In October 2012, I wrote an article about Chuy's Holdings, Inc. (CHUY) entitled, "Chuy's - Another Overvalued Restaurant Company?" At the time I wrote the article, the stock was trading at $27.59 per share and I argued that the stock was worth "high teens to low $20s." Within a month of my article the stock was trading below $21 per share, but it rebounded to the mid $20s before year end. Yesterday the stock closed at $33.40 per share, having risen 50% since the final trading day of 2012.
My article garnered a fair bit of attention and commentary, particularly from patrons of the restaurant chain (of which I am not since I don't live in a geography where Chuy's has restaurants). Apparently patrons are quite enthused about Chuy's menu, which translates into passion for the Company's stock. But the question for investors isn't, "Is their food delicious?" or "Does the restaurant offer good value to the customer?" The question for investors is: "Does buying the stock at today's price make sense relative to the Company's current and future cash flow potential, especially relative to other investment alternatives and historical restaurant-industry multiples?" In short, is the stock a good investment at the current valuation?
Based in Austin, TX, Chuy's operates 40 full-service Mexican and Tex Mex inspired restaurants in the South and Southeast. Chuy's has grown from eight restaurants in 2007 to 39 restaurants by year-end 2012, and is expected to operate 48 restaurants by year-end 2013. From 2007 to 2012, the Company's annual revenue increased from $42 million to $173 million (33% CAGR) and Adjusted EBITDA increased from $6 million to $26 million (31% CAGR).
Chuy's operates in the $6 billion Mexican casual dining space, a category without major national competitors (the only casual dining segment without a $1 billion brand). The Company has a 30-year history in Texas (its core geography and home to 25 of its 39 units) and has now moved outside of Texas for growth. Chuy's has expanded into several Southeastern markets including Nashville, Kentucky/Indiana, Oklahoma, Atlanta, Alabama and Florida. The Company plans to open new restaurants in both established and adjacent markets across Texas, the Southeast and the Midwest where management believes they can achieve high unit volumes and attractive unit level returns.
The Company's restaurants range from 5,300 to 12,500 square feet in size, each serving an average of 400,000 customers per year. All of the Company's restaurants are leased. In terms of restaurant sales, Chuy's average unit volumes of $5 million are in the top quartile for the restaurant industry. Due to its high average unit volumes, Chuy's produces top quartile restaurant level margins.
Chuy's has produced positive same-store sales in four out of the last five years. Chuy's average check of $13.18 delivers exceptional value to customers, which is key in the Mexican category (only 3 out of 49 menu items are priced over $10.00). The business mix is balanced with 60% dinner and 40% lunch. Alcohol beverage mix is high relative to most casual dining peers at 20%.
Based on yesterday's closing stock price ($33.40 per share), Chuy's has a market capitalization and enterprise value of approximately $542 million. This equates to 3.1x sales, 21x adjusted EBITDA, and 54x adjusted net income based on calendar 2012 financial metrics, pro forma adjusted for the IPO. Please refer to my spreadsheet for summary historical projected financial metrics as well as the trailing and forward valuation multiples. Based on Wall Street research, analysts estimate Chuy's will grow its revenue by 18% in 2013 (to $204 million), with adjusted EBITDA growing to $30 million in 2013 and $33 million in 2014. Based on its current enterprise value, Chuy's stock is trading at 18x one-year forward (2013) EBITDA and 17x two-year forward (2014) EBITDA. These are valuation levels close to two times its peer group of high-growth restaurant chains. Many analysts believe Chuy's should trade at a premium to other high-growth restaurant concepts due to its robust growth trajectory and high-ROIC unit development, but multiples close to twice its peer group are unrealistically optimistic and ultimately unsustainable.
Investors also look at a Company's P/E ratio relative to its expected growth rate of earnings, the so-called PEG ratio. A ratio of less than 1x P/E to growth suggests under-valuation, a PEG ratio greater than 1x suggests over-valuation, and a PEG ratio at or close to 1x suggests a reasonable valuation. Chuy's stock is trading at 40x two-year forward (2014) earnings yet earnings are only expected to grow 20% per annum, implying a 2x P/E to growth ratio (massive over-valuation).
Since no meaningful organic growth is expected (company guidance is for 1.0-1.5% same-store growth), these growth rates require the Company to use all internally-generated capital to open new units. To put today's valuation in context, I evaluated a group of casual dining chains that (1) are all expected to generate greater than 10% EBITDA growth in 2013 and (2) on average only reinvest ~60% into capex to drive this double-digit growth (versus ~90% for Chuy's). The average forward multiple for this group is 7.5x forward EBITDA, a 60% discount to Chuy's current valuation multiple. I concede that these chains are larger and more mature than Chuy's and further concede that their early-stage valuations exceeded their current valuation in certain instances, but not to the same extent as Chuy's.
