in the United Kingdom on this subject and our policies tend to mirror theirs.  Rather than a Value Added Tax (VAT) which would raise the most money but tax everyone, taxes targeting the rich alone are more politically preferable. This could include a tax on homes with a value above a certain level, much higher capital gains taxes, higher estate taxes, and higher rates on large incomes. The charts below show the long term trends in tax rates both in the UK and the US. Tax rates in the future may not match the 90%+ as shown in the charts, but higher than today they will be.

People…..it won’t be enough to materially reduce deficits, but everyone will be paying a more “fair share”.

GOLD IS UNDERPRICED, THE GOLD MINERS EVEN MORE SO

The price of gold has historically correlated strongly with the U.S. debt buildup, the growth in money supply, the buildup in negative yield debt, and Central Bank asset buildup. It has also protected purchasing power both during inflation (as in the 1970s) and deflation (as in the 1930s). By every measure, the price of gold should be a multiple of its current price. Central Banks around the world, who are most attuned to long term monetary trends, have been collectively buying over 400 tons of gold every year in the last ten. Though central bankers never admit to liking gold as an asset class, since a gold standard limits the ability of central banks to create more currency, this is a classic case of “do as I do, not as I say”. Gold mining stocks, whose earnings are leveraged to the price of gold, are even more underpriced than gold bullion itself. With the gold price almost the same as the $1900 high of 2011, the gold mining stocks are 50-60% below those levels. This undervaluation is underlined because, as the chart below shows, they have flipped from a negative cash flow position to free cash flow generators. One can only imagine how much cash they will generate as the price of gold (their end product) catches up with other asset classes.  Dividends are already being steadily raised by many of the major miners, just as they were in the 1930s, when Homestake Mining, between 1929 and 1936, paid out dividends worth three times the 1929 stock price.

People….it’s not a question of IF, more a question of WHEN.

CONCLUSION

We see no constructive movement, in terms of dealing with economic imbalances and fiscal/monetary distortions. The problems are an order of magnitude impossible to comprehend, let alone deal with, and have been created over decades, The current crop of politicians, worldwide, give no indication of a willingness to directly confront the situation.

We continually search for the flaws in our long term investment argument. If the facts, and important trends have changed, we would gladly adjust our approach. This is not the case, however. The fiscal/monetary influences on the worldwide economy have been on a parabolic ascent in recent decades. Stagflation, as in the seventies but worse, is the best outcome we can hope for in the foreseeable future. Events will at some point force the necessary financial, political and social changes necessary to encourage long term productive economic growth. The operative phrase is AT SOME POINT…..

Roger Lipton

 

CHEESECAKE FACTORY (CAKE) – STOCK RECOVERED NEAR PRE-PANDEMIC LEVEL – WHAT TO DO?

We published an analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/17. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that Cheesecake Factory (CAKE) is substantially overvalued, which suggests that CAKE is somehow in a much better fundamental position coming out of the pandemic than going in. The stock is within 10% of its high, but the current consensus estimate for 2021 of $1.58 per share is very much below 2019 results and expectations back in February.

Let’s take a fundamental look at CAKE. Back on February 15th, CAKE was selling at about $41/share, with earnings expected in calendar 2020 in the area of $2.85/share. Trailing EPS, for calendar 2019, had been $2.61/share. This premier operator of large box restaurants (206 CAKE restaurants at 12/31/19, with 39 in CA, 19 in FL, 16 in TX) averaging over $10M per unit (almost 1,000/sq.ft.  has had several years of relatively flat operating results. Comp sales, as shown just below, have been slightly positive, with traffic, adjusting for price, slightly negative:

The table below, from Bloomberg LP, shows the historical EPS trend, as well as the current 2021 consensus EPS estimate, obviously still restrained from working through the pandemic burden.

It should be noted that while Cheesecake Factory Restaurants are the heart of this business, CAKE operates an additional 88 restaurants under the names North Italia, Grand Lux Cafe, Rock Sugar, Social Monk Asian Kitchen and Flower Child.   CAKE also operates two bakery facilities that supply their own restaurants as well as third party customers.  As you can see from the summary financials below, Income From Operations declined over the five years ending 12/19, from $165M to $106M. However, the steady cash flow from operations, combined with an increase of $200M of long term debt (to $290M) allowed the Company to shrink the fully diluted shares outstanding from 50.6M to 44.5M. This process, along with a lower tax rate, allowed earnings per share to do better than Income From Operations or Pretax Earnings.

In addition to the summary results just above, it is relevant that, between 2017 and 2019, Cost of sales was reduced by 40 bp to 22.6% of sales, Labor increased 190bp to 36.3%, Other Operating Costs increased by 110bp. Income From Operations decreased 260 bp to 4.2%, obviously reflecting the deterioration in store level margins.

Having pointed out the above lackluster sales trends and deteriorating profit margins, it cannot be ignored that CAKE restaurants serve the broadest menu in the industry, provide an outstanding value of food and service, and consistently receive very high marks in terms of customer satisfaction. Sales of just below $1000 per square foot are unmatched by any large scale casual dining chain. The Brand’s reputation, in the eyes of customers, is far from diminished.

THE CURRENT SITUATION

In terms of cash flow in 2020 and the current balance sheet : the Company took the necessary steps during the heart of the pandemic to assure adequate liquidity. Between 12/31/2019 and 9/29/20, cash increased from $58M to $243M (an increase of $185M, supplied by $200 of convertible preferred stock and an $86M increase in long term debt to $376M).  Cash Generated By Operating Activities  in the thirty nine weeks was a negative  $33M. Management indicated on the conference call that $96M was repaid on the credit line in October out of the 9/29 cash balance, bringing the long term debt balance back to $290M.

