Chuck E. Cheese: Long Term Value Thanks To Demographics

| About: Apollo Global (APO)

I have owned Chuck E. Cheese (CEC) since September 2002 and initially bought in when all restaurant stocks were beaten down due to the retail downturn following 9/11. At the time, the Company was trading at around a 12.5x trailing twelve month PE ratio and had dropped about 40% from its previous high.

Now fast forward five years, the company is currently off about 18% from its 52 week high and trading just under 17x trailing twelve months earnings and about 14x 2008's expected earnings. The recent dip in price has been related to increasing food costs, the cash flow drag of a large store remodeling project and the general uncertainty about consumer spending due to the housing downturn. Traditionally dips like this have been good times to buy Chuck E. Cheese and while I have a full position already, I am holding this one for several more years primarily due to demographics that I will explain later.



Chuck E. Cheese operates kid-friendly themed restaurants catering to families with children between 2-9 years old. While the company defines its age group up to age 12, I can tell you from experience that 10 year olds are not going to Chuck E. Cheeses unless it is as a babysitter. But for younger kids, this place is Mecca. They have tunnels to crawl through, video games to play, arcade games, prizes and of course, the giant robotic singing characters, including Chuck E. himself.

No parent wants to go to Chuck E. Cheese [although I have to confess I have come to love their pizza], but it provides a diversion from entertaining 2-9 year olds. Those are tough ages where outside stimulus from parents is still required to keep them entertained. Chuck E. Cheese provides this outside stimulus while ringing up sales on pizza, drinks, games, birthday parties and toys.

While the company does not publish the average family ticket statistics, I know I rarely left a visit without spending at least $30. With only two children, we have had three birthday parties celebrated at a Chuck E. Cheese and we attended at least six or seven for other children. Chuck E. Cheese currently has about 529 restaurants [44 franchised] and is opening between 25-30 new locations per year.

The real kicker to this story, though, is demographics. Births in the US have exceeded 4.0 million per year since 2000. Besides a brief spike in 1990, the last time births were above that level for many years was during the baby boom of the late 1950s and early 1960s. Clearly 4.0 million now is a smaller increase of US population than it was back then, however births have remained near 4.0 million per year since the late 1990s. By comparison, during the late 1970s and early 1980s, US births had dropped down closer to 3.0 million per year.

What does all this mean? Well, basically the number of US children is increasing because the US birth rates have remained at the high end of the annual range for the past 7 years. Children born since 1998 are really the target market at Chuck E. Cheese and that remains at high relative levels. All these children are going to need to be entertained and I expect that parents will keep taking them to Chuck E. Cheese to appease the little monsters.

The company's net margins are strong for the restaurant sector at 9% of revenue; competitors Applebee's (APPB) and Cracker Barrel (NASDAQ:CBRL) have 6% and 4% net margins, respectively. The company's current PEG [PE to 5 year expected growth rate] is about 1.38X versus an industry average of 1.5X.

Most importantly, Chuck E. Cheese really does not have any direct national competition in its dining/entertainment niche. Despite the lack of competition, the company plans to invest $51 million in 2007 and has averaged $29 million for each of the past five years into upgrading and remodeling its restaurants to continue to lead the charge in this dining niche. While this large store remodeling project is a drag on current cash flow, once completed [2007/2008 timeframe] the company will be a huge cash generator, with earnings before interest, taxes, depreciation and amortization of over $130 million.

Lastly, management is shareholder-friendly and uses its excess cash flow to repurchase shares. During the past five years, the company has purchased about 21% of the fully diluted stock.



Strong Profitability

  • At the higher end of profitability for restaurant chains with 9% net income margins.

    Continued Strong Demographic

  • The number of U.S. births continues above 4.0 million per year which bodes well for the number of children in Chuck E. Cheese's target audience for the next 5-6 years.

    Lack of Competing Concepts

  • Unfortunately for parents, Chuck E. Cheese is a rite of passage that they must endure to keep their young children entertained. There is nothing on the horizon that I have seen that will change that trend.

    Strong Balance Sheet

  • The Company only has about $145 million of debt which is small relative to its $1.2 billion market capitalization and its $360 million of book equity.

  • Risk Factors

    Impact of an Economic Slowdown

  • If the housing market downturn continues to worsen and drives the US into a recession, restaurant stocks could experience a short-term slowdown in earnings.

    At this point, I think the pain is baked into the share price for Chuck E. Cheese, but any surprises to the upside could result in nice increases in the stock. At 14x 2008 earnings and a 1.38x PEG ratio, Chuck E. Cheese is a relative value in the restaurant sector. Management will continue to open new locations, invest in existing remodeling activities and repurchase shares. While there may be some continued pain in the short-term associated with food prices and the consumer spending levels, I like the long-term story at Chuck E. Cheese and it remains firmly planted in my portfolio.

    CEC 1-yr. chart

    Chuck E chart