Three months ago, I published a piece on Hooters' Franchisee Chanticleer Holdings (HOTR), now Chanticleer Roadside Burgers International, comparing it with Buffalo Wild Wings (BWLD) under the framework of the restaurant sector as a whole. In it, I maintained that restaurants lay at the very apex of the economic food chain, which begins with land and labor and ends with the ultimate consumer. There have been large and important developments on several fronts within the last three months that affect nearly everything written in that article. In this piece, I will reiterate my previous thesis in light of recent developments.
A quick recap
In review, restaurants are a pure consumer industry compared with, say, Wal-Mart (WMT) or Costco (COST), whose goods still must be transported and then divided into smaller portions at the consumer's home, and only then finally consumed. At a restaurant, goods are consumed immediately with no further preparation or transportation.
This being so, the profit margins of restaurants are necessarily the smallest of any industry, and are frequently negative at company-owned restaurants. This is why, I maintained, franchising is so crucial, as local management that is familiar with the local economy of each branch is the key to maintaining the efficiency needed for a profit. Franchising and its nearly costless revenue model based on fees and royalties is what frequently pushes large restaurant chains into profitability.
I cited various global restaurant chains that are losing money at company-owned restaurants, including McDonald's (MCD) and Burger King (BKW) on the metric that company-owned restaurant operating expenses at these chains continually outpace company-owned restaurant revenue. The key being that any restaurant chain that succeeds in pulling a profit, even if only symbolic, at its company-owned branches (defined as revenue exceeding total operating expenses), is a sign of a major success.
Buffalo Wild Wings nearly succeeded in doing just that in 2010, with expenses outpacing revenues by only .3%. And in 2011, Buffalo accomplished what most restaurants can't, and pulled a 1% operating profit on its company-owned branches.
Capital growth since Buffalo broke even on this front at the end of 2010 has been upwards of 150%. Lesson being, whenever a restaurant chain comes close to breaking even on its owned restaurants, to paraphrase Nike, just buy it.
HOTR - Why the big move all of the sudden?
From there I turned to Chanticleer, which, as a Hooters' franchisee, operates basically the same restaurant/sports bar concept as Buffalo Wild Wings, but unlike Buffalo, an established player operating almost entirely within the US, Chanticleer is a startup operating mostly in international markets.
I assessed Chanticleer's prospects and financial health, and concluded that while it does have a decent chance to become the next Buffalo Wild Wings, no big order-of-magnitude type move in the stock, if it were to occur, would be seen until 2016 at the earliest when Chanticleer's Brazil plans come to fruition during the Olympic Games in Rio. I did, however, guestimate a trading range for HOTR with a maximum at $5.00 if its two Australian joint ventures came in strong. Those two restaurants cut losses by 44% last quarter (page 13). When the previous piece was published, HOTR was at $2.90 a share. It is now at $5 and change.
I do not believe that this massive move was the result of a couple of Australian ventures losing less money. In fact, the recent explosive move in HOTR probably has nothing to do with that. It likely has a lot more to do with the company's acquisition of a large Hooters in Nottingham, UK, its merging with American Roadside Burgers, and its opening of a fifth Hooters in Pretoria, South Africa.
With this volume of company activity, Chanticleer has doubled its locations since July to 14 in the space of 3 months. What this means is that if Chanticleer is going to be profitable, investors no longer need to wait until the 2016 Rio Games to see it. This is why, I believe, the stock made such an explosive move, as the market is now pricing in what it believes will be a break-even or perhaps even profitable Chanticleer as soon as next year.
While this does not mean that $5 is the new floor for HOTR, it probably does mean that, for the medium term until 2014 earnings take shape, $5 is no longer the upper limit of the trading range I mentioned in the earlier article. I'd say we have shifted to a new medium term range of $3.25 - $7. After that it all depends on 2014 earnings, which could be do or die given Chanticleer's size. If it can't break even by then, Rio may not help. If it can, Rio will add fuel to the fire.
