Wingstop: High-Flying Chicken Wings Franchisor Has Potential, But Now Is Not The Time To Dig In

| About: Wingstop, Inc. (WING)

Summary

Wingstop has been on a tear this year.

The company's ability to grow rapidly while maintaining high comps and expanding margins in recent years is impressive.

The current valuation implies a continuation of recent trends, but the industry environment today is not what it was in years past.

Wingstop is doing a lot of things right, but the valuation is a bit stretched.

Intro

Wingstop Inc. (NASDAQ:WING) shareholders have stomached no small amount of volatility since the company went public in June 2015, but over the past twelve months, the stock is up 25%. Shares have retreated slightly since the Fed raised rates in December, but WING still trades at a valuation that implies a continuation of past growth trends.

It's easy to understand the optimism that surrounds the high-growth franchisor of chicken wing-centric restaurants: the company has demonstrated an ability to scale up quickly, adding to its franchise network at an approximate 20% annual clip over the past four years, while maintaining strong comps and expanding margins. The company is showing no signs of slowing down either. In the latest earnings call, management raised guidance for domestic net new restaurant openings in FY16 from a range of 125-135 to 144-145, good for an 18% increase over last year's count.

But investors need to consider just what they are buying into at the current valuation (forward P/E of 45, P/S of 9.6). Investing now requires you to be certain that WING will be able to maintain its breakneck pace of franchise growth over the next five years. This would be an impressive feat in an ideal operating environment, and it will be a particular challenge given the current conditions. There's no question that WING is an intriguing story, and we like the potential here, but the valuation is a bit stretched. The next five years will not mimic the past, and investors should pass.

Sound Fundamentals Driving Growth (and Expectations)

It's easy to understand why the market has become so enamored with Wingstop. Over the past four years, the company has increased its domestic restaurant footprint almost 20% annually and maintained comps in the high single digits on average. Wingstop's simple and efficient restaurant operating model is central to its success. The menu is limited (wings, fries and sides account for 90% of revenues), so fewer ingredients are required and order processes are more streamlined. The restaurants themselves are small (1700 square feet on average), because takeout customers make up 75% of all orders. This operational simplicity results in relatively low labor costs and low initial cash investment (just $370K, on average, excluding real estate purchase or lease costs), and makes opening a Wingstop restaurant an attractive proposition for franchisees. Average unit volumes (AUVs) exceed $1.1 million (which translates to an average sales/investment ratio of more than 3), and franchisees can expect to generate unlevered cash on cash returns between 35% and 40% within two years of opening a Wingstop.

WING has not had trouble selling franchises, and with a target of 2500 domestic restaurants, the company has a runway for growth. Assuming it hits approximately 1000 this year, as it is on track to do, WING will be only 40% of the way to its objective. Management seems to know what it's doing, and the strategic initiatives are paying off. We think it's more likely a matter of when, not if, the company hits 2500 units. However, the amount of time it takes to reach this target has profound implications on the investment case for Wingstop, and as you will see, the analyst models that investors are using to value WING are based on some aggressive assumptions that don't quite hold up when you consider how things have changed.

What Does the Consensus Price Target Imply?

The consensus price target on Wall Street is $34.50. Analysts are calling for 21.3% annual earnings growth over the next five years. To achieve this kind of growth, Wingstop would need to continue to increase domestic restaurant count at an 18% annual clip (effectively doubling the domestic restaurant base by 2020) and expand margins at a similar rate to years past. The analyst models assume a terminal P/S multiple of 9, virtually unchanged from the current P/S ratio. The following figures illustrate the cash flows that analysts are modeling to arrive at their price targets.

