Biological vs. Economic Food Chains
In biology there's a concept called biomagnification. As you go down the food chain, you proceed through what are known as trophic levels. The further down you get, the more concentrated, or magnified, environmental contaminants become. How is that? The first trophic level is plants and trees, which take energy directly from the sun and a little from the soil. Dilute contaminants in the soil become more concentrated in the plants as they suck them up. From there, are the herbivores, which eat the plants, and ingest the more magnified contaminants in them. After that come the carnivores, which are an order of magnitude, more contaminated than the plants they eat, until you come all the way to the top of the food chain at the giant tuna, the carnivore of carnivores in the ocean, where much human contaminants eventually end up spread all throughout. Nutritionists warn against eating tuna due to mercury poisoning. Why tuna? All the mercury dumped in the ocean becomes biomagnified in them through all the trophic levels that the tuna, ultimately, eats.
Patterns in nature repeat themselves everywhere, and economics is no exception. Economics has a food chain of its own. We call it the structure of production. It begins at commodities, goes to the capital goods industries, goes through middlemen to wholesalers, and finally ends up in the retail consumer goods sector, the top of the economic food chain. At each successive layer, profit margins necessarily thin out, and there are heightened economic sensitivities and ever increasing variables that have to be factored in.
For example, for a mining company at the base of the economic food chain like Freeport (FCX) that sells bulk commodities to the capital goods industry, profit margins from revenue all the way down to net income are consistently in the 20% range. Barring a major failure or disaster, a capital goods company will maintain that cushion assuming it is long-established. Companies in the middle of the structure of production like Apple (AAPL) and Microsoft (MSFT) are also in a similar range. But as you proceed down the economic food chain to the consumer retail sector, profit margins become razor thin. Wal-Mart (WMT), for example, typically has a profit margin of between 3-4% a year. So does Whole Foods (WFM). Costco (COST) to take another retailer at random, takes in only 1-2% of total revenues annually. The further down, the more delicate the business becomes, the more variables come in from every direction as retail companies are absorbing the costs of every industry that came before them in the food chain to put their goods on the shelves. The more costs absorbed, the thinner profit margins have to be, the more sensitive the industry becomes to economic contaminants.
But even retailers like Wal-Mart and Costco are not at the ultimate apex of the economic food chain. All of the goods at Wal-Mart and Whole Foods are still, to a certain extent, capital goods. Meaning, they all have to be prepared in some way before consumption actually takes place. Meat has to be cooked. Cereal has to be mixed with milk and eaten in a bowl. Vegetables have to be cut up and put in a salad. Beverages have to be poured from a 2 liter bottle into a single serving glass. And everything has to be put in a car and transported to the consumer's home. There is yet one layer after these retailers that represents the very tip of the economic mountain, the apex of the food chain, the proverbial economic giant tuna all too sensitive to the slightest mercury dumped into the economic system at the capital goods level. That is, restaurants.
Restaurants - the top of the economic food chain
Almost everything at a restaurant is a purely consumer good. Vegetables are already cut up and served in salad form. Meat is already cooked and served as a juicy steak. Beverages are already served in cups. Everything is brought to you physically. No transportation of the goods is required. Absolutely nothing needs to be done but consume.
At the apex, profit margins at chain restaurants are even thinner than razor thin. Most are actually negative, and the only thing making these companies profitable are the franchise fees and sales royalties from non-company-owned restaurants. A few examples:
- Dunkin' Donuts (DNKN) - Total operating expenses are 101% of company-owned restaurant sales
- McDonald's (MCD) -102%
- Burger King (BKW) - 132%
Despite being unable to cut down expenses enough to make their own restaurants profitable, all three of these companies are still successfully profitable. This raises the question, if corporate headquarters is constantly struggling to make its own restaurants profitable, why do franchisees continually buy up new branches and how do they operate them at a profit? The answer lies in the wonders of decentralization. The restaurant business is so economically sensitive with such small margins that it requires local managers who know their local economies extremely well to make a franchise profitable. Centralized corporate management often cannot do it, which is why company-owned franchise restaurants usually suffer an operating loss.
The real stars in the restaurant sector, then, are the franchises where even the company-owned restaurants can eke out an operating profit. Now that we've laid the groundwork, for the rest of this article I'd like to focus on two restaurant chains - sports bars in fact - with virtually the same menu, structure, and appeal. Both were founded in the early 80s. One is a smashing success that has made early and faithful shareholders rich. The other, at least in its publicly traded form, is a struggling startup.