Same store sales at Cheesecake Restaurants were down 23.3% in Q3, a lot better than the 56.9% decline of Q2. There was a Loss from Operations of $34.9M, much better than the $83.7M of Q2.  Store level EBITDA margin of 7.8% was also much better than the negative 7.0% of Q2. Most importantly, comps improved sequentially throughout the quarter, from down 32% in July to negative 10% in September, and  running through October 27th at a negative 7%. There are lots of operating details we could provide, but the most important takeaway seems to be that the off-premise effort has apparently been retained even as dining rooms have reopened. Management expressed their confidence that this enlarged off-premise effort can be largely sustained, and the 35% flow through of cash from the incremental Q2 to Q3 sales can be sustained as sales build further. Management guided on the conference call to positive operating profit in Q4, with positive EPS after a 10% tax rate. Looking toward 2021, management indicated that commodity inflation would be about 2%, and wage rate inflation might not be quite as difficult as in recent years. Overall, management seemed to hold out hope that store level margins could be back to pre-pandemic levels (approximately double the 7.8% of Q3),  even at something just short of matching year ago sales (a 95% comp). This seems to be based on their confidence that off-premise sales can be maintained, better margins can be produced by call-in and online ordering (more than offsetting lower margins for deliveries) and labor inflation will be 1-1.5%, rather than the recent 5.5-6.0% annual increase. While we can’t forget that 18% of the Cheesecake restaurants are in lockdown challenged CA, that’s been the case already in the reported numbers and presumably included in management guidance.

CONCLUSION:

Putting it all together, we believe Cheesecake’s fundamentals are within reach (a year or so) of achieving pre-pandemic sales and margins. A large part of our consideration is the newly built satisfaction level of off-premise customers. We also consider that CAKE is in a class by themselves in terms of providing a very broad menu of well prepared food at compelling prices. We don’t doubt that their packaging and service, off premise,  is among the best within casual dining, and the possibility exists that off-premise can be largely sustained even as dine-in rebuilds. It therefore wouldn’t be shocking if two years from now, the AUVs are 10-20% higher than just before the pandemic, and operating margins could return to levels well above 2018 and 2019. Considering that the recovery is well established, CAKE’s operating skills are second to none, and an important new venue is now available to be served from existing facilities, CAKE shares are reasonably priced relative to their peer group.

Roger Lipton

BJ’s RESTAURANTS – (BJRI) – DOWN ONLY 10% FROM PRE-PANDEMIC LEVEL – WHAT TO DO?

BJ’s RESTAURANTS – (BJRI) – DOWN ONLY 10% FROM PRE-PANDEMIC LEVEL – WHAT TO DO?

We published an analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/17. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that BJ’s Restaurants (BJRI) is substantially overvalued, which suggests that BJ’s is somehow in a much better fundamental position coming out of the pandemic than going in.

Let’s take a more complete fundamental look at BJRI. Back on February 15th, BJRI  was selling at about $41/share, with earnings expected in calendar 2020 in the area of $2.40/share. Trailing EPS, for calendar 2019, had been $2.20/share. This fairly mature, well managed billion dollar company, operating 209 large box casual dining units averaging over $5M of revenues annually, had experienced several years of relatively flat operating results. Comp sales had been as follows, flattening in calendar 2019, after a relatively strong 2018 that followed a weak 2017:

The table below, from Bloomberg LP, shows the historical  EPS trend, as well as the current 2021 consensus EPS estimate, obviously still restrained from working through the pandemic burden.

The operating earnings were actually down over the period, as shown in the following table, but stock buybacks ($460M since 2014) allowed for earnings per share to increase between 2016 and 2019.  The long term debt increased modestly during the period, from about $100M to $140M, allowing for modest unit expansion as well as shrinkage of the share count.

In the early years of its growth, from the 1990s  to 2006, BJRI was a spectacular winner, but the last ten years it has traded essentially in a range from $30 to $70, with a brief dip in March of this year to under $10/share.

The steady cash generation over the long term allowed BJRI to enter the pandemic in relatively strong financial shape, with trailing Adjusted EBITDA of $129M in calendar 2019, down slightly from $140M in 2018.  The historically consistent cash generation attracted, in Covid-19  panicked late April of this year,  Act III Holdings (controlled by Panera’s legendary CEO, Ron Shaich) and T.Rowe Price advised investors, who invested $70M, at $20/share. In addition to the 3.5M shares of common stock, the new investors received a warrant to purchase 875k shares at $27.00 per share and one directorship. It is worth noting that, at $20/share, the Enterprise Value was less than $600M, something like 5x the Adjusted EBITDA in 2018 and 2019, so Shaich’s interest was understandable, and courageous under the circumstances. This vote of presumably long term confidence by Shaich and company  has no doubt been instrumental in allowing BJRI stock to approximately double from 4/30 when the deal was announced. This price performance is much better than almost all other company operated casual dining operators have experienced.

The above background brings us to the current situation, and an evaluation of  today’s Enterprises Value in relationship to reasonable expectations of future performance. BJ’s has predictably suffered this year  from the same circumstances as other casual diners. Management has reacted, in their own fashion, similarly to companies such as Darden, Bloomin’ Brands, Chuy’s, Chili’s and others. Starting with at only about 10% of the historical $108k average weekly volume from off-premise sales, they have built outdoor patios, encouraged curbside pickup and delivery, slimmed down the menu to reduce labor, partitioned indoor dining areas, enhanced digital ordering  (now 80% of off-premise activity), introduced group meals (now 20% within the catering effort), and  most recently introduced a beer subscription service. The third quarter, with comps down 30.2%, a $12.7M loss from operations, an 8.3% store level Adjusted EBITDA margin (vs.13.5% YTY) and a $6.6M positive Adjusted Corporate EBITDA was a huge improvement from Q2 when comps were down 57.2%. (The details of the disastrous Q2 operating results are not important at this point.)

The most important thing now is the current level of average sales per store, the current margins and the possibility that further improvement is in the cards. Average sales per restaurant rebounded steadily through Q3, from $64k in July to $78k in September. Most importantly, according to management on the Q3 call, average sales in October were above $83k per week, but not expected to increase much in the remainder of Q4’20 or Q1’21. There are too many patios that will be affected by colder weather, social distancing that will limit revenues during the holidays, the national tendency to roll back Covid-19 easing,  and 62 out of 209 stores in California, perhaps the state most aggressively locking down again. Margins, management indicated, could improve by a couple of points to 10-11% of sales at the store level, with sales per store in the $80-85k area (still down almost 20% from pre-pandemic levels) but visibility beyond that is too difficult at this time.

BJRI common stock was trading before Covid-19 with an Enterprise Value of 10-11x the run rate of EBITDA, not especially high, but far from a bargain for a chain that could be considered fairly mature. The Enterprise Value today, with 22M shares outstanding, a $38 stock price, and $65M of long term debt net of cash,  is about $900M.  That  level is only about 7x the  $129M of calendar 2019 Adjusted EBITDA, but it is impossible to know when, or if, the Company can do that again. There are a host of management initiatives, but the degree and timing of success is uncertain. The price level at which Shaich and Co. entered this situation should work out well for them because this too (the Covid) will pass. (Parenthetically: Shaich and Co. are not locked in. A double’s not bad.) For new investors at the current level, the reward risk ratio over the next several years is not nearly as attractive.