Potential Catalysts and Insider Trading Signals
I believe there are a number of catalysts that could serve to drive CHUY shares to a more rational value over the next 12 months:
1) Labor Cost Pressures. With the looming implementation of Obamacare, we expect there will be increasing investor scrutiny on the cost pressures facing restaurant chains in the second half of 2013. Although not a core part of my thesis, it is also worth noting that beyond Obamacare, continued initiatives by the Democratic administration (such as President Obama's interest in pursuing minimum wage reform), create additional headline risk given their potential to adversely impact low-wage employee-centric business models, such as casual dining restaurants.
2) Poor Near-Term Organic Growth Prospects. Chuy's restaurants typically open at high volumes, which exceed their ultimate base run rate. Given the small number of restaurants currently in the comparable store base (less than half of the company's 40 units were in the comp store base for 2012), the recent proliferation of new restaurants will create a headwind in comparable restaurant sales growth in the near term. Chuy's opened 17 of its 40 units in 2011 and 2012 - as these units mature, organic growth will be difficult to come by. As alluded to above, because the Company's restaurants generate little organic growth (relative to the select group of publicly-traded restaurant chains that can justify a double-digit EBITDA multiple), it is forced to reinvest all its cash into new restaurants as rapidly as possible.
3) Near-Term Consumer Headwinds. The Company's largest states (Texas and Tennessee, which represent 30 of the company's 40 restaurants) are currently facing above average headwinds from the fiscal sequestration. Practically speaking, I don't expect this will have a dramatic lasting economic impact, but considering the valuation, any marginally negative impacts to near-term earnings trends could cause the market to lose its faith in the story.
Based on these potential headwinds, most (if not all) value-based investors would conclude that Chuy's does not "deserve" the valuation that the market is currently placing on it. To put this view in context, I believe that the private market value of the company would be roughly half of the current public market value and it is the magnitude of this disparity that draws me to the situation. For example, in October 2010, Kelso (a private equity firm) acquired Logan's Roadhouse for 7.3x trailing adjusted EBITDA. At the time, Logan's was a 200-unit steakhouse chain with roughly comparable average check size, slightly better margins and slightly lower growth rates when compared with Chuy's (~15% EBITDA growth versus the prior year).
One factor that investors should consider is that the Company's insiders have been bailing out of the stock like rats on a burning ship. Goode Partners LLC, a New York-based private equity firm, acquired its controlling stake in the Company in 2006, at which point the company operated eight restaurants in total. In July 2012, Chuy's completed its initial public offering (IPO) of common shares at $13.00 per share. Goode Partners sold roughly half of its interest in the Company at the time of the IPO, which reduced its ownership stake to 57%. In January 2013, as soon as the IPO lockup expired, Goode Partners sold another 5,175,000 shares of the Company's common stock at a price of $25.00 per share, further reducing its stake to 23%. Yesterday, barely two months after divesting a huge portion of its stake in the Company, Goode Partners announced another secondary offering for up to 3,450,000 shares, which would reduce its ownership stake to 5%.
It seems that Goode Partners, an astute investment firm and the institutional investor with arguably the most knowledge about the Company's future prospects and growth potential, has made the decision that $25.00 is a more-than-fair price to sell the Company's stock (read: over-valued). As such, I'm sure Goode Partners is thrilled to be dumping more stock around $33 per share. You know the saying on Wall Street: buy low, sell high.
I acknowledge that the valuation Chuy's "deserves" may not be entirely relevant in the current near-term Fed-manipulated equity markets, but history suggests that valuations eventually become reasonable proxies for the cash generating potential of an enterprise. While overpriced stocks can become more overpriced for a period of time, the fact that (1) Chuy's can't use its overvalued stock as a strategic currency (an acquisition would not make sense given its story) and (2) no buyer could acquire it near the current value, leads me to conclude that the risk of permanent capital loss from shorting Chuy's is negligible at the current price. As such, I am following the signals of the "smart" money (i.e., Goode Partners) by shorting the stock as its current price. For investors, Chuy's stock is currently priced beyond perfection, leaving no room for any hiccups such as the ones described above, or other potential risks such as macroeconomic weakness, higher commodity food prices, or consumers' reluctance to embrace the concept in new markets.