Figure 1: FCFF Forecast (in USD thousands)

(Source: Madison Investment Research)

Figure 2: Terminal Value (in USD thousands)

(Source: Madison Investment Research)

Figure 3: Equity Value (in USD thousands except per share data)

(Source: Madison Investment Research)

The first thing that stands out is the use of a P/S ratio of 9 for the terminal value calculation. Is it reasonable to expect that the growth prospects for Wingstop in 2020 will be the same as they are now, assuming the company doubles its restaurant base and closes in on its domestic store target? We don't think so, but this is what the ratio implies, and it has a big impact on the intrinsic value calculation. One of the drawbacks to the DCF approach is that the fair price estimate is highly sensitive to terminal value assumptions. At a P/S multiple of 9, the terminal value cash flows account for 90% of the fair price estimate. The following data table shows how the fair price target changes across various P/S and WACC inputs.

Figure 4: Fair Price Sensitivity to P/S Multiple and WACC

(Source: Madison Investment Research)

Our second gripe relates to the earnings growth assumption, as it requires that WING, at a minimum, continue to grow the franchise base at the rate it has been over the past few years. Wingstop has a strong development pipeline (530 signed domestic commitments at the end of 2015), but it is unlikely that the company will be able to maintain this growth as the franchise base increases. More importantly, while conditions have been close to ideal for restaurants in recent years, signs suggest the latest cycle may have peaked. The US restaurant industry over the next five years is projected to grow at less than half the annual rate that it did between 2011 and 2016, and the risks to the outlook have increased.

Decelerating Same-Store Sales Growth Reflects A Weaker Economy

In the years following the housing collapse, quantitative easing and low interest rates propped up the economy, boosted consumer spending and drove down unemployment. Between January 2010 and December 2016, the unemployment rate declined from 10% to 4.7%, and the income growth from new job gains, combined with the wealth effect from rising asset values, translated into increased restaurant visitation (Figure 5). Interest rates can't fall much further, and with unemployment levels hovering around the long-term natural rate, restaurants are unlikely to benefit going forward like they did in the past.

Figure 5: US Restaurant Chain Sales

(Source: IBISWorld)

The industry environment during the next few years will not resemble that of the past. This is not to say that Wingstop has reached an inflection point and that it can't eventually recover to higher levels of growth, but the restaurant sector is cyclical, and a downturn appears imminent. Factor in rising labor costs to the mix and the prospect of higher interest rates, and it is unlikely that Wingstop will maintain its recent pace of franchise growth.

Management expects domestic comps for FY16 to come in between 3.5% and 4%. This is a significant drop-off compared to recent years (Figure 6).

Figure 6: Slowing Comps

(Source: 10-K)

To be fair, any company would struggle to maintain these comps for long, but the slowdown is significant, and it reflects how industry conditions have changed. 2016 was a bad year for restaurants. In fact, it was the worst year for restaurants since 2009, when the economy was coming out of a recession. Industry-wide restaurant comps in the US decreased for the ninth consecutive month in November, and same-store sales decreased 1.1% in each of the past two quarters. This is a stark contrast to the past few years, when restaurants were averaging annualized comps growth of 2-3%. Weak traffic is primarily to blame, and this is a problem for restaurants, because most companies lack pricing power and rely on traffic to drive same-store sales growth. On a rolling three-month basis, restaurant traffic is down 3.3%.

We understand the counterargument here. If low unemployment is crucial to the success of restaurants, why have restaurants struggled so much during the past year? Last summer, the unemployment rate dropped to its lowest level since August 2007, but household spending on retail products, including restaurants, has not kept pace. The problem is that the unemployment rate is a misleading metric. When you dig beneath the surface, the cracks in the US economy become apparent. The low unemployment rate is largely the result of near 40-year low labor force participation and a transition from full-time to part-time labor. Employers are replacing full-time workers with part-time laborers, which is what companies tend to do when they are uncertain about the direction of the economy or anticipate a recession.

This dynamic is at the heart of why restaurants have struggled despite all the jobs added during the past year. Consumers aren't really wealthier - many are simply working multiple part-time jobs, whereas in the past they only had one full-time job. Average hours worked per week steadily increased during the post-crash period, but dropped off in the past year. As a result, people are eating out less frequently and consumers are more price-sensitive than they were in the past. This is why quick service restaurants (which emphasize value and compete on price) continue to take market share. In 2016, quick service restaurants were the only segment to register comps growth above 1%.

