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COMPANY OVERVIEW (2017 10K)
Irving, CA based HABT operates and franchises restaurants in 11 states plus 2 in the United Arab Emirates and 1 in China and competes in the $44B fast casual sector. Of the 209 stores as the end of calendar ‘17, 193 are company stores and 16 franchised/licensed. Habit stores are heavily concentrated in CA and spreading in adjacent states (except Oregon) and recently to the East Coast.
HABT’s financial record in the past 8 years (including the pre-IPO years) reflects its early growth stage, with rapid percentage growth in the early years, still growing but slowing more recently, as shown in the table above. Sales have grown from $28.1M in 2009 to $331.7M in 2017. The overall sales progress has been complemented by a positive string of comps for the entire period until finally interrupted, but just barely. Adjusted EBITDA grew from $1.9M to $32.4M, with store level EBITDA consistently above 20% until this past year. AUVs grew during the same period from $1.2M in 2009 to the current level, but also have come down from their highest level. While the overall strategy remains the same, the company (rightly) is targeting about half the historical unit growth rate in the near future.
While still admirable, many of the operating parameters have moderated from their peak levels. Comp sales, positive for over 50 quarters, finally showed a very small recent decline. Part of the slow-down is surely caused by the industry-wide malaise, but still, traffic declines in recent quarters evidence the company’s transition and the challenges of the company’s “more of the same” strategy. This is a particular concern as it plants its flag in all new markets on the other side of the country. We are encouraged by our own limited observations of New Jersey stores and we are also encouraged that the company has beefed up its real estate staff, which will be crucial in penetrating these new and unfamiliar markets. Undoubtedly the company’s new emphasis on drive-thru locations is a positive move, in combination with the above noted real estate approach.
MENU, DEMOGRAHICS, AND DAYPARTS
Habit Restaurants specializes in made-to-order entrées char-grilled over an open flame. It is centered on its signature burgers (60% of entrée sales), but its menu includes tri tip (bottom sirloin) steak, albacore tuna filet, and chicken sandwiches (26%). Habit also offers fresh, hand cut, made-to-order salads with char-grilled chicken, tuna and tri tip steak options (14%). The dessert menu consists of handmade frozen, shakes, soft serve cones, malts and sundaes. The daypart mix is split evenly between lunch and dinner, and over 60% of the customer base is in the age range of 25 to 54. The company prides itself on providing exceptional quality at a great value. In a recent comparison between a cheeseburger, fries and drink combo with peer fast casual burger competitors, only In-N-Out burger’s $5.95 price point bettered HABT’s range from $7.23 to $8.77 in 2017. Other competitors included Smashburger ($9.97), Shake Shack ($11.39) and Five Guys ($11.47). Mobile and on line ordering is processed through a call center, and tablets are used in selected restaurants to expedite drive-thru service and faster delivery times during peak hours.
UNIT LEVEL ECONOMICS
HABT stores, which are all leased, average about 2,000-2,800 square feet. It seeks locations with co-tenants such as Walmart, Costco and Target, grocery stores, theaters and drug stores. Surprising perhaps to some, it also locates stores in proximity to Chipotle, Starbucks and Panera, pleased to “throw their line in the water where the fish are biting”, or as Willie Sutton said, “hit the banks because that’s where the money is”.
For the 52 weeks of 2017, restaurants open 12 months or more had an AUV of $1.9M and generated a cash on cash return over 40%. In the TTM through Q4’17 the average unit volume (AUV) of company locations was $1,885k, while the company store-level EBITDA margin dropped 250 bp YTY to 18.5%. Store level EBITDA averaged 21.9% in the 7 years prior to ’17, holding steadily in the 21-22% range until the recent margin slippage.
New stores require an average cash investment of $850K, which is net of landlord allowances for non-drive-through locations and $1,250k for drive-through units, which “blends” to an average cash investment of $1,050k. On a blended basis, by their third year the company targets an AUV of $1.85M and a cash-on-cash return of at least 30%, implying store-level EBITDA margins of about 17%.These “targets”, especially the margins, are no doubt designed to be conservative. Still, using management guidance, we estimate volumes of the most mature stores (i.e. open > 3 years,) seem to be have peaked at about $2,200k, probably running somewhat less lately. Similarly, we estimate the most mature stores (open 3+ years) generated store level EBITDA margins of closer to 25% if those open less than 3 years average 17% or less, with all categories doing less lately with the reported margin pressure.