Buffalo Wild Wings (BWLD) a smashing sports bar success
Over the last five years, Buffalo Wild Wings has been as fun and stable a stock to own as there can be. Consistent and steady earnings growth, a nice steady chart with a reliable upward trend line, not too many crazy pullbacks and jumps along the way, culminating in an overall capital growth of 532% since 2009.
Much of that growth has come since 2011. What were the signs that this kind of capital growth could occur? In 2011, Buffalo Wild Wings accomplished what most franchises can't. It actually pulled an operating profit on its company-owned restaurants, just over half a percent in FY 2011 and 2012. This is not, I believe, because BWLD corporates are such ingenious centralized managers that they can successfully manage their restaurants from a distance unlike any other restaurant chain. And it's not that crossing over into positive, excluding franchise fees and royalties, is some magic formula where if a company earns a dollar, you can be sure the stock is going up, and if it loses a dollar, it's doomed.
Rather, if a corporate franchise can manage to operate its wholly-owned restaurants at a symbolic profit, it is a sign that, despite centralized management of these chains that generally need local owners to be profitable, patrons really like them. Further and more importantly, the franchisees with local decentralized management, where the real profits are made for corporate, will in turn operate their own chains even more effectively, attracting even more franchisees in an ultra-low cost passive expansion model.
Stormy Stagflation Skies ahead for Buffalo
But being at the apex of the economic food chain, as we earlier noted, is a dangerous place to be. One drop of mercury anywhere in the economic system is enough to poison the tuna. Even a slight tick-up in inflation, for example, is enough to disturb such a thin profit margin. Just as restaurant stocks typically go up at a much faster clip than the broader market, they go down much more quickly as well. We saw this with another franchise back in 2004 when Krispy Kreme (KKD) had to suddenly and rapidly downsize due to a massive impairment on its balance sheet, and the stock shriveled from $49 to $6 in 18 months. It has gained back 28% of that loss over the last year, but Krispy Kreme does show us that when a franchise makes a bad calculation, it can really get smashed for the long term.
What makes BWLD particularly dangerous to hold especially now as opposed to a stock like McDonald's, other than the obvious skirting of all-time highs, the lack of dividend to protect from capital loss, and the fact it is trading at 34x earnings, is that virtually all of Buffalo's chains are located within the US. Only 7 of the 891 are in Canada (page 18). If the US economy really turns sour, Buffalo has nothing to fall back on. One of the worst things for the restaurant industry is stagflation, which hits restaurants first and foremost at the tip of the economic food chain. And there are signs stagflation is coming to the US.
Stagflation happens when money long stuck at the very bottom of the food chain suddenly comes unhinged and floods the economy in a torrent. The very, very bottom of the food chain is not really capital goods. It is, rather, money stuck outside the system lying dormant, the unused fuel for the whole chain. Right now, there is $1.9T of Federal Reserve printed money lying dormant outside the system in excess bank reserves, more than ever in history. If you've been tracking the "why hasn't inflation happened yet despite QE" back and forth, the answer is that the vast, vast majority of this QE is still stuck dormant at the Fed. What is this $1.9T waiting for to come out? The banks figure that they can earn more at the Fed than they can loaning it out at current interest rates, given the Fed can always pay the interest, while loaning it out to the public at historically low interest rates is much more risky given the possibility of default. The banks are waiting for higher rates to compensate for that risk.
Since May, interest rates on the 10-year have jumped from 1.63% to a current rate of 2.5%. If they go any higher, that money could start to come out in force, and as banks can loan out new money at a factor of 10, there is a maximum of not $1.9T, but $19T of money lying dormant, liable to enter the US economy at any time at the whim of a handful of bank executives. Think of an earthquake hitting a mountain. The base of the mountain (commodities and capital goods) will grow as prices will spike. The summit (consumer goods and restaurants especially) will fall over in to a ditch. Any Californian will tell you that the top of a building is the worst place to be during an earthquake. With this kind of inflationary time bomb, it is not safe to be at the summit of the economic mountain in the US, especially in a stock skirting its all-time highs with no dividend.
Chanticleer (HOTR), international Hooters franchisee, an alternative sports bar stock
While domestic inflation means higher consumer prices in the US, the flipside is strengthening currencies and lower consumer prices abroad. A strengthening currency may hurt local exporters, but it sure helps local consumer industries by cheapening imports and lowering consumer prices.
Chanticleer is a Hooters franchisee operating exclusively in the international market. Though Hooters of America has been around since 1983, Chanticleer as a Hooters franchisee is a startup, with 4 Hooters restaurants in South Africa, one in Australia and another on the way, and one in Budapest, Hungary. Like almost all restaurant chains in the beginning stages, it is operating at a loss, 46% of revenue in 2012.