Despite these headwinds, Wingstop is on pace for a relatively strong year and will have grown its domestic restaurant base approximately 18% by the end of FY16. But this does not mean the company is immune to the problems impacting the restaurant space, or that this rate of growth should be expected to continue. It is important to consider that the vast majority of the commitments that make up WING's development pipeline were signed in prior years, when industry fundamentals were more attractive. Restaurants that opened in 2016 had been under construction for some time, so the challenging conditions that permeate the current restaurant environment will not have factored into the decision to buy these franchises. Current conditions will impact these decisions going forward, however, and it should begin to show in the out years.

Harder to Sell Franchises

The focus on comps is essential, because the ability to increase unit volumes at newly opened stores is a key selling point when it comes to expanding the franchise base. As management explains in the 10-K, "our restaurants do not generally experience a honeymoon period of higher sales upon opening, but instead typically build year over year... Our domestic AUV has grown consistently." This has certainly been the case in recent times (Figure 7), but past results are not a reliable indicator of future growth. AUV is volatile and fluctuates according to consumer income levels, economic conditions and the degree of competition in the marketplace. It's easier to sign franchises during a period of 10% average same-store sales growth than it is when comps are only expected to grow in the low single digits.

Figure 7: Domestic AUV

(Source: 10-K)

Management has a number of strategies for driving same-store sales growth going forward, which involve flavor innovation, investments in technology to grow online orders and improve store efficiency, and a more cost-effective marketing strategy that leverages social media, but none of these provides WING with a moat. Given the company's high takeout rate, the strategy of expanding online orders through the digital platform has potential, especially since online orders garner higher tickets ($4 more on average). Unfortunately, Wingstop isn't doing anything that its competitors aren't. Domino's Pizza (NYSE:DPZ) and Papa John's (NASDAQ:PZZA), both of which offer chicken wings, are the gold standard of the quick service/fast casual online order model. These companies have long histories of processing online orders, and their mobile apps are much more popular than Wingstop's. (DPZ's and PZZA's apps have over 6000 and 8000 ratings respectively on the Apple app store, compared to just 20 ratings for WING's app.) And as fellow contributor Diamond Technology Management points out, both companies appear ahead of Wingstop in the Google search results for online wings orders. Management has shown in the past that it can execute, and we think its actions can help cushion some of the deceleration in comps growth. But Wingstop's peers have the experience and resources to turn up the heat as the company expands, and investors are playing a dangerous game by relying on management's initiatives to fuel a rebound in comps. The issues hampering growth are largely outside of the company's control.

In the current restaurant environment, Wingstop will find it more difficult to sell franchises, and a weaker comps outlook is not the only reason. Labor costs are rising as well, and Wingstop is not differentiated enough to pass the increase on to consumers. In the latest quarter, profit margins at its company-owned stores declined, primarily due to an increase in labor costs. Cost of goods sold as a percentage of company-owned revenues increased from 70.7% to 74.7% y/y as labor costs jumped from 20.7% to 23.7% of revenues. Wingstop is 98% franchised, so the impact on its bottom line is not significant. But the wage increases are somewhat of a concern for the franchisees that employ these workers. Wage inflation is "here to stay," and it will impact the cost-benefit analysis for potential franchisees going forward. Franchisees will experience some margin pressure, especially as comps growth slows and the ability to leverage fixed costs across higher volumes diminishes.

Added Risks

The risks to the outlook are greater now than they were a few years ago. The biggest risk is the prospect of higher interest rates. Wingstop's growth strategy is predicated on the ability of franchisees to finance their own development. The company does not directly provide franchisees with financing, and higher borrowing costs could make it more difficult to find franchisees and could slow the rate of unit development. Low interest rates played a crucial role in helping restaurants expand after the crash, and while WING's low-capex, asset-light business model makes franchisees less reliant on low interest rates than more capital-intensive peers, higher interest rates would further add to the cost inflation that franchisees are experiencing.

