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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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WINGSTOP

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WING: Company Overview (2017 10-K)

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

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

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

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

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

Unit Level Economics

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

Shareholder Returns

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

WING: Current Developments  (17Q4 Conf. Call)

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

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

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

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

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

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

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WHAT’S HAPPENING ON MAIN STREET ? – FIRST QUARTER SALES AND TRAFFIC TRENDS

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  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

HIGH GROWTH RESTAURANT STOCKS DOWN AN AVERAGE OF 39% – WHAT’S HAPPENING?

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.