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Summary

  • BAGL's actual growth profile is mismatched against the expectations baked into its share price.
  • BAGL underperforms its peers and is evidence of undermanaged assets.
  • Low reinvestment and low return on capital makes BAGL an unattractive "growth" play.

One of the most irksome things I noticed growing up as a teenager in the U.S. was how certain groups of people were classified according to what others saw from the outside without ever getting to know those same people. So, if you wore dark clothes, smoked cigarettes, listened to heavy metal while putting up an antisocial non-talkative front, most likely you would be perceived as a stoner or even a skater if you brought skateboards to school. If you wore varsity letter jackets and dated a cheerleader, you were the brawny athlete protected against the weakness of emotion. And if you were an Asian with glasses, most likely the stoner, the athlete, and the cheerleader would avoid you like the plague because you reeked of nerdiness that emanated from the TI-86 you carried in your pocket on your way to calculus AP class.

Of course, a thorough examination would've revealed that the athlete was also valedictorian and poet, the stoner a top student in calculus AP with aspirations to major in physics, and the Asian with no clue how to derivate or integrate as the only thing he had any proficiency in was (take a deep breath) driving.

The point of this tangential anecdote is that this type of thinking carries over to investing. In the context of Kahneman's Thinking, Fast and Slow, it is a clear example of System 1 thinking that lazy people do to quickly identify friend and foe in the face of a dangerous environment. It comes to us naturally and takes effort and patient thinking to fend off. Looking at the market today, an egregious example is Einstein Noah (NASDAQ:BAGL). The fundamental problem with BAGL is that it trades like a growth stock, when in fact it operates more like a mature, slow-grower. In other words, it has an identity problem.

COMPANY DESCRIPTION

Figure 1.

(click to enlarge)

BAGL owns and operates one the largest chains of fast casual restaurants specializing in breakfast (bagels and coffee) and lunch (bagel sandwiches, lox, etc.). As of July 1, 2014 they owned 857 restaurants across 42 states including wholly owned, licensed, and franchised. Recently, in an effort increase margins and profitability they have started an aggressive push towards utilizing the franchising model similar to competitors.

BAGL: the Justin Bieber of growth stocks

As hyperbolic as that sounds the gist that I want to convey is that just as Justin Bieber proves that talent is in the eye of the beholder, so is growth in the context of what can be considered GARP stock ideas.

BAGL trades at 19x LTM earnings, 6x BV, 13.2x free cash flows, and can hardly be considered anything other than a possible GARP idea. In fact, the level of current free cash flow is largely due to BAGL running negative changes in noncash working capital. If we were to use a normalized net capex and positive change in noncash working capital (as a percent of expected revenue changes) the price to free cash flows ratio would jump to 20.3x FCF. Some analysts have pointed to BAGL's low EBITDA multiple versus peers as a sign of undervaluation, but when you look at the historical figures it arguably lends support to the opposite view.

BAGL EBITDA GROWTH
LTM20132012201120102009
EBITDA$43,006$46,067$43,935$43,777$45,340$41,544

*In thousands

*CAGR calculated with LTM as the ending value, 2009 as the beginning value, and 4 as the number of years

*This is not adjusted EBITDA used by company in presentations which adds certain operating expenses and restructuring expenses

That's a CAGR of 0.87%. If we only use the years from 2013 - 2009, the CAGR jumps to 2.62%. On an absolute valuation basis, with a dividend yield of 3.5%, the only way BAGL could justify its valuation (basic P/E unadjusted for risk) is with an expected growth rate in EPS of around 13%.

In the most recent quarter, total revenues grew $4.4 million at 4.1%, while system-wide same store sales grew 1.6%(averaging 0.6% over the last 13 quarters), and company-owned same store sales grew at a tepid 1%. In addition, pre-tax operating income declined by 22.5% over the same period last year largely due to $1.2 million charge related to management changes. Without these costs, pre-tax operating income would have declined by 5.5% YoY. Even if we were to concede that this company has a very long runway for growth in terms of utilizing the franchise model, these numbers hardly signal a young growth company ready to take over the world of breakfast. This seeking alpha article even compared it to Dunkin' Brands (NASDAQ:DNKN) and Panera Bread (NASDAQ:PNRA). But is this comparison justified considering BAGL's size ($263MM) and historical growth rates?

BAGL vs. PEERS (EBIT margin and ROIC)
(NASDAQ:SBUX)201320122011201020092008CAGRAVG EBIT margin

ROC(after-tax)

Revenue($)14892.213299.511700.410707.49774.6103837.50%
EBIT($)2458.71997.41728.51419.4562503.937.30%
EBIT margin16.50%15.00%14.80%13.26%5.75%5% 12%32.30%
(000,000s)
BAGL2014 LTM20132012201120102009CAGRAVG EBIT marginROC(after-tax)
Revenue4423724344814270064235954117114085621.60%
EBIT2546827864242282451827571249170.44%
EBIT margin5.76%6.41%5.67%5.79%6.70%6.10% 6.07%10.50%
(000s)
PNRA201320122011201020092008CAGRAVG EBIT marginROC(after-tax)
Revenue23850022130057182203215424891353494129885313.00%
EBIT30975628287022025918506914089711270622.40%
EBIT margin13.00%13.30%12.10%12.00%10.40%8.68% 11.58%30.00%
(000s)
DNKN201320122011201020092008CAGRAVG EBIT marginROC(after-tax)
Revenue713840658181628198577135538073NA35.44%
EBIT304736239429205309193525184545NA13.40%
EBIT margin42.70%36.38%32.70%33.50%34.30% 35.92%8.68%
(000s)