Roger Lipton

NOBLE ROMAN’S REPORTS THIRD QUARTER- PROFITABLE AGAIN – COMPS ALMOST FLAT

NOBLE ROMAN’S REPORTS THIRD QUARTER, PROFITABLE AGAIN, COMPS ALMOST FLAT

CONCLUSION

Noble Roman’s (NROM) reported their third quarter results, which were once again profitable in spite of the pandemic. More important than the exact operating results is that (1) Same store sales for the original four Noble Roman’s Craft Pizza and Pubs (NRCPPs) have steadily recovered and were negative by only 2% in October. (2) The two most recently opened NRCPPs look like they will generate sales and store level margins almost 50% higher than the first four locations.  Brownsburg and Greenwood, IN have changed the NROM equation. Average store level EBITDA margins among the current six locations  can now be expected to approximate 18%, generating a 40% cash on cash return on investment, among the best in the restaurant space.  (3) The balance sheet is the strongest in many years (4) The corporate cash flow has been positive all year, in spite of the pandemic, and can be utilized in the next several years for growth rather than debt service.

The corporate EBITDA which has been in the area of $3M in recent years, with much of it necessarily servicing debt, could expand over the next eighteen months to something on the order of $5M, most of which can fund growth. Though the NRCPP concept is still small among publicly traded restaurant companies, with only six (soon to be seven) company units and three franchised locations, the Brand has legs, in the Midwest at the very least, which leaves a very long runway for growth from this modest base in Indianapolis. The 650 unit non-traditional franchised locations, while currently inhibited by the pandemic,  provide another long term growth opportunity.  The Enterprise Value currently is in the range of $16-$17M, obviously a very modest valuation considering the cash flow considerations as described below.

THE THIRD QUARTER

Noble Roman’s, Inc. (NROM) reported their third quarter, ending 9/30, results on Tuesday. The quarter was profitable, as same store sales for their flagship Noble Roman’s Craft Pizza Pubs chain improved steadily through the quarter. The non-traditional fleet of over 600 franchised C-stores, convenience stores, etc., is recovering more slowly but the franchising division was solidly profitable as well. Overall corporate results for the quarter showed Operating Income of $411k. After deducting $328k of interest, $105k of which was non-cash, pretax income was $83k. GAAP EBITDA for the quarter, adding back $98k of D&A to operating income, was $509k.

The now six unit Company operated Noble Roman’s Craft Pizza & Pub (plus 3 franchised locations, including Kokomo which opened yesterday) showed a modest negative comp for Q3 of 6%, sharply improved from a negative 28.1% in Q2. October, importantly was down only 2%. Store level EBITDA of the 5 NRCPPs in Q3, improved to 13.2%, up from 11.8% in 2019, with the addition of Brownsburg that opened 3/25. The Company noted that, after adding back 1% cost of sales from pandemic related commodity shortages, about 2% from additional pandemic related operating expenses, and 1% from non-cash lease expense. the Adjusted store level EBITDA was about 17%. It was pointed out that Brownsburg is projected  to do about $1.7M of annual volume and contribute $383k (22.5%) EBITDA at the store level, generating a 59% cash on cash return on the approximate cash cost of $650k. Management pointed out on the conference call that the 3 points of pandemic related expenses applies to these numbers as well, so the post-pandemic margin could be even higher.

The non-traditional franchising venue is recovering more slowly, with revenues of $1,252k vs, $1,681k, down 25.6%. The margin contribution from this segment was 62.5%, down from 69.7%. The uncertainty regarding the duration of the pandemic make it unclear how quickly the results from this division will recover.

NEW LOCATIONS

The sixth company operated NRCPP location opened to record weekly sales in Greenwood on 10/12. Management indicated, on the conference call, the possibility that sales and margins could exceed those of Brownsburg. Though Greenwood is only open one month, so it is early to draw conclusions, Greenwood sales after one month are exceeding those of Brownsburg at the same point. The third franchised location, in Kokomo, IN opened two days ago. The seventh company location opens just after Thanksgiving in McCordsville, IN. The Company refrained from making projections relative to future openings, but reflected on the comfortable balance sheet ($1.6M in cash) and the consistently positive cash flow, concluding that they are continuously screening location prospects and an eighth location could open in Q1’21.

STORE LEVEL ECONOMICS

The most important consideration in terms of investment prospects for any  restaurant chain is the return on investment at the unit level, which depends on the “operating profit”, or “store level EBITDA” compared to the investment per unit. That outlook, while more than adequate prior to the recent openings, has been enhanced substantially by Brownsburg and Greenwood. The four original NRCPPs, the first of which opened in January 2017, produced an average of $1.2M of sales in calendar 2019, with an average operating profit of 12%. A case can be made that there were some non-recurring factors, amounting to at least two points, that affected those results, including the operating learning curve from introducing a brand new concept, shockingly high Common Area Charges at two locations, third party delivery charges, and some degree of cannibalization of sales from the highest volume original Westfield location. A 14% Adjusted Return generates $168k of average annual operating profit, or a very acceptable 26% cash on cash return on the $650k of average investment per store. However, the fifth and sixth location look like they will do something like $1.7M of sales, with a normalized operating margin above 26%. That would bring the average annual volume to $1.37M with an average store level EBITDA margin of $261k, which is 18% of sales generating a 40% cash on cash return. This  is obviously a huge improvement in the outlook in the wake of the two most recent openings. Future openings can, of course add or detract from the 18% on $1.37M but it seems like a reasonable bet that McCordsville and others will at least match the new average.

CONFERENCE CALL COMMENTS

Scott and Paul Mobley, CEO and CFO respectively, commented further that labor is a continuing challenge, especially with the masking requirement but the Company has managed to adequately cope. Relative to the non-traditional venue, 20 new locations have opened this year, in spite of pandemic related hesitancy of potential franchisees, matching the 20 lower volume locations that have closed. The dine-in portion of sales at the two newest NRCPP locations is about 40%, and it varies more widely at the first four locations. Partitioning and other physical adjustments have allowed for almost 100% of pre-pandemic seating, but customer attitudes still affect the sales mix. Third party delivery, which hurt margins in 2019 and early 2020 and which the Company has never promoted, has trailed off to minimal levels. The proprietary Pizza Valet curbside pickup service has been embraced by both customers and staff (who like the tips). In terms of the number of potential NRCPPs in the vicinity of Indianapolis, Scott Mobley referred to the twenty Buffalo Wild Wings as just a starting point, so the geographical pipeline close to home is substantial.