Since its 11/19/14 IPO at $18.00, HABT shares traded just over $40.00, then declined steadily to the current level, near its low. Candidly, the stock traded at a very high valuation, as we have noted in our earlier writings, so the correction in price was to be expected, even without the moderation in some of the operating parameters. There is no dividend and the Company has not been a buyer of its own shares.
CURRENT DEVELOPMENTS (Per ’17 Yearend Report and 2/28/18 Conf.Call)
Highlights for Q4’17 included a comp sale decrease of 1.0% (with transactions down 3.0%), adjusted pro forma net loss of a nominal $44,000. Adjusted EBITDA declined from $8.4M to $7.3M. There were 13 new company operated locations opened (four with drive-thrus) and one franchised (in Shangai, China). Reported GAAP earnings were of course affected by adjustments related to the new Tax Act. In their formal guidance for ‘18, the company is looking for comp sales of flat to slightly positive with store level margin of 16.0-17.0% (vs. 18.5% in ’17), G&A of $37.5-$38.0M (up 15.9% from ’17, at the midpoint), D&A of about $24M (up 28.3% from ’17), Capex of $43-46M and an effective tax rate of 29-30%. Expansion plans for ’18 include 30 new company operated locations (15 with drive-thrus, and 5-6 on the East Coast) and 6-8 franchised units.
On the conference call, the company reiterated their reluctance to get drawn into the price wars taking place in the QSR burger business, they are selectively offering (new to HABT) lower priced items (as a test) solely in digital channels. Delivery is being tested in two markets, using two different third party provider, and cover 20 locations. The business generated appears to be mostly incremental, and enthusiasm (so far) was expressed. A proprietary mobile app is being developed, as well as a self ordering kiosk, both to be launched in 2H’18. As indicated, greater emphasis is being put on new drive thru locations. A national ad agency has been hired and new products continue to be developed, including an expansion of breakfast offerings. Labor efficiencies are a continued objective, especially since so many locations are in California. Looking toward 2019, company new store growth will slow to 10% on the base, allowing more operational focus on existing locations.
Operating details for Q4 included an increase of 100bp in CGS to 30.4% and an increase of 120 bp in labor expenses to 34.6%. The average hourly rate was up over 6%, some of which was offset by productivity gains. Occupancy and other expenses were up about 100bp to 18.1%, due to higher rent at new units, higher advertising, utilities and CAM charges. G&A was down 30bp to 9.6% of revenues. D&A was up 60 bp to 6.2%, no doubt due to higher investment in new stores. Pre-opening expenses was $1.1 milllion, up from $813k in ’16, expected to range between 90-100k in ’18. CGS expense is expected to be up about 2%, and the average wage rate will rise 6-7%, as in ’17. The Company confirmed on the call that it was the labor and occupancy expense lines that were the most problematic.
An analyst, predictably, asked whether Q1 sales were running in “the flat to slightly positive” range as the year’s guidance would imply, and the response was “Quarter to date, we’re within that guidance that we laid out”, possibly helped by slightly better weather (which hurt last year by about 1%). There was also a comment by management indicating that the slightly better trend would be back weighted to H2, considering the new product initiatives. Our interpretation would be that, if comp sales were running positive as of the 2/28 call, it was only “barely”. Pricing is running about 2.9% in Q1 and more price may be taken in the middle of ’18.
CHEESECAKE AND HABIT REPORT Q1 – IMPORTANT TAKEAWAYS
We consider Cheesecake Factory (CAKE) and Habit Restaurants (HABT) to be two of the better managed publicly held restaurant companies, CAKE within casual dining full service, and HABT among the QSR/Fast Casual segment. Both companies reported their first quarter results wednesday evening. The numbers, and especially the conference call commentary provide a timely report on Q1, and, most importantly, a view into the short to intermediate term future for the dining industry and the general economy. We consider the restaurant industry to be a valuable leading indicator for the general economy, because the public “walks the talk”, or doesn’t, depending on their willingness to back up the “sentiment surveys” with actual spending. We now have a current view into how the “best of breed” can use “best practices” to build their businesses further, and what it implies for other less skilled restaurant companies and the economy as a whole.