The second major risk is that the company may struggle as it expands into new and less familiar markets where the Wingstop brand doesn't carry as much weight. Geographically speaking, Wingstop is somewhat unproven: at the end of 2015, 59% of its domestic restaurants were concentrated in just two states (Texas and California). As the franchise base grows, WING will need to penetrate new markets if it hopes to maintain its pace of growth, and there is no guarantee that the company will be as successful in these regions as it was in Texas and California.

Valuation

Our DCF model, which incorporates more conservative assumptions for franchise development, comps growth, profit margins and terminal value, arrives at a fair price target of $24.59.

Figure 8: Model Assumptions

(Source: Madison Investment Research)

Figure 9: FCFF Forecast

(Source: Madison Investment Research)

We believe restaurant growth will decelerate to management's long-term steady state guidance of 10% by year 3. We expect same-store sales growth to average approximately 2% growth over the forecast period, consistent with management's long-term guidance of low-single digit comps. Profit margins will continue to expand, but they will do so at a slower pace than the market expects. The margin expansion story requires that WING continue to add franchises at a high rate so that it can leverage its fixed overhead, advertising, D&A and interest costs across a larger fee/royalty base. As new franchise growth slows and same-store sales account for an increasing percentage of company revenues, margins growth will slow. Finally, our terminal value calculation is based on a 2020 P/S multiple of 7, a number that is still very aggressive when you compare it to an average of 2.4 for the peer group, which consists of DPZ, PZZA and Buffalo Wild Wings (NASDAQ:BWLD). A premium is justified given the higher growth outlook and profitability, but the P/S ratio loses some of its meaning when you consider how WING's cash flow characteristics differ from those of some of its peers.

Figure 10: Peer Group Fundamentals

(Source: Madison Investment Research)

Figure 11: Peer Group Valuations

(Source: Madison Investment Research)

As expensive as WING looks based on sales and earnings, the stock is even more expensive when you consider free cash flow, which is ultimately what matters for an investor. Wingstop's cash flow conversion looks impressive on the surface, but the metric is misleading, as it does not distinguish between free cash flow to the firm (before net borrowing) and free cash flow to equity holders. Wingstop's trailing P/CF ratio after adjusting for debt payments is 65.5, and its massive debt burden (LTD accounts for 137% of assets) means shareholders see little (if any) cash unless the company levers up to fund payouts (Figure 12). Shareholders received a special dividend worth $2.90 per share last year after WING refinanced its debt, but with just $3.8 million (3.4% of assets) in cash on the books, investors should not expect such distributions to recur consistently.

Figure 12: Cash Flow Statement

(Source: 10-K)

Conclusion

We think Wingstop has potential, and our issue with the bull thesis has more to do with its valuation than fundamentals. The success of Wingstop's long-term growth strategy is predicated on new restaurant development, and at the current valuation, investors must be certain that the company will be able to maintain its blistering pace of restaurant growth over the next four years. WING is on track for a strong FY16, but the market is asking too much of the company. Industry conditions have changed, and the past cannot be relied upon as an indicator of future performance.

The lack of confidence from insiders is arguably the greatest indictment of the WING bull thesis. As recently as the end of 2015, Roark Capital Group owned 67% of the company's outstanding shares. In November, Roark sold off the remainder of its position at a price of $26.27. It exited its position at an average price of $25.87 in 2016, a significant discount to WING's 200-day moving average of $29.12 and the current price of $28.92. An increasing number of investors seem to think WING has entered overbought territory. Shares sold short currently make up 31.3% of the float, compared to just 9% in May 2016. We agree that Wingstop is overvalued, and investors should think twice before getting caught up in the hype.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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