BALANCE SHEET AND CASH FLOW CONSIDERATIONS

The balance sheet showed $1.645M of cash at 9/30, up from $1.577 at 6/30, with Greenwood (now open) and McCordsville (to open by December 1st) almost fully funded. Corporate EBITDA was over $500k in the third quarter, obviously still affected by the Pandemic, obviously with no contribution from the new Greenwood location. Nine month reported EBITDA was $2.3M, which included the forgivable $715k PPP loan, but that loan replaced lost sales and profits so the normalized EBITDA would likely still be in the same range. It seems reasonable that 2021, in a more normalized environment, with Brownsburg (opened in March’20), Greenwood (opened in October ’20) and McCordsville (about to open) could generate something at or above $4M of corporate EBITDA. As opposed to last several years, when debt service absorbed a large part of corporate cash flow, aside for the possibility of principal payments out of excess cash flow, as defined, there are no principal payments due on the $8M of current long term debt until 2023. Management has not committed to a further schedule of company NRCPP openings, primarily because of pandemic related uncertainties, but they have demonstrated an ability to open stores within 90 days of a lease signing, are continuously evaluating locations, and it would be surprising if two or three new company operated locations don’t happen in 2021. It is not hard to picture therefore a $5M run rate of corporate EBITDA within 18 months from today.

CONCLUSION: provided above

Roger Lipton

RESTAURANT COMPANY STOCK HIGHER THAN PRE-PANDEMIC – IS IT WORTH IT?

RESTAURANT COMPANY STOCK HIGHER THAN PRE-PANDEMIC – IS IT WORTH IT?

We published our analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/9. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that Papa John’s (PZZA) while still carrying a very high multiple of earnings and EBITDA, is valued more reasonably today than ten months ago.

Let’s take a more complete fundamental look at Papa John’s.  Back on February 15th, PZZA was selling at $66/share. Trailing EPS, for calendar 2019, had been $1.17/share. This previously troubled multi-thousand unit international franchisor was beginning to turn around. The table just below shows the turn to positive comps in the second half of calendar ’19, after the management change, the new product effort and the introduction of Shaquille O’Neal as a corporate spokesman.

As the following table, as provided by Bloomberg LP, shows: earnings per share had turned slightly positive in Q3’19, dramatically so in Q4, but still far below the earnings power from a few years ago. By February 15th, before the pandemic hit, expectations were no doubt for continued same store sales progress and more earnings recovery. Still, the system was far from healthy as several quarters of low single digit comps don’t begin to compensate for the high single digit negative comps that went on for eighteen months. It is worth noting, however, that international sales (about 30% of the 5300 unit system) were nowhere near as weak during the tough times, apparently not so much concerned with the drama surrounding John Schnatter’s departure. It is also worth pointing out that about 600 domestic units are company owned, providing operating leverage, right now on the upside, to corporate results.

In any event, back in February, before the pandemic came into view, the expectation was for continued positive comps and EPS in the area of $1.40, up from $1.17.  PZZA, at $66/share was therefore trading for about 47x expected EPS, a fairly high P/E, but this is mostly the case when earnings are depressed and investors are anticipating a recovery.

Today, at $83, PZZA is trading at about 37x calendar 2021 consensus EPS. Adjusting for the the fact that calendar 2021 is farther out from today than 2020 was in February of ’20, the comparable multiple is about 39x expected EPS, about 18% less than back in February.

Just as we did in the case of Wingstop, the current question becomes: Is Papa John’s better or worse off today, as a result of the Company’s position in a post-pandemic world.

As the table above shows, the comps have been dramatic, both in North America and internationally. The EPS progress, after the first quarter, has been dramatic. Earnings have also showed dramatic improvement so far this year, with expectations of further progress next year. The Company has said that the  third quarter was the last of the financial support provided to franchisees. Most importantly, free cash flow has been $134M in the first nine months of ’20, $67M in the third quarter alone.  Cash and cash equivalents was $140M at 9/30, up from $28M at 12/31/19. Long term debt was unchanged in the last nine months, at $340M (including $20M current portion), relatively modest in this day and age from franchisors, considering that EBITDA this calendar year should be on the order of $150M. PZZA has a current dividend yield of just over 1% and has recently authorized the repurchase of $75M of common stock.

CONCLUSION:

The pandemic has been productive for Papa John’s, accelerating the improving trends that were already in place. New products have been successfully introduced, marketing has been increasingly effective, operational improvements have been implemented, John Schnatter’s departure and the following management transition are now firmly in the rear view window. The strong  same store sales trends seem firmly in place and newly satisfied customers will likely (if the Company has their way) remain loyal. Earnings can still be considered depressed, especially with the upside leverage from 600 Company operated locations. The balance sheet could be leveraged further, to the benefit of shareholders. Among the (largely) franchised operators, the reward/risk ratio for PZZA seems better than most.

Roger Lipton

Note: The numbers in the table below were calculated as a “first look”, to be refined further as individual situations are reviewed. For example, the PZZA numbers below shows it undervalued by 34%, while the refined analysis above shows the s tock still undervalued but by a more modest 18%.

COULD THIS HIGHLY VALUED RESTAURANT STOCK BE A RELATIVE BARGAIN ? – DEPENDS ON FUNDAMENTALS

COULD THIS HIGHLY VALUED RESTAURANT STOCK BE A RELATIVE BARGAIN ? – DEPENDS ON FUNDAMENTALS

We published an analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/9. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that Wingstop (WING), while still carrying a very high multiple of earnings and EBITDA, is valued more reasonably today than ten months ago.

Let’s take a more complete fundamental look at Wingstop. Back on February 15th, WING was selling at $101/share. Trailing EPS, for calendar 2019, had been $0.73/share. This steadily growing franchising company was expected to earn around $0.87/share in 2021, so the P/E on forward earnings was a very high 116x. Investors obviously were valuing this small box pure franchisor, with consistent unit growth based on strong store level economics, with free cash flow providing recurring special dividends to shareholders.

The table below, from Bloomberg LP, shows the EPS trend. 2020 EPS has obviously accelerated, as a result of Wingstop’s positioning relative to the pandemic.

