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P.F. Chang’s China Bistro (NASDAQ: PFCB) owns and operates nearly four hundred restaurants split between its full-service P.F. Chang’s China Bistro brand and quick service Pei Wei brand. Both brands feature Asian cuisine, and the vast majority of the locations are located in the United States. The company has expanded abroad, as well as into a line of prepared frozen entrees via a licensing agreement with Unilever. International expansion has occurred through partnership agreements with local operators, whereby PFCB received an initial territory fee, store opening fees and ongoing royalties as a percentage of sales.

The company has negligible debt, with a net cash position of around $34 million (or about 5.5% of its market cap). Furthermore, the company has generated on average $83 million in free cash flow over the last three years, which translates to a strong 14% yield on an ex-cash basis. Furthermore, the company has been actively repurchasing shares (spending on average $39 million in each of the last five years), and began paying a dividend in 2010. Despite the strong free cash flows and shareholder friendly capital allocation policies, 2011 was not kind to PFCB shareholders, with the company’s shares falling 40% as of the time of writing (12/20).

The bulk of this decline occurred in late July after the company issued its Q2 report, which showed weak comparable store sales, and a dreary full-year outlook. Though this spooked the market, the value investor with a long-term investment horizon knows to look beyond the next quarter or year to consider a company’s normalized operating performance over a full business cycle. The question becomes whether the comparable store sales decline amounts to a secular trend or is rather transitory and related to the bleak macroeconomic environment or perhaps a management misstep.

One of the things I like most about PFCB is the amount of information management provides about its restaurants. On its Investor Relations website, the company provides a link to Return on Invested Capital where management opens the kimono, providing detailed information about revenues, operating costs, and store-level ROIC for its stores on a “vintage” basis, whereby stores (for each brand) are grouped together by the year in which they were opened for directly comparable data. Unfortunately, the company does not provide this level of information on a quarterly basis, and the fiscal 2011 data have not been released, but having this information has been extremely useful in assessing where there might be problems at PFCB (at least, those that existed leading up to this year).

Going through the data, we see that the most recently opened stores suffered by far the greatest decline in average weekly sales. For the Bistro locations, 2008 and 2009 vintages rang up declines of 4.2% and 16.9% respectively, with the only other year experiencing declines anywhere near this being 2001, with a 2.5% decline. The Pei Wei locations had even more pronounced declines with the 2009 vintage experiencing a 9.5% reduction in sales, and almost all other vintages actually showing growth.

It is interesting to see the decline in sales being limited to recently opened locations. This can be the result of management relaxing its standards to open more locations in order to inflate revenue growth, or it could be the result of the company entering new territories that are suffering more pronounced economic strain than elsewhere. Luckily, we can compare the company’s locations from each 10-K to see where it expanded in these years. The data show that the 2009 vintages solely added capacity to states in which PFCB was already operating (adding, for Bistro and Pei Wei, on average 29% and 17% capacity, respectively). The 2008 vintages were far more likely to expand into brand new territories, with Bistro breaking ground in five new states, and Pei Wei zero.

The new states in 2008 include Alabama, Connecticut, Massachusetts, Maryland, and South Carolina. PFCB does not break out the sales by store by state, so the problems could be contained further, either in the northeast or the southeast. It appears that the company has relatively few stores in the northeast (and a sizable number in the southeast outside of the states mentioned), so I would suspect that the problem may be in the northeast, and could simply be a reflection of the fact that the brand is relatively undeveloped in this region.

This leads me to believe that the company, although showing declining comparable store sales, is experiencing problems in only a small subset of locations. The problems could be confined to new geographic regions, or they could be the result of overeager management relaxing its standards. Given the fact that the company severely reduced the number of new locations in recent years in response to the macroeconomic climate, I would guess that the former is more likely the issue. Furthermore, if I am correct in believing that the northeast could be the source of the problem, as the brand develops in that area to the extent that it has elsewhere, these locations could be the source of significant growth as weekly sales begin to match those of the rest of the chain. In either case, the problem locations represent no more than 12.4% of the entire chain, and it seems to be a mistake to throw the rest of the chain out as a result of comparable store declines.

One thing to note is that part of the massive growth in the company’s free cash flow over the last three years has been the result of the dramatic decline in new stores. From 2002 – 2007, the company was opening close to 20 Bistro locations and 25 Pei Wei locations, whereas in the last two years, the company opened just 6 and 4 each (on average). This shows that the bulk of capital expenditures should be classified as growth capex rather than maintenance. This is a good thing, as growth can be slowed if the company finds itself in a bind, whereas maintenance capex is mandatory. For this reason, I think the recent free cash flows modeled on a per store basis, provides a good starting point for valuing the company. Note that the recession has certainly taken a toll on the American consumer, which provides some upside, and the company’s focus on restaurant-level ROIC indicates that management appears to only make capital expenditures for growth where it is good for shareholders.

What do you think of PFCB?

Disclosure: No position.