Cheesecake Factory (CAKE)
The news headlines described comp sales up 0.3%, barely less than the estimated (by analysts) 0.6%. “Adjusted” earnings were $0.72 vs. $0.73 estimated. Fully diluted GAAP earnings were $0.71 vs. $0.68 on 49.2M shares O/S vs 50.0M shares a year earlier. The company guided Q2 to $.85-.88, versus a street estimate of $.86, very much in line. For all of ’17, the Company guided to $2.93-$3.02, just a little lower than the previous guidance of $2.95-$3.07. Not too bad, on the surface. If there is a story, it is “how the sausage got made”. The details, from the income statement, include: Cost of Sales lower by 70 bp, labor higher by 90 bp, occupancy and other higher by 70 bp, G&A the same at 6.4% of sales, D&A up by 20 bp, pre-opening expenses lower by 10 bp, Income from Operations DOWN by 90 bp and DOWN year to year by 8.6%. What saved the day was a tax rate of 17% versus 27% a year earlier and 2% fewer shares outstanding due to stock buybacks (“cash being returned to shareholders”), allowing EPS per share to be up by $.03.
The above details are interesting, but we are equally interested in the company commentary on the conference call about “the state of the restaurant world”. In a nutshell: it is still very challenging out there, apparently right up to the present. Comps were slightly positive in Q1, but menu pricing and product mix were up a total of 2.6% so traffic was down 2.3%. The weather and the timing of Easter hurt by about 50 bp, which will presumably come back in Q2. February was the weakest month, apparently typical of the industry, but there was no indication that traffic and sales have rebounded strongly in April. The guidance for ’17 includes an assumption of comp sales between 0.5%-1.5% and, importantly, commodity inflation of 1-2% and wage rate inflation of 5%. The tax rate is expected to be about 23% for ’17, down from 27.3% in ’16, and the shares outstanding is expected to shrink by 4-5% from $100 million of share repurchases. It’s fair to say that the EPS progress (about 6%) this current year is more a result of “financial engineering” than improved operating earnings. There is nothing wrong with that but what it is worth in terms of the stock’s valuation is another subject. (Just sayin’, we have no horse in this particular race at this time.)
Other noteworthy commentary included: “we did not think we were affected by the timing of tax refunds….overall, for the quarter we continued to take share, and we maintained our healthy sales gap to the industry….GDP grew 0.7% in Q1..leads us to believe that 2017…is going to look a lot like 2016…our business is stable. We’re just not seeing any macro lift right now……..we’re not seeing a difference in the malls, per se…in those A locations and most instances…….we would expect to see a year over year decline in operating margin…about the operating margins..we’ll see a little pressure on it. The bottom line margin we shouldn’t (see as much deterioration, after taxes, etc.)……..commodity inflation in Q1 was flat to slightly up..we continue to expect it to be 1-2%..into the next 3 quarters.” There was additional conversation about delivery initiatives, CAKE as a destination rather than an impulse in the malls, trends in Texas and California, etc.et., but we have excerpted above the comments most interesting to us.
Habit Restaurants, Inc. (HABT)
The news headlines included: Comp sales up .9% vs. Street estimates of 0.4%, EPS of $0.09 versus $.08 estimated, Company sees comp sales for ’17 at 2.0%. The headlines of the Company release included Adjusted EBITDA of $9.5M compared to $8.7M in ’16. This predominantly company operated chain is on track with their planned ’17 openings (31-33C + 5-7F), which, as described on their conference call, seem to be meeting or exceeding targeted levels of sales and profitability.