Enter the Fed and interest rates
A much more obscure, yet in my view, far more important and long-term point I made 3 months ago had to do with interest rates and their implications for Chanticleer and Buffalo Wild and the entire restaurant industry. That is, the excess reserves at the Federal Reserve. Back in July, there were $1.9 trillion stuck at the Fed in un-loaned liquidity, more than ever in American history, indeed in the history of mankind. That statement may sound extreme, but it is in fact the case, meaning, we are in total uncharted monetary territory. There is now $2.2T (table below) stuck in excess reserves. Those excess reserves cannot simply sit there idle forever. When they come out, they will come out at a factor of 10 given the Fed's 10% fractional reserve requirement, which means $22T dollars added to the money supply. This spells massive price-inflationary potential, which affects first and foremost the industries closest to the end consumer, being restaurants.
I had stated that the only thing keeping these reserves un-loaned and out of the money supply was low interest rates. Banks would rather earn the .25% the Fed pays on excess reserves than risk them by loaning them out for a pittance. But that was 3 months ago. A lot has changed since then.
In early July, interest rates on the 10-year were 2.47%. In September, they reached a peak of 3% and have now settled back down to 2.62%. This is not enough to bring all the money out of reserves and into the economy, but it does look like the move has begun.
In order to track it, one needs to understand the H.3 Aggregate Reserves Tables published by the Fed on a weekly basis. You can find them here. The latest is below, from table 2.
The important points to note here are total reserves, required reserves, and the difference between the two columns, which would be the excess (Interestingly, the Fed used to have a separate column for excess reserves, but has since excised it in recent months when they crossed the $2 trillion mark, possibly because the number got too large and didn't look very good sitting there so explicitly). Required reserves will tell you how much banks all over the country have loaned out. If that number increases, it means that banks are taking out of excess reserves and loaning out at a factor of 10 and into the economy. The more required reserves increase, the less the corresponding total increases.
Notice, also, that the required reserves number jumped up in the two weeks ending September 4 to record levels of $124B, the very date that interest rates on the 10-year peaked at 3%. The two weeks ending October 2 also saw a large increase in the amount of required reserves to $127.7B, pushing them again to record levels, though still tiny compared with how much money is yet to be loaned out. There is still $2.22T in excess reserves, and they are still growing despite the increased lending of late. It is difficult to convey the extreme nature of the new reality here. Keep in mind, excess reserves have almost always been a big fat zero.
So the money is starting to come out, but the process has barely begun, as it is not even coming out fast enough to compensate for the Fed's non-tapered $85B monthly shoveling into the excess reserves pile. If interest rates continue to climb, even more will come out. When that happens, prices will start to climb fast. Normally, this is the opposite of what one would expect, because rising interest rates are supposed to tame inflation. That's because in normal times, there are no excess reserves. All banks are "fully loaned up," so when rates rise, there is nothing extra to lend out and prices go down. But these are not normal times, and there has never been so much money laying dormant at the Fed. This time, when rates go up, the money supply and therefore inflation will go up with them and the US restaurant industry will be the first to suffer at the top of the economic pyramid.
The flip side of the coin is that as the dollar falls and domestic consumer prices rise in an inflationary spike, consumer prices abroad will correspondingly fall and restaurants in international markets will benefit. Just to give a small concrete taste of this in action, it is quite interesting to note the precise reason (page 33) for Chanticleer's 7% revenue drop over the last two quarters compared with the previous two quarters:
Restaurant sales, net for our four locations in South Africa amounted to $2,863,177 for the six months ended June 30, 2013 and $3,083,618 for the six months ended June 30, 2012. The decline in revenue of approximately 7% is primarily attributable to a decline of approximately 16% in the local currency exchange rate from the prior period…
When local currencies start going in the other direction, so will revenues, as well as restaurant patronage as consumers in foreign countries will have more purchasing power.
Cash Position and Conclusion
Chanticleer's financial position has not changed much in the last 3 months. It issued some debt to pay for its $3M acquisition of Hooters Nottingham and paid for American Roadside Burgers in an equity exchange deal. Debt, however, is still a low 3.2% of market cap (it was 2.8% as of my last writing), and cash on hand has gone from $389K up to $2.9M, enough to sustain the company for 1 year at current burn rate.
When interest rates begin to shoot up and those excess reserves come out in force, sports bar fortunes will flip from Buffalo Wild, with no international presence, to Chanticleer, with a growing one.
By mid 2014, I suspect we will see much higher rates coupled, however unusually, with much higher price inflation. If, by then, Chanticleer manages to break even with its new acquisitions, the checklist will be filled.