Buffalo Wild Wings: Growing Despite a Recession

Buffalo Wild Wings (BWLD)

1. Is this a Good Business run by smart people ?
2. What is the company worth?
3. How attractive is the price for this company, and what should I pay for it ?
4. How realistic is the most effective catalyst?

0. Preamble

This is an abridged write-up on Buffalo Wild Wings. The information and data comes from Morningstar, various research reports and websites.

1. Is this a good business run by smart people?

Company Background and Business Overview

Buffalo Wild Wings owns, operates and franchises a chain of casual restaurants serving Buffalo-style chicken wings in a variety of hot sauces and an array of alternative menu items including bottled beers, wine and liquor. The restaurant concept is a mixture of causal dining and fast casual dining, packaged in a sports theme concept. It features counter food as well as table service. Started in 1982 as a single restaurant by two entrepreneurs in Columbus, Ohio, the company was publicly listed in 2003 under the NASDAQ ticker BWLD.

In the most recent quarter, Buffalo Wild Wings owned 197 restaurants with 364 franchise stores across 40 states. Half of restaurants are concentrated in six states, Ohio, Michigan, Indiana, Illinois, Wisconsin, Minnesota and Texas. The restaurants have an average size between 4,500 to 6000 square feet, and are filled with 40 TV screens and 2 projection screen, and gaming consoles.

(Source: KeyBanc Capital Research Feb 2009)

In the most recent quarter, wings represented 21% of menu sales on average, while boneless chicken items like sandwiches and tenders were 14%, and alcohol was 29%, with other items at 37%. While the demographic was predominantly male, it has successfully branched into the family dinner as well as the lunch-time business crowd, 15% of sales occur during 2pm to 5pm while an additional 15% occurs from 9pm to close of business, dinner customers represented 49% of sales.

From the 2008 annual report, the company seeks to grow to 1,000 outlets as it expands nationally. Despite the recent economic slowdown, the company has held on to the stated aim on opening 15% more outlets in 2009 while not compromising its earnings and revenue growth goals. Financially, the company generates healthy cash flow, and is free of long-term debts. Franchise stores produce higher average sales volume of USD 2.5m in 2008, 13% more than the company owned stores.

Porter’s Five Forces

OVERALL INDUSTRY RATING	Favorable	Moderate	Unfavorable
1. Threat of New Entrants	4	1	7
2. Bargaining Power of Buyers	4	1	5
3. Threat of Substitutes	1		3
4. Bargaining Power of Suppliers	1		6
5. Intensity of Rivalry Among Competitors	3		6

From the P5F analysis, the industry profile can be generalized: The industry has a low barrier of entry to new entrants, customers have moderate bargaining power although branding is a strong differentiator, and substitutes do exist from customers who can choose to cook at home, the industry has a few large suppliers with strong bargaining power. The rivalry among competitors is intense and this makes it hard to earn above average profits.

TOWS Analysis

Opportunities (Industry specific)

1. Increased Boomers (45 to 64 yrs) dining out
2. Increased social activity in eating out ( aka “The Third Place” effect)
3. Increasing trend towards convenience
4. Increasing adoption of U.S. fast food diet world wide
5. Increasing usage of multiple delivery channels
6. Increasing trend of ethnic and themed food
7. Increasing trend towards healthier food

Threats (Industry specific)

1. Decreasing spending due to Recession
2. Increased competition from other social activities
3. Food choices are increasingly becoming indistinguishable
4. Increased competition in the restaurant business
5. Increasing costs in commodity prices
6. Increasing awareness of health scare by avian or mad cow disease
7. The industry is increasingly being regulated
8. Increasing trend towards healthier food

Strengths (BWLD specific)

1. A winning formula in the new Fast Casual segment
2. Highly innovative product development
3. Popular weekly promotions
4. Strong regional brand recognition
5. Ability to pass cost on to consumers
   
6. Strong management team
7. Strong financials

Weaknesses (BWLD specific)

1. Limited operating history as a public company
2. Small national advertising budget
3. Highly dependence on sports season
4. Weaker lunch time sales
5. Diminishing free cash flow as company expands

FCF	2008	2007	2006	2005
BWLD	-1	2	9	3

Management

Most of the senior management team has been in the company for at least 5 to 10 years. The role of the CEO is separate from the Chairman and six out of seven board directors are independent.