Our affectionately termed Q1 “sausage” in this case included: Franchise revenues up from $144k to $329K in the quarter, growing dramatically but still modest overall. More importantly, Cost of goods was down 90bp, labor was up 110 bp, “occupancy and other expense” was up 100bp, G&A was flat at 9.9%, D&A was up 30 bp, pre-opening expenses were up 10bp. Pretax Income from Operations was 5.3% vs. 6.8% of sales, DOWN about 7% in absolute dollars. You can see that the 150 bp decline was primarily due to higher labor costs and higher “occupancy and other”, partially offset by lower cost of goods (which won’t help going forward). After a higher tax rate of 32% vs. 23% in ’16, Net Income was down about 19% in dollars. Below the net income line, “net income attributable to non-controlling interests” was $1.1 million less this year than last, so the “Net Income attributable to Habit Restaurants, Inc., was $1.843M vs. $1.381M, up 33%. The fully diluted shares outstanding were 20.2M, up from 14.0M in ’16, still affected by pre-IPO calculations, and the fully diluted EPS was $.09 vs. $.10 – compared to the “pro forma” $.09 vs. $.08 shown in analyst presentations.
Once again, we are even more interested in the color commentary from the call to see what’s happening on the ground, and what it looks like going forward. With good reason, management is proud of their result, having posted another positive comp quarter (53 in a row) in a continuing difficult QSR environment. It is pertinent, of course, that menu price was up about 2.2%, partially offset by a negative mix impact, so the average ticket was up about 1.5% and traffic was down about 0.6%. Even adjusted for weather and Easter, as discussed below, traffic was close to flat at best. This trend is better than many competitors are showing, but not exactly Panera in its heyday (and again, most recently) or Wingstop of a couple of years ago. The promotional environment continues, but no worse than it has been. HABT prides itself on not discounting, providing an exceptional level of “hospitality, great every day value of the core menu, plus a continuous flow of interesting Limited Time Offers. They are steadily moving out of their California base, with successful beachheads being established in distant markets such as Florida and New Jersey. Management indicates that the new markets are meeting and beating initial expectations. Their commentary made passing mention of unprecedented amounts of rain in both Northern and Southern California, but the timing of Easter helped a little, so “normalized” traffic might have been about flat, for all intents and purposes.
The most noteworthy comments by management during the call included: “comp sales are expected to increase approximately 2% for ’17.. restaurant contribution margin (EBITDA) expected to be approximately 20% for the full year…commodities will be up 1-2% for the year, primarily driven by short term Q2 pressure on produce combined with escalating ground beef and chicken prices. Our prior expectation was flat for 2017….we continue to expect our average wage rate to increase 6%-8% in 2017” (thank you, California)….”we have been working on labor productivity initiatives that we believe will help to offset some of the commodity inflation……increased amount of strong promotional discounting….by the bar grill category in the full service category……commodity pressure….will have some affect on the ability of traditional burger QSR players maybe not to be able to do as much deep discounting…….with our results over the last 53 quarters…..we don’t have to go there (discounting wars)…..we know the macro environment is going to ebb and flow, but we feel really good about Q1 and…..the outlook for the remainder of the year……our sales trajectory is pretty much in line with the last couple of quarters….in Q2 running up against, running up against our strongest quarter last year….our target on average is $1.4 million for the new traditional stores and for the last three years of openings, we’ve been above that average, exclusive of the drive throughs….which are at higher volumes….stores that aren’t in the compo base but are open more than 12 months are performing at a number that’s significantly higher than the comp totals we reported. ….we are opening in the East, against well entrenched Smashburger and Five Guys, at volumes that are well above their system average…occupancy expenses will be up for the year but not as much as in Q1…..produce is going to be up over 27% in Q2……we feel like we can attain our 20% store level (EBITDA) margin for the year…..with a little bit lower margin in Q2 than we maybe initially thought and a little better in Q3 and Q4.
These are well run companies, continuing to cope with a very competitive industry situation and material macro headwinds. Even for these relatively “Best of Breed” companies, traffic gains are hard to come by, Labor Expense continues to rise, Cost of Goods Deflation is behind us, Occupancy Expenses continue upward. Over time, menu prices will rise, as restaurant companies do their best to prevent profit margins and ROIs from collapsing. Unfortunately, price increases cannot be aggressive in a competitive world and a sluggish economy. My concluding takeaway, as an analyst and money manager, I wouldn’t shy away from an attractive long term situation because of commodity prices alone, because protein and produce prices can (and do) change in a matter of months. However, traffic trends, competition, labor, and rent concerns are far longer term in nature, and will continue to make life difficult even for the best of operators.