As I looked through Chanticleer's filings and compared them with other franchised restaurant stocks, I could see why these losses have been consistent, though shrinking. (Losses were 78% of revenue in 2011.) Chanticleer began with buying up 4 Hooters franchises in South Africa, shouldering all the costs of these restaurants, which tends to not work so well without local, decentralized ownership. We've seen that even the biggest and best franchises have trouble making their own restaurants profitable. A weakening dollar will strengthen foreign consumer markets giving Chanticleer a significant tailwind, but in order to succeed, Chanticleer is going to have to joint venture, or, in other words, sub-franchise.
In fact, this is exactly what Arcos Dorados (ARCO) does with McDonald's. Much like other franchises, ARCO's operating expenses are 98% (page 2) of restaurant sales. A McDonald's franchisee, its profits really come from sub-franchise fees. ARCO leases out McDonald's restaurants to private owners on the same terms that McDonald's franchises restaurants out to it. That is where most of ARCO's profits come from.
Recently, it seems that this is indeed the direction that Chanticleer has chosen to take. Its first joint venture, 49% to Chanticleer and 51% to the local owner, opened in January 2012, and it is opening a second joint venture in Australia in Q2 of this year. According to its 10-K:
We have no involvement in the day-to-day operations, and have no further obligations to fund additional losses. (Page 5)
This is what franchising, or sub-franchising in this case, is all about: giving up the restaurant to local control and taking a royalty.
Chanticleer's success is by no means assured, and its current mostly centralized management structure is going to have to change. Just to take one small example, travel expenses were $173,333 in 2012 (page 13) as Chanticleer Corporate management had to fly around making deals in different locales managing its current and future restaurants. That may not sound like a lot, but that is 5.5% of its 2012 loss, a substantial sum for a company this small.
Despite losses over the last 2 years, there are important and significant bright spots. The first is its enormous revenue growth from 2011 to 2012 of 366%. The second is its strong balance sheet. Debt is low (2.8% of market cap), and total liabilities are steady at below $2M despite losses.
There are two big tests for Chanticleer coming up. The first will be Q2 and Q3 earnings, more specifically, the earnings stats on its Australian joint ventures. As the company is no longer on the hook for losses there, if revenue comes in strong in Australia, perhaps Chanticleer Corporate will take a hint that this is the approach it needs for its future ventures, and that local franchises usually cannot be managed effectively by corporate ownership.
The ultimate test for Chanticleer, however, will be coming up in 2016 at the Rio de Janeiro Olympic Games. I cannot think of a better place for a Hooters sports bar than Brazil during the 2016 Summer Olympics. Chanticleer currently has development rights in 5 Brazilian states including Rio, and plans to split ownership 60-40 with local franchisees there. If these Brazilian joint ventures are successful in 2016, then I believe HOTR will be off to the races as the next BWLD. On the other hand, if they are not, the company could fail.
What will happen to HOTR until then? Probably nothing too exciting, a trading range of $1.50 to $4 or maximum $5 depending on its Australian joint ventures in the coming quarters. (See recent YTD trading range below.) If operating expenses shrink as a percentage of its revenues, HOTR will trend to the top of that range. If expenses grow, it will trend down towards the $1.50 area. There won't be much liquidity or volume given that there are only 55 shareholders on record (page 8), 44% of shares outstanding are in the hands of either insiders or major owners or both (page 59), and most of those are also likely waiting to see what will happen in 2016 as well.
I don't believe Chanticleer will pull a net profit between now and 2016, so the short-term trading range will depend on whether operating expenses can be brought down in the near term or not. Total expenses, I believe, will be an even larger factor in the near-term share price than absolute loss.
As for the long term, Chanticleer will have the wind at its back if and when stagflation infects the top of the US economic food chain as foreign consumer markets are strengthened. Long-term success will depend, ultimately, on Brazil in 2016, and further decentralizing its business model as it is doing now in Australia.
Conclusion: BWLD vs. HOTR
Let's not forget that when Buffalo Wild Wings went public in 2003, only 33% (page 5) of restaurants were company-owned. 66% were franchised. This means that Buffalo had close to 66% less operating expenses to shoulder than HOTR off the bat, and operating expenses still outstripped company-owned restaurant revenues by 5% that year. BWLD went public at a market cap of $204M. It is now $1.83B.
HOTR is just $11M. Losses could be total if Brazil fails in 2016. But in terms of the risks of these two stocks, unconventional wisdom says that BWLD at this point in time is even riskier than HOTR for the reasons outlined above. That, and the potential gains, if Chanticleer gets its act together and decentralizes by 2016, are much larger than BWLD's 756% from IPO to date.