*Eliminated litigation charge of $2.7 Billion for Starbucks

*Return on Capital (NYSE:ROC) = Current EBIT(1-t)/Invested Capital

where Invested Capital(end of last year) = Total Assets - Non-interest bearing current liabilities - excess cash

If PNRA and DNKN are what BAGL aspires to be in 5-10 years, it has a long way to go. In fact, I contend that BAGL might never get there. Not only does BAGL have the lowest growth rates out of the whole group, but it also has the lowest average operating margins coming in at half the rate of PNRA and SBUX. Some analysts believe that BAGL can match the margins of its peers as they accelerate the new franchising model they've adopted. This is smoke and mirrors, and is based on a flawed mental model.

The problem boils down to the fact that these restaurants all have different operating models. Similar, but different enough so that the operating margins is the wrong place to look for signals about the future concerning BAGL. This goes back to the idea that BAGL suffers from an identity problem. Contrary to what analysts believe, BAGL is not a casual restaurant like PNRA. Anyone who has ever gone inside of one knows that BAGL sits uncomfortably in the middle between a DNKN shop and a SBUX coffee shop, yet does not enjoy the economic advantages of either one.

First, BAGL doesn't have anywhere near the brand equity that SBUX and DNKN possess in terms of the perceived quality of coffee. I personally like their hazelnut flavored coffee, but the only reason why I would think about going there for coffee would be for the free refills. I like their bagels, but I've heard from many east coast people that BAGL's bagels taste mediocre at best. Second, at least in Las Vegas, a significant portion of the customers I've noticed at BAGL are elderly people who sit, drink free coffee, and read the newspaper for about an hour. Most of the stores don't have drive-thru windows, so turnover is relatively low compared to the many Starbucks coffee shops that sit in close proximity to BAGL's stores. Third, I invite readers to check out some of the reviews of BAGL on Yelp (NYSE:YELP) where a significant portion of the negative reviews center around slow service. I believe the layout of individual stores limit volume increases and prevent turnover of customers. In fact, if you read the reviews of stores with drive-thru windows one of the primary complaints is how slow the service is when there aren't that many cars in line. This is not good news when considering that the average American spends just 12 minutes a day on breakfast.

I believe the key metric for analyzing BAGL is ROIC. At 10.50%, it's at the low end of its group and barely covers its cost of capital. In fact, under highly conservative assumptions it wouldn't cover its cost of capital in which case growth would be harmful to shareholder value. What's interesting is that DNKN has the lowest ROIC with the highest margins. This would be problematic for BAGL because BAGL's franchise model seeks to replicate DNKN's franchise model. And growth requires two things:

1.) A sustained high ROIC

2.) Opportunity for growth

There's no doubt that BAGL has the opportunity for growth. But its low ROC metric casts a shadow of doubt on whether BAGL can achieve the kind of growth that adds to shareholder value.

VALUATION

Trumpeting EBITDA...is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a 'non-cash' charge. That is nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. - 2002 Berkshire Hathaway Shareholder Letter

I know I'm preaching to the choir with respect to how I feel about EBITDA because I think many other value investors feel the same way. First, EBITDA is not cash flow. I bring this up because some analysts feel it is an appropriate method to value restaurants, and allows investors to perceive BAGL as relatively cheap (BAGL EV/EBITDA = 8.03). I couldn't disagree more. I think EBITDA distorts comparisons between and amongst firms because the measure favors those with high maintenance capital expenditures as it removes non-cash deductions. This is especially true for firms that possess short-lived assets. And while it can be argued that restaurants operate long-lived assets, some restaurants need to reinvest heavily every 5 to 7 years to modernize and rebrand. As a result, I don't think using a ratio with EBITDA as the denominator gives investors the best feeling for relative value especially when looking at companies with different capex needs in different phases of the capex cycle. Furthermore, EBITDA ignores changes in working capital accounts which would be highly distortionary to companies like BAGL running both negative noncash working capital and changes in noncash working capital neither of which are sustainable in the long run.

The best way to value BAGL is with a simple DCF using the stable growth model. I feel that the stable growth version is fitting as it matches the actual growth profile of BAGL both historically and going forward. Also, the comparison of EBIT margins and ROIC between BAGL and peers casts a shadow of doubt on the idea that higher margins from the franchising model unconditionally leads to higher profitability and growth.

Under steady-state assumptions (in thousands), using a 35% marginal tax rate, an expected growth rate of 2.2%, expected EBIT(1-t) next year comes out to $16,918.40. Using reinvestment rate of 20.72%, reinvestment next year comes out to $3,505.50 which gives us an expected free cash flow to the firm of $13,413. Using a relatively low cost of capital of 8%, the value of the operating assets comes out to $231,258. Adding net debt of (-$91,552), and considering shares outstanding, I get a value/share of $7.71 which is around half of what it currently trades at.