You can see that EPS for 2021 are estimated to be $1.43/share so that WING, at $129/share is valued at “only” 90x 2021 earnings. Adjusting that multiple upward by 5% to account for the fact that calendar 2021 is about 15 months away versus the forward 2020 normalized EPS as of 2/15/20, the comparable multiple is about 95x versus 116x on 2/15.

The question now: is WING better or worse off as a result of the pandemic, and going forward into a normalized environment at some point?

The key question in any franchising situation relates to unit level economics, which translates into unit growth and then cash flow for the franchisor. As stated in the 2019 10K, the operating model “targets an average investment of about $390k, excluding real estate purchase or lease costs and pre-opening expenses. In year two of operation, we target a franchisee unlevered cash on cash return of about 35% to 40%.” The Wingstop franchise system was growing steadily though calendar 2019. The table below shows the admirable trends, all compelling in terms of attracting investors. This is IDEAL. No wonder the valuation was (and is) so high.

Which brings us to the current situation. In the second quarter, the first during the pandemic,  for thirteen weeks ending 6/27/20, same store sales were up 31.9%. There were 23 net new openings. Adjusted EBITDA grew 54%.

In the recently reported third quarter same store sales were up 25.4%. There were 43 net new openings. Adjusted EBITDA grew 19.5%.

Predictably, the pipeline for new stores is building, with 135-140 net new openings in 2020 now the expectation, up from only 95 earlier in the year. Management stated that “our brand partners are enjoying unlevered cash on cash well above 50%….our existing brand partners make up over 80% of our pipeline.” We don’t doubt that franchisees, who were very happy at the end of ’19, with C/C returns in the area of 35-40%, are even more pleased with sales up 25-30% so far in calendar ’20.

We won’t go into the operational details other than to say that Wingstop is doubling down from an operational, marketing and real estate standpoint. International growth is a major focus, especially the expansion into China.  There is a current “regular” dividend of $0.14/share quarterly (less than 0.5% annually) but “special” dividends have been provided, with a $5.00 dividend going “ex” next week, bringing the total to over $13.00 per share over the last four years. The Company continues to carry long term debt approximating 6x trailing EBITDA, but that’s typical among franchisors and investors don’t object as long as they are getting “theirs” in a continuing low interest rate environment.

CONCLUSION:

There is no reason to expect that Wingstop’s industry position is anything but strengthened over the last ten months. While 25-30% same store sales growth will no doubt moderate, perhaps even decline a bit once a vaccine is available and dine-in activity is re-established, franchisees should continue to generate their “above 50%” C/C returns and build out their territories. We therefore view the existing consensus EPS estimate of $1.22 for 2020 to be a reasonable base  on which to build to $1.43 in 2021 and more thereafter. Investors that were prepared to pay well over 100x expected earnings for WING back in February should be more comfortable today, with an even stronger company and a slightly lower valuation.

Roger Lipton

 

 

INVESTING IN PUBLICLY HELD RESTAURANT COMPANIES – WHAT DID THE PANDEMIC TEACH US?

INVESTING IN PUBLICLY HELD RESTAURANT COMPANIES – WHAT DID THE PANDEMIC TEACH US?

The dust is beginning to settle, especially with a vaccine now in view. The stocks within the restaurant industry made a huge move on Monday, going a long way to recovering from the severe decline that started at the end of February. We are comparing prices from before the pandemic to the current prices. We published a chart on October 22nd that attempted to compare the current valuations (relative to reasonable expectations) to those before the pandemic began. That exercise revealed some interesting “inefficiencies” in terms of valuations. Shake Shack screamed “overvaluation” so we wrote first about that Company. Of course, it stands to reason that the apparently most overvalued situation would make one of the largest upward moves in today’s news about a possible vaccine. Thank goodness we are not short  this volatile situation, which our experience has taught us is a nerve wracking exericise in a Federal Reserve supported easy money environment.

Before we get into a broader discussion of the last seven or eight months, there’s a lesson to be learned by a conversation we had with one of our money managing friends. Back on April 30th, he asked for our suggestion as to a “paired trade” in the restaurant industry. You know… one name that was well positioned and would outperform on the upside, paired with the short sale of a weaker  company that would not do as well. The theory, which fifty years ago spawned today’s multi-trillion dollar hedge fund industry, is that equal amounts invested in well chosen offsetting positions would be market neutral yet hopefully outperform the general market over time. It stands to reason, of course, that the stock price will follow the fundamental performance over time, and the good companies will fundamentally do better than the weaker participants. Ideally the long position will go up and the short position will go down, profiting on both sides in a neutral market. That was often the case decades ago, when stock ownership was more broadly spread among individuals and institutions who were picking Individual stocks. These days, investors are more typically ETFs which have to own broad swaths of  particular industries, as well as institutions that are fighting for day to day performance. The result is that all stocks within an industry have a strong tendency to move together, and it takes a long time for fundamentals to prevail. Adding to this “inefficiency” is that multi-billion dollar hedge funds maintain large short positions, managed with a hair trigger to limit losses if even short term news is announced.  That’s why  on a day like Monday when the general stock market makes a really big move, the stocks with the largest short positions go up the most, whether the specific fundamentals justify that price action or not.  We could go on….but suffice to say that short term trading has become very difficult in recent years.

As an illustration: relative to the request for a couple of paired trades back in April, after we suggested that this approach has become pretty difficult, we provided a couple of apparently compelling suggestions. We paired the highly respected Darden  (DRI) on the long side with the enormously challenged Dave & Buster’s (PLAY) as a compensating short. Surely DRI would outperform PLAY, especially with the predictable health concerns of the public, even after the worst of the pandemic. The chart below shows in retrospect that by 4/30 PLAY, which had declined by 68% between 2/14 and 4/30, was already “oversold”. The profit in Darden (62%) from 4/30 to 11/9 (today) was almost exactly equal to the loss (60%) on the PLAY short. So that trade hasn’t worked yet. It is worth noting that PLAY  would have worked well from 2/14 (before the pandemic) to 11/9 (45% profit), against a 2% loss in DRI, but it was already too late by 4/30.