Insider currently own about 6.71% of the company, I see this as a positive, as management have an incentive to align with the shareholders, however in the last six months, management has been selling in the open market about $1.8m of BWLD stock at an average price of $34. While I believe the management is taking a long term view of BWLD, perhaps the selling of shares is an indication of the share price appreciation in since the Nov 2008 swoon.

Financial Ratio Analysis

No	Ratio	BWLD	Chili's	Red Lobster	Applebee's
1	Sales Growth% (CAGR Last 3 years)	24.50%	0.80%	3.63%	6.80%
2	Unit Growth % (CAGR Last 3 years)	15.8% (YoY)	11.00%	0% (680 flat)	NA
3	Same Store Sales Growth% (Year on Year)	6.83%	-2.40%	1.10%	NA
4	Gross Margin% (Avg 3 yrs)	72.40%	72.00%	22.80%	21.30%
5	Operating Margin% (Avg 3 yrs)	7.9%	7.17%	8.47%	10.57%
6	Debt / Equity (Latest)	0	1.29	1.22	0.22
7	Quick Ratio = (CA– Inv)/(CL)	1.45	0.578	0.175	0.612
	Other Metrics	BWLD	Chili's	Red Lobster	Applebee's
A	% Restaurant company owned	35.10%	61%	100.00%	26.10%
B	Restaurants total (Franchise + Company)	561	1487	680	1943
C	Average Sales per restaurant	2.1m	3.2m	3.8m	2.63m
D	Average Check per person	$12.50	$12.93	$18.50	12.50
E	% Alcohol of sales	29%	13%	7.80%	12%
F	% Take-away of Sales	17.00%	10.00%	3.30%	9.40%

(Source: Research reports on individual companies)

Analysis:

BWLD is an upstart compared to Chili’s, Red Lobster or Applebee’s, and while it is much smaller in terms of revenue, and number of restaurants units, its growth rates are impressive, revenue growth, unit growth experienced double digit growth in the past three years.

Same store sales are much higher than the more mature competitors, this is also seen in the average sales per restaurant where it is only $2.1m as compared with the high of $3.8m for its peer group Red Lobster, generally, this means that BWLD can still continue to grow the SSS and average sale per restaurant.

BWLD has a higher alcohol mix (29%) which is quite uncharacteristic of the Casual dining, more often seen in high casual / fine dining. The high take-away reflects the Fast Casual hybrid nature of the business, where business is done at the counter and the company promotes convenience as well as full service.

iii. ROE Decomposition for BWLD

Analysis of historical trends

ROE = Net Margin x Asset Turnover x Financial Leverage

The BWLD ROE shows an impressive trend, ROE has been increasing steadily because of improvement in margins and asset turnover; it generates sales of $1.92 for every dollar of assets. This is done while financial leverage is held constant (asset / debt). BWLD has no long term liabilities.

Comparison with ROE with Peers:

Source: Morningstar

The ROE of BWLD is the lower than its peers except for Chili’s for 2008, however, a better comparison would be against Applebee’s 18% ROE since Red Lobster and Chili’s deploys a lot of leverage to magnify the ROE. BWLD does not use debt, this is a prudent discipline as a result of the company’s financial troubles in the mid-80s. Red Lobster and Chili’s are mature companies and stable cash flows, hence it is confident of such high debt to equity ratios (financial leverage around 3).

iv. Free Cash Flow

Free Cash Flow ‘Millions	2008	2007	2006	2005	Dividend Yield %
BWLD	-1	2	9	3	0
Chili's	91	54	116	109	3.3%
Red Lobster	NA	225	379	254	2.7%
Applebee's	NA	80	52	82	8.6%

BWLD has been able to grow aggressively while not sacrificing its margins, the operating margins is only slightly lower than the more mature and stable competitors. BWLD is using its operating cash flow to build more restaurant units, thus it has a lower free cash flow than its peers. Unlike the more mature restaurants, BWLD does not issue a dividend.

