There are many things to consider in equity research. How much is the company worth? Are its growth prospects, which are embedded into the value assessment, feasible? Is there upside potential beyond that growth forecast? What are the biggest concerns to the downside? What about wing costs and the prospect for wage pressures? All of this and more is considered in our assessment of Buffalo Wild Wings' (NASDAQ:BWLD) intrinsic value calculation. Let's take a look in this article.
But first, a little background to help with the understanding of some of the terminology in this article. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Our process is rather simple -- we like to find stocks that we think are generally underpriced and are just starting to go up (stocks that are adored by value, growth, GARP, and momentum investors, all the same). We want to find stocks that will soon be liked by the most money managers, as we think those stocks will soon be the ones to outperform -- the ones soon to experience the most buying interest. We liken stock-selection to assessing the qualities that the judges of a beauty contest (money managers) use to select the contestant (stock) that they think will win. The contestant that is liked the most by the judges will win. In a similar respect, the stock that is soon to be liked by the most money-managers will win.
At the core, if a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale (it is liked by a variety of judges/money managers). Buffalo Wild Wings posts a Valuentum Buying Index score of 6, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. This isn't a poor rating by any stretch of the imagination, and we continue to hold the firm in the Best Ideas portfolio, until it registers a 1 or 2 on the index (the equivalent of a "we'd consider selling" rating). The Valuentum Buying Index rating is an actionable system at any point in time -- but once firms are included in the portfolio, they don't need to register the highest ratings of 9 or 10 to stay there. For relative valuation purposes, we compare Buffalo Wild Wings to peers McDonald's (NYSE:MCD), Starbucks (NASDAQ:SBUX), and Yum! Brands (NYSE:YUM). With that said, let's now dig in.
Buffalo Wild Wings' Investment Considerations
- Buffalo Wild Wings' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- Buffalo Wild Wings has plenty of room to grow its restaurant base, though its established restaurants appear to be maturing. After opening its 900th restaurant, the firm believes it can achieve 1,700 locations in the US, and we completely agree.
- A restaurant focused on the concept of wings, beer, and sports seems like nothing special, but Buffalo Wild Wings certainly has carved out a solid presence in this arena. With each restaurant boasting an extensive multi-media system, a full bar and open layout, 'B-Dubs' has become the place of choice for many social chicken-wing lovers.
- 'B-Dubs' has partnered with craft brewer Redhook to create a new premium beer called Game Changer, designed to complement the taste of wings. We like this move, and we think it could add another gross margin driver to the company's product mix.
- Buffalo Wild Wings continues to invest in technology to improve the guest experience and attract new demographics. Tablet ordering/payment, music and premium arcade, and B-Dubs TV are but a few initiatives.
Buffalo Wild Wings is not a dividend growth gem and not an idea for the risk-averse investor. However, we think the company serves a valuable slot in the Best Ideas portfolio and has been one of the best-performing ideas since the portfolio's inception. Though we would be cautious in allocating new money at these levels to Buffalo Wild Wings, we are comfortable holding it until it registers a 1 or a 2 on the Valuentum Buying Index. We generally add firms to the Best Ideas portfolio when they register a high rating on the Valuentum Buying Index and hold them until they register a 1 or 2. We may tactically add to or trim positions in the portfolio if they register a rating between a 3 and an 8, depending on a variety of considerations (from technical, economic, diversification, etc.).
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Buffalo Wild Wings' 3-year historical return on invested capital (without goodwill) is 27%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Buffalo Wild Wings' free cash flow margin has averaged about 2.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Buffalo Wild Wings, cash flow from operations increased about 21% from levels registered two years ago, while capital expenditures expanded about 7% over the same time period.
Our discounted cash flow model indicates that Buffalo Wild Wings' shares are worth between $130.00 - $196.00 each. We think the high end of the range is possible should Buffalo Wild Wings deliver on its store growth endeavors, and PizzaRev becomes a success. Shares are trading near the low end of the range at this juncture, at $136 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $163 per share represents a price-to-earnings (P/E) ratio of about 43 times last year's earnings and an implied EV/EBITDA multiple of about 15.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 15.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 27.4%. Our model reflects a 5-year projected average operating margin of 9.5%, which is above Buffalo Wild Wings' trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 10.4% for the next 15 years and 3% in perpetuity. For Buffalo Wild Wings, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $163 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Buffalo Wild Wings. We think the firm is attractive below $130 per share (the green line), but quite expensive above $196 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Buffalo Wild Wings' fair value at this point in time to be about $163 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Buffalo Wild Wings' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $222 per share in Year 3 represents our existing fair value per share of $163 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
All-in, we continue to like Buffalo Wild Wings' long-term opportunities with respect to its store growth potential (both with its namesake and with PizzaRev). The company's ability to execute in the face of myriad challenges (commodity and labor cost uncertainty) is also noteworthy and speaks to a talented management team and staff. We don't expect to make any changes to its position in the Best Ideas portfolio. In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: BWLD is included in the Best Ideas portfolio. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.