The second presumably intelligent paired trade I suggested on 4/30 was to go long Starbucks (SBUX) along with a short sale of Shake Shack (SHAK). Who could argue with a worldwide brand selling an addictive product (with major growth ahead in China), offset by the short sale of a ridiculously valued hamburger chain whose business model couldn’t be designed more poorly to cope with a pandemic. SHAK had no drive-thrus, high rents, resort locations, city locations inhibited, etc.etc. You can foresee the result. Between 4/30 and 11/9, an investor would have made 26% on his long SBUX position, and lost 51% on the SHAK short. Even from pre-pandemic 2/14 until 11/9, right through the pandemic, SBUX gained 9%, but the SHAK short lost 14%. Every time we write about SHAK, we emphasize our respect for their management, but they are not magicians, and the store level culture cannot force customers to come to the mall or bring NYC stores back to the $7M level of a few years ago.

So…be careful “trading” out there.

On a broader level, we tabulated, as shown below, the price changes among the “darlings” of the institutional investing set, the asset light, free cash flow pursuing pure franchising companies. Without the operating “risk” of running restaurants, they can leverage up their balance sheets to 5-6x trailing EBITDA in a historically low interest rate environment, often with the intent of declaring special dividends to shareholders.

The chart below shows that the ten fairly pure franchising restaurant companies declined by a relatively modest 12% from 2/14 to 4/30. The average was helped quite a bit by Domino’s, Papa John’s and Wingstop which had the twin benefit of delivery and pure franchising. Even eliminating those three names, the seven remaining companies were down 24%, a lot less than the 37% decline shown by the company operated restaurant chains shown below. The franchising  companies rebounded 23% between 4/30 and 11/9, more than recouping the worst of the pandemic, and showing a 6% gain through the cycle.

The chains that are primarily operating company stores, with all the operating challenges, have fared worse, also shown below. The stocks were down as a group by 37% by 4/30, recovered 48% by 11/9 and were down 8% through the cycle.

CONCLUSION:

Avoid “paired trades” on a short term basis. It’s just too tough.

For longer term investing, we too, in this environment would favor the pure franchisors, in general, even at their high multiples of earnings and cash flow, and historically high debt/EBITDA levels. We don’t see anything on the economic horizon that will reduce the availability of low interest rate financing. The operating challenges for those companies with company stores are not going away.  It’s of course true that franchisors cannot prosper unless their franchisees are doing well, and franchisors will likely have to do more than in the past to support their franchisees but they can borrow at low rates and could even pass through part of that low cost capital to their franchisees.

SEMI/MONTHLY FISCAL/MONETARY UPDATE – ELECTION DAY !! – WHAT DOES IT MEAN FOR THE ECONOMY?

SEMI/MONTHLY FISCAL/MONETARY UPDATE – ELECTION DAY, WHAT DOES IT MEAN FOR THE ECONOMY?

It is difficult to step back from the 24 hour news cycle and focus on the forest, rather than the trees.  As of 9/30/2000, a mere twenty years ago when GW Bush was elected,  the total US Debt amounted to $5.7 trillion. In 2008  Barack Obama bemoaned the “irresponsibly built” debt of  $10.0 trillion, then took it to $19.6 trillion by 9/30/2016. Donald Trump campaigned suggesting he could balance the budget and begin to reduce the debt and the current total is now over $27 trillion. Even without the “extra” couple of trillion to cope with Covid-19, he was on pace to substantially exceed the pace of his predecessors. The deficit the next twelve months is likely to be in the $2-3 trillion range in the current fiscal year ending 9/30/2021, so the beat goes on.

Anyone who thinks our economy will resume long term real GDP growth in excess of 3% is ignoring the crushing burden of the ongoing debt buildup. The best we can hope for is “stagflation” as our dollar loses its purchasing power over the long term and the worldwide economy moves toward the “European Model”. This conclusion applies no matter which candidates, for the presidency and congress, prevail. The public (on both the political right and the left) wants health care insurance with no regard for pre-existing conditions, continuation of social security and other entitlements, increasing support for education at all levels, continued high defense spending, as well as other forms of government support. The Federal Reserve Bank has taken up the task of narrowing the wealth gap. All of this means continued major government spending, far in excess of government receipts. Larger government may be more predictable under Democratic leadership but will also be a necessary reality under the Republicans. Neither Trump, Pence, Biden or Harris created this situation. It has been created over decades, and the current players can only kick the can down the road, at best.

The worst outcome that we can envision is a deflationary depression, possibly one that could match or even exceed that of the 1930’s.

Our opinion is that the can gets kicked down the road, at least once more. These cycles take years to play out, so the timing of the ultimate “reset” is impossible to accurately  predict.

For the moment:  THE DISTORTIONS, AND PRESSURES ONLY INTENSIFY – YOU NEVER KNOW WHICH SNOWFLAKE WILL CAUSE THE AVALANCHE

There is lots of additional news, all of which only serves to intensify the financial distortions that we have been describing for years. With the US election upon us,  there seems to be nobody that expects government (fiscal) or federal reserve bank (monetary) support to be reduced after the election. It is virtually certain to be quite the contrary. Below we will hit a few “high” or perhaps “low” points, while quoting several more well known authorities than ourselves.

We have described many times how debt issuance brings forward demand, at the expense of future consumption. We have also pointed out, as Reinhart and Rogoff described over ten years ago in “This Time is Different” (chronicling 800 years of business history) that once government debt reaches approximately 100% of GDP it is a noticeable drag on productive growth.

Lacy Hunt and Van Hoisington of Hoisington Research said recently: “Countries in a debt trap (our italics) like the US, Japan, the UK and the Euro Area have experienced a fall in short term interest rates to the zero bound, in some cases into negative rates, thus eliminating monetary policy to play a role in supporting the economy.” In other words, once at zero, below zero can’t help much.

Hunt and Hoisington described the increasing burden of the debt buildup this way: “As proof of the connection (between debt and GDP slowdown), each additional dollar of debt in 1980 generated a rise in GDP of 60 cents, up from 54 cents in 1940. The 1980s was the last decade for the productivity of debt to rise. Since then this ratio has dropped sharply, from 42 cents in 1989 to 27 cents in 2019.”

Hunt and Hoisington also said “Debt financed fiscal policy can provide a short term lift to the economy that lasts one to two quarters. This was the case with….2009, 2018 and 2019. However, the benefit of these actions…even when the amount of funds borrowed and spent were substantial, proved to be very fleeting and the deleterious effects remain. The multi-trillion dollars borrowed for pandemic relief in Q2 encouraged the beginnings of a “V” shaped recovery, but this additional debt will serve as a persistent restraint on growth going forward. When government debt as a percent of GDP rises above 65% economic growth is severely impacted and becomes very acute (our italics) at 90%.”