Readers please note that the expected growth rate I'm using is a fundamental growth rate which is a product of two factors:

1.) the reinvestment rate which uses normalized versions of net CAPEX and changes in noncash working capital

2.) ROIC of current year

This is what I prefer, not because analyst forecasts are necessarily wrong, but because it internalizes the growth rate with the operating dynamics of the firm without overly relying on historical growth rates.

I can already see that many bullish analysts aren't going to be happy with the assumptions I've built into the stable-growth model. Fine, let's say the bulls on this stock are right about BAGL's future growth. I personally think growth visibility is low, but let's say that BAGL will execute its strategy flawlessly and their operating margins double. Where is growth actually going to come from? At best revenue growth will remain tepid. While BAGL has been expanding its geographic footprint across the U.S., its unit growth isn't particularly exciting, and there seems to be no potential for international expansion as I believe bagels have limited appeal not only within the U.S., but in most other countries as well. Compared to something like a breakfast burrito, or even a crepe, bagels just aren't that sexy. Add to this the fact that BAGL has no competitive advantage in a crowded breakfast market trending towards healthier/organic alternatives, BAGL lacks meaningful pricing power, and therefore revenue growth without new store expansion is likely to continue its weak pace.

I believe margin improvements from continued cost cutting and efficient asset utilization will be a source of growth, but not for the long-term. Furthermore, while I like the juicy dividend yield that rewards patient investors, the high payout ratio isn't particularly attractive for a company of its size and growth profile, and prevents the company from instituting a meaningful stock buyback program.

So, basically it comes down to new store expansion and margin expansion as the only growth drivers for BAGL. If we generously assume that each adds 2% to the fundamental growth rate of 2.2%, and run a DCF with a five year high-growth period this is what we get:

BAGL DCF with High-Growth period
Current12345
Reinvestment rate 20.72%20.72%20.72%20.72%20.72%
EBIT(1-t)$16,55417,58018,67019,82721,05722,363
FCFF$21,26213,88814,74915,66316,63517,665
Cost of Capital 8%8%8%8%8%
Cumulated Cost of Capital 1.081.171.261.361.47
PV 12,85912,60512,43012,23112,017

* In thousands

Assumptions for the high-growth period are 6.2% expected growth rate, 20.72% reinvestment rate, and a constant marginal tax rate of 35%. Furthermore, in the stable-growth stage cost of capital drops to 5%, tax rate stays the same, growth rate drops to 1.8% in line with historical rates, and excess returns disappear equating return on capital with the cost of capital. As a result, terminal reinvestment rate increases to (1.8%/5%) 36%.

Putting everything together along with net debt (-$91,552), we get a value per share of $8.45 a share. This is the value we get after almost tripling the fundamental growth rate due to margin expansion and new store expansion, and allowing the terminal cost of capital to drop to 5%. Very generous terms indeed, and yet we still end up with an overvalued stock and a mediocre company competing against an army of ants.

RISKS

There are a number of risks in this stock. The biggest of them being the fact that investors are using the wrong mental model of growth to price the stock. There's no guarantee that BAGL will ever catch up to the likes of DNKN, PNRA, and SBUX. Their cost structures might converge over time, but the different operating models might mitigate whatever increases in profitability shareholders get from margin expansion. Another risk exists in the form of David Einhorn who owns a huge chunk of BAGL, albeit at a decreasing rate. There's a good chance he'll eventually sell his entire stake and put his money to work in better value plays. The final risk that I see in this company is the lofty valuation that it trades at. I've read that valuation can itself be a catalyst for stocks trading up to its intrinsic value. But if valuation itself can be a catalyst for a move up, it can also be a catalyst for a move down at the slightest sign of disappointment.

In conclusion, while I like BAGL's hazelnut coffee and honey almond schmear on honey wheat, I don't particularly like the stock due to the mismatch between price and fundamentals. They've consistently underperformed peers with no discernible competitive advantage and lower brand equity. BAGL's historically low ROIC doesn't help the case for future growth either. Too much of their future growth depends on margin expansion from the flawless execution of the franchising model. I don't have anything negative to say about the management except that they seem intent on maximizing shareholder value with their juicy dividend yield, but I think the economics of their business model places a ceiling on their free cash flows. I expect these trends will continue into the foreseeable future.

I know investors want to hear actionable ideas, but I don't really have any. Sometimes, the best action an investor can take is no action. Warren Buffett's rules of investing numbers one and two is a reiteration of this idea. I don't recommend anyone short the stock, since I have zero experience shorting anything. The only thing I can say with certainty is that BAGL is a definite pass for me- plenty of value in the sea (maybe). And yeah, the Asian guy with glasses? That's me.

Source: Einstein Noah: Desperately Seeking Growth At An Unreasonable Price

Additional disclosure: Not meant as investment advice, but only for research and discussion. Please do your own due diligence.