2. What is the company worth?

I. Asset Based Tool (Based on Discounted Cash Flow)

I am going to model 2 scenarios; the first assumes that we follow BWLD Management’s guidance of 20% long-term earnings growth (and 25% revenue growth). I refer to this long term as 10 years. While this may look overly optimistic, BWLD’s previous years of EPS growth have been impressive with 1yr, 3yrs and 5yrs coming in at 23.6%, 38.7% and 37.7%. During the most recent quarter, it has reaffirmed this year’s EPS growth of 20%.

And the second scenario assumes a more conservative growth rate of growing EPS at 15% for the next 5 years followed by another five years of 10% and a long term rate of 5% (following the restaurant industry long term trend).

Assumptions: Discount rate of 15% to denote the expected rate of return I expect from this small cap.

Management Guidance Growth: EPS growth rate of 20% for 5 years, followed by 20% for another 5 years with a terminal growth rate of about 5%

Conservative EPS Growth rate: 15% for the next five years, followed by 10% for the next five years and a long term growth rate of 5%. This is conservative estimate for a growth stock.

Management Guidance Scenario

Ticker	BWLD			%
			Growth (Y1 to 5)	20.00
Free Cash Flow	1.46		Growth (Year 6 to 10)	20.00
SharesOut	1		Discount Rate	15.00
Long Term Debt	0.00		Long Term Growth Rate	5.00
			Long Term Discount Rate	15.00
DCF-IV	42.05

Conservative

Ticker	BWLD			%
			Growth (Y1 to 5)	15.00
Free Cash Flow	1.46		Growth (Year 6 to 10)	10.00
SharesOut	1		Discount Rate	15.00
Long Term Debt	0.00		Long Term Growth Rate	5.00
			Long Term Discount Rate	15.00
DCF-IV	25.98

Using 1.46 TTM EPS as a proxy for cash flow, the IV is calculated between $25.98 and $42.05.

II. Comparison based tool: Peer Price to Earnings Ratio (P/E Ratio)

To work out the relative value of BWLD, I am adapting the valuation by Cowen & Company and comparing BWLD against the average PE of high growth peers and against the average PE of low growth peers.

I am using historical trailing twelve months P/E because this is factual, though not forward looking.

High Growth Peers	Price	P/E TTM
BJRI	14.34	35.10
CMG	79.19	30.20
PEET	26.09	29.60
PNRA	53.24	22.40
Average		29.33

No Growth Peers	Price	P/E TTM
CAKE	17.06	21.90
PFCB	31.94	20.1
TXRH	11.63	21.30
DRI	36.17	14.50
EAT (average)	17.90	19.80
Average		19.52

** I substituted the TTM P/E of Brinker’s (Chili’s Restaurant, Ticker: EAT) with its 10 year average because it had a PE of 51+, which is not consistent.

	Current Price	P/E TTM
BWLD	35.50	24.30

By comparing BWLD against its high growth peers and its low growth peers, we work out a multiple of 29.33x and 19.52x. It translates the EPS TTM of 1.46 to a new BWLD price range of $28.50 and $42.82 per share.

III. 5 Year Thumbnail Valuation for Growth Stock (TMF method)

Assumption: 5 years earnings growth rate of 20% a year, this is keeping inline with management’s long term EPS growth goal.

Earnings (trailing twelve months) of 26m x (1.20)^5 = 64.7m earnings in 5 years.

P/E multiple of Growth Rate x 1.3 = 20*1.3 = 26 times

Market cap in 5 years = 26 x 64.7m= 1682.2m

Divided by Shares outstanding of 18m = $93.5 per share

Target share price in 5 years is $93.5 assuming 20% EPS growth a year.