Keeping the above in mind, we present the following chart, provided to us within our subscription to Grant Williams’ “Things that make you go hmmm”. Shown are examples of what was going on, describing profound societal adjustments that have accompanied the debt levels of today. Fifty one out of fifty two times in the past, when debt gets to 130% of GDP, the country eventually defaulted  on its financial obligations, one way or another, which is exactly where the USA is right now.

 

As the final footnote to this discussion, to demonstrate how dramatic the government intervention has recently been: the legendary investor, Howard Marks, pointed out recently that: “in the four months from mid-March to mid-July of this year, the Fed bought bonds and notes and other securities to the tune of more than $2.3 trillion. That was roughly 20 times what it bought in 18 months during the Global Financial Crisis (of ’08-’09).”  We have it it this way: the “drug addict needs an increasingly powerful ‘hit’ to maintain the ‘high’”.

Take all of this under consideration as you position yourself financially.

Roger Lipton

INSPIRE BRANDS ABOUT TO PAY 22X ’21 EBITDA AND 34X ’21 EPS FOR DUNKIN’ BRANDS – ARE THEY OUT OF THEIR MINDS? NOT QUITE !!

INSPIRE BRANDS ABOUT TO PAY 22X ’21 EBITDA AND 34X ’21 EPS FOR DUNKIN’ BRANDS – ARE THEY OUT OF THEIR MINDS? NOT QUITE !!

It has been widely reported that Inspire Brands, controlled by private equity firm, Roark,  is negotiating to buy Dunkin’ Brands (DNKN) for about $8B, which, including approximately $3B of debt, values DNKN at about $11B. This amounts to about 22x EBITDA in calendar ’19, and the same multiple of consensus 2021 estimates. Franchising companies are attracting investors, including private equity owners, largely because of their supposedly free cash flow from the royalty stream. We have written many times that the cash flow is not entirely “free” because some of that income stream should be reinvested in the system to maintain its relevance and franchisee profitability. For the moment, let’s put that concern aside for the moment, since interest rates are close to zero, the music is playing and investors are dancing. More relevant in the short term is that the $3B of debt is about 6x trailing, and projected, EBITDA, so the debt load is already at the top of the range currently viewed as comfortable by the marketplace. There is therefore not too much more leverage that can be currently squeezed out of this situation.

However, executives at Roark, and Inspire Brands, are far from ignorant or reckless, so let’s think about the potential appeal. It is no secret that Dunkin’ is surviving better than most, not as well as some, due to the preponderance of drive-thru locations, while limited during the pandemic by less breakfast traffic. Indeed, same store sales in Q2 were down 18.7% at US stores. It is also well known that this fifty year old worldwide brand (forgetting about it’s much smaller sister brand, Baskin Robbins) is most heavily concentrated in the northeast, with expansion opportunities out west and abroad. On the other hand, the Dunkin’ brand can no doubt benefit from continued reinvention, as they have consistently lagged a little company called Starbucks in terms of growth, sales comps, and store level profitability. With those broad brush thoughts out of the way, it occurs to us that:

  • The $500M of historical and projected EBITDA for DNKN is after spending $507M in ’19 on advertising and $237M on G&A. Inspire Brands owns about 11,000 stores among its subsidiaries, including Sonic, Jimmy John’s, Buffalo Wild Wings and Arby’s. No doubt there are certain “synergies’ that could be achieved as advertising and SG&A are consolidated with the DNKN system that includes almost 10,000 stores within 21,000 distribution points. It wouldn’t surprise us if the numbers crunchers at Inspire have figured out that somewhere between $100 and $200M could be saved, out of the total of over $700M in ads and G&A.
  • Dunkin’ can sell coffee to 10000 new locations. If coffee is only 1% of $10B in sales, and the profit margin is 25%, that would be $25M of additional profit.
  • There is no other major brand in public hands that could as easily (and inexpensively) be rolled into Inspire’s existing ten thousand locations than Dunkin’s COFFEE and other offerings, whether or not a new daypart is desired. Dunkin’s coffee alone has a great deal of consumer acceptance and could be a meaningful addition at Inspire’s other brands. So: Dunkin 21,000 points of distribution could become more like 31,000, with minimal incremental investment by various franchisees. If 10,000 existing Inspire locations do something over $10B systemwide, a 5% addition to sales (throughout the day from Dunkin’ products) would add $500M to sales. A 5% royalty rate would amount to $25M of additional royalties, plus about $10M of additional advertising contributions. We could be high or low with these broad brush suggested numbers, but this seems like a material opportunity to us.
  • Dunkin’ franchised units an be cross sold to other Inspire brands. The same strip center housing a Jimmy John’s can house a Dunkin’ or and even a Baskin Robbins next store. Hard to quantify but another plus.

It is not hard to imagine (on a spread sheet, at least) that $500M of past (’19) and future (’21) EBITDA (forget about ’20) could become $650-$700M after G&A and advertising efficiencies, with another $50M thrown in from additional profit margin, royalties and ad contribution by way of Dunkin products spread through Inspire’s other brands. That brings the debt, as a multiple of EBITDA, down quite a bit, allows for new borrowing that can be reinvested in the business or paid out to equity holders.

The only other suitor that comes to mind is Yum Brands, large enough to absorb Dunkin’ without “betting the company”, with enough scale to get administrative synergies, and enough existing units to get a material benefit from the addition of Dunkin’ products. Wendy’s already has a breakfast program and adequate debt, and doesn’t have enough units to get a material benefit from adding Dunkin’ products. Domino’s or Papa John’s or Wingstop couldn’t put Dunkin’ products to enough use. Jack in the Box is nowhere near large enough. Restaurant Brands already has Tim Horton’s. Chipotle, with their company operated locations, enjoys being debt free and wouldn’t tolerate 25-30% dilution of their equity. McDonald’s doesn’t need it, and is not in an acquisition mode.

Conclusion: The acquisition of Dunkin’ by Inspire makes more sense at a record high valuation for DNKN than is apparent on the surface. Unless Yum Brands competes for it or Inspire Brands gets discouraged somehow, Inspire will be in the coffee business, to be spread to their currently owned franchise systems, and current Dunkin’ shareholders will say “thank you very much.”

