As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Buffalo Wild Wings' (NASDAQ:BWLD) case, we think the firm has valuation upside north of $100 per share based on the high end of our fair value range.
For some background, 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 (click here for video about our methodology with President Brian Nelson). Our methodology ranks stocks on a scale from 1 to 10, with 10 being the best. In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Buffalo Wild Wings posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the company, its neutral relative valuation versus peers, and very bearish techinicals. We use Darden Restaurants (NYSE:DRI), McDonald's (NYSE:MCD), Starbucks (NASDAQ:SBUX), and Yum! Brands (NYSE:YUM) for our peer group analysis.
Our Report on Buffalo Wild Wings
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Buffalo Wild Wings earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 27% during the past three years.
If the firm's share price fell into the $60s again, we'd take a closer look at adding to our position in the market-beating portfolio of our Best Ideas Newsletter. In the spirit of transparency, we show the performance of our Best Ideas Newsletter below:
Buffalo Wild Wings' cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 2% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. The firm had no debt at the end of last quarter.
Most Recent Quarterly Results
In late April, best-idea Buffalo Wild Wings reported strong first-quarter results that support our view that the firm's expansion efforts are still in the early innings. Our fair value estimate for the bar-and-restaurant chain remains unchanged.
The firm's first-quarter revenue advanced an impressive 37.9%, as sales from company-owned restaurants jumped more than 40% from the same period a year ago. Same-store-sales increased 9.2% at company-owned restaurants and 7.3% at franchised restaurants, indicating that the Buffalo-Wild-Wings concept continues to resonate with consumers. The company did a nice job mitigating the rise in wing costs during the quarter, and while earnings expanded less than the pace of sales, they still increased over 22%, with diluted earnings per share coming in at $0.98 in the quarter. During the period, Buffalo Wild Wings added 64 new company-owned restaurants and 17 new franchise locations relative to the same period in 2011. We think unit restaurant growth potential is still robust, and our view is that management's saturation estimates are conservative - 1,500 locations in North American in the next five to seven years. We were also encouraged with management's commentary regarding the pursuit of international franchising opportunities and potential new concepts that would offer incremental expansion.
Looking ahead, management indicated that same-store-sales are advancing at roughly a 7% pace during the first four weeks of the second quarter. Though this is slightly lower than the rate achieved during the first quarter, it still is quite robust. Further, we think Buffalo Wild Wings will have no trouble achieving its net earnings growth of 20% for 2012.
In the spirit of transparency, our report on Buffalo Wild Wings and hundreds of other companies can be found here.
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 (ROIC) with its weighted average cost of capital (OTC:WACC). 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% 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 87% from levels registered two years ago, while capital expenditures expanded about 76% over the same time period.
Our discounted cash flow model indicates that Buffalo Wild Wings' shares are worth between $62.00 - $104.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $83 per share represents a price-to-earnings (P/E) ratio of about 30.4 times last year's earnings and an implied EV/EBITDA multiple of about 11.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 19.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 22.9%. Our model reflects a 5-year projected average operating margin of 8.7%, which is below Buffalo Wild Wings' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 14.6% 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 $83 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 $62 per share (the green line), but quite expensive above $104 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 $83 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 $113 per share in Year 3 represents our existing fair value per share of $83 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
Additional disclosure: BWLD is included in the portfolio of our Best Ideas Newsletter.