From the current share price of $35.5, this works out roughly 21% share price growth a year. If I were to model a Earnings growth of 15%, the per year share price appreciation of only 9.8%

EPS Growth	Share Price in 5 yrs	Share price appreciation from last current price
20%	$93.5	21% a year
15%	$56.7	9.8% a year

IV. Summary of BWLD Valuation

From valuation calculated in (I) & (II), I put BWLD’s intrinsic value between $27 and $42. Using a margin of safety of 35%, this puts the buy price between $17.5 and $27.3. Interestingly, Morningstar puts BWLD at a fair value of $27 and a buy below price of $13.50.

3. How attractive is the current price for this company, and what should I pay for it?

The 52 week price range is quite extreme; it reached a euphoric $ 44.98 in Sept. 2008 and a low of 14.50 in Nov. 2008 where investors priced it as a stock with a perpetual growth of only 5%. It recently touched a shade below $43 at the end of April. The current price is $35.50.

The reason for the extreme price appreciation in the last months (almost 100%) is because (a) BWLD managed to beat analyst expectations, and (b) reaffirmed its 2009 EPS projection (and long term EPS growth of 20%).

By using forward estimates, analysts find that BWLD is trading at a cheap multiple, of 7.7x times EV/2009 EBITDA estimates, which is only slightly higher than the multiple given to slow growth companies and not the 9.3x EBITDA multiple given to High Growth restaurants.

Because of the recent analyst upgrades at the positive earnings surprise, BWLD shares are priced for perfection. There is a 30% short position on BWLD. Any negative outlook or challenges will cause the share price to swoon.

Owning BWLD shares is making a bet that the management team will grow the company to the stated 1000 outlets goal and possibly make an expansion into the overseas market. I am confident that this is achievable. However, rather than buy into a richly valued company, past experience with BWLD stock has shown that we are almost always given a chance to buy at the right price if we are patient.

4. How realistic is the most effective catalyst?

Because of the high expectations on BWLD, the following are the possible catalysts to unlocking the price:

Positive Catalysts:

• Company continues to meet and beat analyst estimates through the winning Fast Casual concept.

• The economy picks up and consumer trend continue to favor eating away from home.

• BWLD is successful in growing the lunch segment past 21% as well as expand the growing late night segment.

• BWLD expands overseas, e.g. in Asia where crispy chicken has shown to be successful (e.g. KFC is more popular than McDonalds (MCD) in China).

Negative Catalysts

• The most serious is not being able to meet analyst expectations. For example, BWLD is heavily concentrated in Michigan, Indiana, Illinois, Wisconsin, Minnesota and Texas, these states are very affected by possible auto industry fallout, and restaurant units will feel the brunt of a sales slowdown if substantial auto manufacturing jobs are lost.

• Other exogenous threats such as Avian Flu or diminished interests in sports will affect likely affect BWLD (see TOWS analysis).

Comments

[John Gordon:]

Seems that writer has perhaps has never been in a Buffalo Wild Wings unit.

It's difficult to compare BLWD to a Brinker (EAT) or Darden (DRI) concept operation: AUV, capital investment, investmnent strategy all vary because the concept varies.

Also, it is very problematic to categorize the fast casual and casual dining operators into high growth and no-growth cells. Even so, interesting to note how little the valuations differ, right? And I would not include PEET in any like analysis. Its a coffee shop and wholesaler. Alot in going on in each of these companies.

But, for now, BWLD has a nice momentum underway, good sales comps and nice valuation, and perhaps a niche somewhere between casual dining and fast casual, which could be unique and priceless.


John A. Gordon
pacificmanagementconsu...
Restaurant Economics and Earnings Experts

Jun 07 11:50 PM

[brombonz:]

Notably absent from "high-growth peers" is RRGB, and confounding quick-serve (CMG) and the anomalous PEET with casual dining chains is not useful. However I appreciated the detailed and systematic approach.

Jun 08 09:57 AM