Roger Lipton

RESTAURANT STOCKS – INDUSTRY OUTLOOK IS CLARIFYING, STOCKS UP FROM LOWS, HOW MUCH RECOVERY IS DISCOUNTED? WITH A FRESH LOOK AT SHAKE SHACK

RESTAURANT STOCKS – INDUSTRY OUTLOOK IS CLARIFYING, STOCKS UP FROM LOWS, HOW MUCH RECOVERY IS DISCOUNTED? WITH A FRESH LOOK AT SHAKE SHACK

Our readers have no doubt noticed that we have had very few writeups on individual companies over the last six to seven months. The whole world is in a “workout” situation and restaurant companies are no exception. Aside from the fact that we don’t know what current balance sheets look like, what operating margins can be expected, how much more sales recovery can be expected and the mix between dine-in and off-premise, everything is perfectly clear. However, we expect to know a lot more with the release of the third quarter results and should be able to make some informed judgements at least as far as the next twelve months.

AT THE MOMENT

The stock prices of the most prominent restaurant companies have recovered a great deal of the sharp decline in February and March, of course with a great deal of variation between companies. Most of the restaurant companies are selling much below their highs early in the year. You will not be surprised to know that Chipotle, Wingstop and Papa John’s are a lot higher than in mid-February. You might be surprised to know, however,  that Dunkin Brands, Brinker, Pollo Loco, McDonald’s, Del Taco, and Yum China are also higher, though more modestly.

TODAY’S VALUATION VS. PRE-PANDEMIC

The following exercise is designed to compare today’s valuation relative to the current best guess of calendar 2021 earnings, compared to the valuations as of 2/15/2020 (before the pandemic hit) relative to “normalized” 2020 earnings, meaning the earnings that were expected in 2020 as of 2/15/20. For the purpose of “normalizing” the 2020 earnings (ex the pandemic’s effect), for the first look we simplistically added 10% to the reported TTM ending 12/31/2019 (or as close to that date as we could calculate). Going forward from here, we used the earnings consensus estimate, per Bloomberg, LP as of today, for 2021, to calculate today’s P/E multiple of forward earnings. To compare earnings 14 months out to the 2020 earnings as of 2/15/20, which were 10.5 months out, if earnings are growing at about 10% annually, we have reduced the forward multiple (calendar 2021) by 5% to bring it roughly in line with the forward multiple as of 2/15/20.  Keep in mind, this initial look is to help us focus on the individual situations that might be most overvalued or undervalued compared to pre-pandemic. As the table below shows, the apparently most overvalued stocks, relative to pre-pandemic levels, are Shake Shack (SHAK) and BJ Restaurants (BJRI). The apparently most undervalued are Wingstop (WING) and Papa Johns’s (PZZA). With this first look in mind, we will fine tune our view of the current situation for each of these four companies, none of which are we currently long or short. We are drawn first to Shake Shack (SHAK), for which the market is apparently discounting quite a recovery.

Shake Shack (SHAK)

Shake Shack (SHAK) has been provided by the capital markets with a great opportunity to raise capital with minimal dilution, as well as allowing pre-IPO shareholders with great liquidity at a high valuation. We have consistently praised management for the culture they have built within a very rapidly growing worldwide system. The halo created by founder Danny Meyer and his team led by Randy Garutti has been maintained, even though modest traffic declines, even before the pandemic, were a fact of life. Earnings per share were $0.71 and $0.72 in calendar 2018 and 2019 respectively, though millions of dollars were capitalized as investment in SG&A (e.g.Project Concrete). We have written many times about how the extraordinarily favorable store level economics, driven early by New York City locations doing approximately $7M annually has been (as Company management predicted) come down materially since the IPO. We encourage readers to SEARCH on our home page for more details, but in essence, new locations, pre-pandemic were doing a little over $3M annually, with store level EBITDA less than half of what they were before and immediately after the IPO.

With that very quick summary in mind, the consensus estimate, as of 2/15/20 was not materially more than the $0.72 of 2019, because traffic was lagging, margins were coming down (as management had predicted) with the more modest new unit volumes, and SG&A was still being built up to support 35-40% unit growth of Company locations. Shake Shack found themselves more exposed than almost everyone else to the effects of the pandemic, since many of their locations are in malls and destination sites, with heavy rents, no drive-thrus and relatively little delivery or curbside pickup before the pandemic.

Management has done an admirable job of adjusting to the new reality. Digital ordering, curbside pickup, and delivery have all been expanded, and there has been sequential improvement from the disastrous lows of March and April through July when the Company reported their Q2 results. With so many urban and destination locations, the sequential improvement has been material but more modest than many peer competitors. SSS were down 64% in April, down 42% in May, 42% in June and 39% in July. Digital sales represented 62% of total Shack Sales in July, with 800,000 first time digital purchasers between March and July, four times higher than a year earlier.

Even so, Q2 same shack sales were down 49.0% and overall sales (including non-comp units) were down 39.5%. There was a predictable operating net loss of $18M and negative EBITDA of an adjusted $8.8M.

There has been no public update of sales trends since the Q2 report, but it is safe to say that the third quarter will be another substantial operating loss (Bloomberg, LP estimates $12.3M), since 50% of the store base and 60% of SSS prior to Covid-19 are in urban locations, plus non-traditional locations in airports and stadiums are still a drag.

In spite of the operating loss so far this year, the Company has no liquidity concerns because they raised about $146M through common stock sales in April. The pleasure of a high valuation is that equity can be raised with minimal dilution. Cash and cash equivalents as of 6/24/20 was $173M vs. $37M on 12/25/19. The number of shares issued and outstanding grew from 34.4M to 38.2M, up only 11%.

There are lots of other operating details we could provide relative to company efforts to adjust to the situation at hand, but analyst consensus estimates provide a pretty good general idea of expectations going forward. Estimates call for a loss in 2020, then profits of $0.11 per share in 2021. There are no current estimates beyond 2021, but it is obviously questionable how quickly Shake Shack can re-invent itself sufficiently to deal with the world as it has changed. Not only are sales trends uncertain but margins are equally in doubt.

At the current price of $68/share, the market capitalization of the equity is $2.8 billion. The $173M of cash could be deducted, still providing an enterprise value of over $2.6 billion. Let’s assume that SHAK can re-acquire something like its previous high valuation, perhaps 50x earnings per share and 25x EBITDA. The Company would need $52M of earnings ($1.36 on the current share base) and $104M of EBITDA to support the current stock price. Based on the obvious uncertainty relative to the newly evolving business model, we don’t know when (or if) that will happen.

Roger Lipton

P.S. The next company we will explore, at first glance within our table above, undervalued, is Wingstop (WING)