Shares of CEC Entertainment (CEC), which operates Chuck E. Cheese's, fell last week on disappointing quarterly results, though shares are still up 40% in 2013 on hopes for growth from an international expansion. In this article, I will go over the quarterly numbers, explain what they mean for 2014 and future growth, and conclude with what I believe to be a fair valuation of the company.
After solid 4% revenue growth in the first half of 2013, there was a stunning reversal in the third quarter with revenue actually declining 0.4% due to a 2.1% drop in same-store sales, a worrisome drop that brings in to question growth expectations for 2014. On the conference call, CEO Michael Magusiak blamed an 11% drop in birthday parties for the same-store sale drop. Birthdays account for nearly 20% of CEC's business, so it is critical that management addresses the problem.
I would also suggest that for Chuck E. Cheese's, birthdays are worth more than the 20% of revenue for which they account. Parties showcase the restaurants to 25-35 kids on average, many of whom may never have gone to a Chuck E. Cheese's before. These parties are the best way to acquire new customers. Parents can see how much their kids enjoy Chuck E. Cheese and bring them back once a month or as an incentive for doing well in school, etc. Birthdays allow new customers to try out Chuck E. Cheese's for free (as the birthday family foots the bill), make it the most cost-effective marketing program CEC has. A decline in birthday party sales can lead to weak non-birthday sales in future quarters.
Fortunately, on the conference call, Magusiak says management has been addressing this problem and that trends have improved in October, which bodes well for fourth quarter sales. However, I did find the explanation for the weakness a little troubling. The drop in birthdays was blamed on a de-emphasis on birthday parties in CEC's TV advertising. This de-emphasis came even as overall advertising expenses increased by 7%.
Given how important birthdays are to the business, it is mind-numbing that the marketing team would not advertise them, which brings into question managerial competence. Now, management has done a great job over the past 18 months, successfully updating the look of its mascot with the roll-out of the "Chuck E. Rocks" ad campaign, which had been boosting same-store sales and re-established the brand's popularity among children. Given this track record, I am willing to give management a mulligan on the birthday advertising. However if there is another managerial misstep in the next few quarters, I would be forced to downgrade my view of management.
Besides the decline in birthday sales, other data points were pretty much in-line with store operating margins virtually unchanged at 18.9% vs. 19.0%, though increased advertising expenses did contribute to slightly lower profit margins of 3.8% to 4.0%. The company has cut leverage with a $41 million decline in credit facility borrowings while the cash balance grew $2 million. The company remains on pace to generate roughly $80 million in free cash flow this year, for a FCF multiple of 10x. Improving cash flow trends have allowed management to raise the quarterly dividend by 13% to $0.27 for a yield of 2.4%.
In 2014, management is looking to accelerate net new store openings from this year's nine locations to 12-15 new stores. The company will also continue to try to grow internationally where it has 16 franchise stores and has sold the rights to an additional 61 with a focus on South America and the Arabian Peninsula. With 556 stores in total, international remains a very small piece of the pie and has the potential to be a key driver of growth for the next several years. Measured international expansion could provide incremental growth of 2% annually for the next five years.
The company is also testing "token inflation." For several years, $10 has bought 40 tokens, which are used to play games and earn tickets to "buy" prizes. The company is now testing giving out 33 tokens per $10. This is a way to make consumer spend more to buy prizes, which should be accretive to margins and could increase visit time per family, boosting both restaurant and arcade sales. I believe the company should be able to roll out this change gradually in 2014 to more locations, which will be beneficial for financial results, by alleviating some cost pressures.
Overall, this quarter was clearly a disappointment with birthday sales dragging down overall results. However, management contends this is a blip on the radar rather than the start of a new trend, pointing to better October sales as proof of this. Given how well the company managed the brand transition of its mascot last year, which boosted sales, I am willing to give the management one mulligan and take them at their word that the problems have been rectified. However, I do believe it is fair to closely scrutinize their performance to ensure we are not seeing declining managerial performance. Despite declining sales, free cash flow remains strong, accelerating international growth should boost 2014, and increasing token prices should provide a boost to margins.
In 2014, I believe 1% same store sales growth is a realistic expectation with new stores providing another 2% growth for 3% revenue growth to about $855-$860 million. I am looking for a mild boost to margins from its "token inflation," which gives CEC earnings of $3.10-$3.15. At 45.53, CEC has a forward multiple of 14.6x. To me, that is an expansive multiple for a company with moderate growth prospects as it provides no margin of safety if birthday trends remain weak in 2014. The company has the potential to expand internationally more quickly by selling more franchises or adding some leverage to its balance sheet, which could hasten growth though management seems content with a slower, more controlled expansion. However, the current strategy allows for moderate international growth for several years; speeding up the expansion would just pull forward future growth rather than actually change overall earnings potential. I am more comfortable with CEC's current, measured approach.
I am a fan of Chuck E. Cheese's, given its strong cash flows and moderate growth potential, but I do believe the stock has moved a little too far with a forward multiple of 14.6x. I would look to initiate a long at $40-$41, but at current prices, I do not believe shares have a positive risk/reward profile and think they are fully valued. CEC has a decent story but the market is discounting downside potential, making it unattractive at current prices.