The Long Case For P.F. Chang's China Bistro

| About: P.F.Chang's China (PFCB)

P.F. Chang’s stock has cratered over the past few months over concerns about a weakening economy and a decline in same store sales. The stock recently closed at $29.82 and offers a great risk-reward trade-off. There are four factors I look at when analyzing a potential purchase and it all starts with risk. I look at valuation risk, business risk, balance sheet/bankruptcy risk and management risk. P.F. Chang’s passes all my risk hurdles. Let us look at each risk hurdle one-by-one.

Valuation Risk

The stock trades significantly below my estimated intrinsic value. There are two primary ways I measure intrinsic value. First, what is the discounted value of the normalized, unlevered free cash flow from the business. Second, what is the implied stock price if we were to overlay the acquisition multiples of similar companies.

My estimated discounted cash flow value for the company is $50.50. This assumes a 10 percent discount rate and growth of four percent. I believe this is a conservative estimate since the company has grown its intrinsic value at seven percent over the past five years.

Recent acquisitions multiples in the casual dining support the fact that I believe P.F. Chang’s is significantly undervalued. In 2007 OSI Restaurant Partners (the parent company of Outback Steakhouse) was acquired at a 12.7 enterprise value/free cash flow multiple and Applebee’s International was acquired at a 15.6 enterprise value/free cash flow multiple. In 2010 Burger King was acquired at a 20 EV/FCF multiple. P.F. Chang currently trades at a very cheap 9.5 EV/FCF multiple. If we apply a 15 EV/FCF multiple to P.F. Chang’s, the value of the stock would be $49.30.

Business Risk

The company is consistently profitable and has generated 15 percent returns on invested capital over the past five years. As a result, it is an average business. The biggest risk to their business is a prolonged slump in the economy. However, as we will see with management, I think they are implementing a capital allocation strategy that should mitigate the impact of an economic slowdown. The business has been growing over the past year and three years despite the weak economic backdrop.

Balance Sheet Risk/Bankruptcy Risk

The company has net debt to tangible shareholder’s equity of 26.5 percent. The company could pay all of its net debt off in a year from free cash flow. As a result, I do not view the company’s balance sheet as being risky.

Management Risk

As far as I can tell, the risk with management is below average. They do not appear to be prone to doing a dumb acquisition and have exhibited above average capital allocation skills. These capital allocation skills are evident by the fact that since 2007 capital expenditures are down by 75 percent, they instated a regular dividend in 2009 (the stock currently yields 3.4 percent and have been aggressive with recent repurchase programs. The company’s management has made a nice transition from the hyper growth stage to a well-managed capital allocating company. (One other significant positive about management is that in August three different insiders bought between $30,000 and $63,000 worth of stock at prices between $29.50 and $30.32.)

Below is a chart comparing PFCB’s stock price to my estimated intrinsic value (based on an EV/FCF multiple of 15) since 2002. As the chart illustrates, the stock is selling well below my intrinsic value estimate. At the most recent closing price of $29.82, the upside is about 49 percent. My estimated downside is 50 percent of estimated intrinsic value or $24.65. This implies downside risk of about 17 percent. Hence, the reward-risk trade-off is an attractive 3-to-1. I acquired the stock for clients and myself in mid-October at 27.33. As the European Crisis situation plays out, you will probably get a chance to buy this stock in the $27 range. In the $27 range, the stock offers upside potential that is about four times as much as the downside risk. Regardless of where you buy the stock, I think over the odds are high that you will be generously rewarded over the next five years.

P.F. Chang's China Bistro - Stock Price vs. Estimated Intrinsic Value (Log Scale)

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Disclosure: I am long PFCB.