BJ's Restaurants Patiently Shaking Out The Competition

| About: BJ's Restaurants, (BJRI)


BJ's CEO made an interesting statement on the company's positioning.

There seems to be merit to his assessment of the competition.

He could also be right about BJ's opportunity.

These things don't necessarily mean BJ's stock is a buy.

With only 189 locations, BJ's Restaurants (NASDAQ:BJRI) isn't exactly a household name. But the Huntington Beach, California-based company has been steadily expanding its brewhouse chain over the past decade. This steady and promising expansion once led the stock to be traded at very high earnings valuations, but that metric is now reasonable at just 18x forward earnings.

The story for BJ's is pretty simple. The plan is for existing restaurant locations to continue delivering strong positive cash-flow, and have that cash reinvested in opening new company-owned restaurant locations as it builds out towards at least 425 locations long-term.

In regards to that build-out, management said something in the most recent earnings report that caught my eye.

...we are positioning BJ's to be a significant beneficiary of the shakeout of weaker competitors..." -CEO Greg Trojan

For context, Trojan was discussing the current slump in the restaurant industry. Basically, he's saying he fully expects this restaurant industry storm to sink a few ships. BJ's, meanwhile, plans to patiently wait out the storm and then seize the opportunity once the competition sinks.

For 2017, BJ's is planning to open only 10 locations. That growth rate is half of 2016's growth rate. Management went on to say: time, real estate values will improve with the demise of weaker performers in our space, thus presenting even better opportunities for BJ's."

This is a very interesting plan from management and worth exploring the merits. First, can we reasonably expect a "shakeout" of some of BJ's competitors? Second, will BJ's be positioned to be a beneficiary? And finally, what does this mean for the stock?

The shakeout

Without a doubt, 2016 was a tough year for restaurants. Traffic dipped across the entire industry and no segment was immune. Given the tough environment, how did BJ's competitors fare?

Ignite Restaurant Group (NASDAQ:IRG) owns a concept similar to BJ's called Brick House Tavern + Tap. Darden Restaurants (NYSE:DRI) owns Yard House. And a very small player called Good Times Restaurants (NASDAQ:GTIM) owns a concept called Bad Daddy's Burger Bar (yes, that's really its name). At first glance, all these companies are expanding these chains.

Upon closer examination, there might be something to BJ's expectation. Ignite way back in the 2012 Annual Report, said it would focus Brick House's development in "...the top 50 designated market areas across the country." With currently just 26 Brick House locations, that story is already looking very unlikely.

Traffic at Brick House is dropping like a brick balloon. In the first three quarters of 2016 traffic fell 4.5%, 6.9% and 8.8% respectively. The company opened three new locations in the first quarter, but opening new locations of a concept falling this hard is never a good idea and surely won't help Ignite's ever more precarious financial situation.

Good Times Restaurants has struggled some with its namesake chain, but the Bad Daddy concept has performed relatively well. Last quarter the chain enjoyed a 2% comparable sales increase - which is nothing to sneeze at for a very small player in a very tough market environment. Not surprisingly, the company plans to scale this business up from 20 current locations.

For 2017, the company plans to open 8-9 new locations. That's a whopping 40-45% unit growth. But there's a catch. The company is a little jittery about opening up new locations in competitive markets, and instead is choosing to run away to less competitive markets in the Midwest and Southeast. Specifically, the company abandoned recent plans to expand into Arizona because it wouldn't have been able to handle the state's new minimum wage laws. In the earnings call, management conceded that it is likely giving up superior average unit volumes, but hopes to benefit from better margins by making this choice.

So while one of BJ's competitors is falling and another is running for safer territories, what is happening with Yard House? Darden paid up big time in 2012 for the then 39-location chain. The $585 million purchase valued Yard House at about $15 million per location. For perspective, BJ's is trading at around $5 million right now.

Darden paid up in large part because it believed the Yard House concept could become a high growth chain as its more mature concepts were lacking meaningful growth. And for the most part, Yard House has been that for the company. In the almost five years since acquisition, locations have nearly doubled.

But more recently - 2016 - Yard House has slumped. It posted a 1.4% comparable sales increase in 2016, which at least was a gain. But it was also the worst performer of the seven restaurant chains in Darden's portfolio. That lagging comparable sales growth is probably why Darden plans to only open 2-4 new Yard House locations in 2017.

So, in summary, there does seem to be some merit to the notion of a shakeout. Some chains like Brick House are falling fast and don't have a lot of resources to weather the storm. Other chains like Bad Daddy's are looking to grow in less competitive markets. Then there's Yard House which I have little doubt will weather the storm, but isn't exactly looking like it's getting ready to be a beneficiary of the competition's weakness.

Of course, we're only looking at publicly traded chain restaurants. The argument gets stronger if you look at independent restaurant chains. According to The NPD Group, independent restaurant units dropped a whopping 4% in 2016.

BJ's a significant beneficiary?

It's not enough for the competition to stumble. BJ's must be ready to take advantage of the opportunity. This means having a strong brand, using a disciplined location selection process and being financially strong. Does BJ's fit this bill?

The strength of the BJ's brand is somewhat debatable. Traffic has fallen at the chain for five straight years.

2016 2015 2014 2013 2012 2011
-2.6% -1.4% -0.8% -1.1% -0.1% +2.2%

Most would look at that and ask what is debatable. Falling traffic should automatically mean a weak brand, right? Well, there is a bit more to the story. This is what management had to say in the most recent 10-K:

Since most of our established restaurants currently operate close to full capacity during the peak demand periods of lunch and dinner, and given our relatively high average sales per productive square foot, we generally do not expect to achieve sustained increases in comparable restaurant sales..."

This is an important thing to understand when looking at BJ's declining traffic. Management is saying that the restaurants are full and have been for years, making increasing traffic pretty difficult. This is due to BJ's being a casual dining establishment. In the quick service and fast casual segments, increased traffic comes with increased throughput. But rushing customers at casual dining establishments could have the opposite effect of angering customers who are looking to have some leisure time out.

So while one might look at declining traffic as signs of a weak brand, I see a restaurant filled to capacity at peak hours as signs of a strong brand.

Moving on to location selection process, we have seen BJ's struggle here in the past. Back in the second quarter of 2013, CFO Greg Levin had this to say:

" most of our newer restaurants, while generating strong top line sales and therefore solid returns on shareholder capital, tend to slightly cannibalize nearby BJ's Restaurants."

This might sound good with "solid returns on shareholder capital," but at the time the company had just 136 locations in 15 states. There was no excuse for cannibalization at that stage in BJ's growth. Since that time BJ's has branched out into nine new states, and growth in California and Texas - the company's two biggest markets - has slowed considerably.

To be sure, cannibalization is a big deal. But while cannibalization is important and something worth watching, even more important is for BJ's to elect new locations that will allow its impressive average unit volumes - AUVs - to continue.

Over the past several years, average unit volumes have been increasing. In 2016, AUVs hit $5.5 million. Now, had AUVs declined steadily as BJ's expanded, you'd have to question management's location pipeline. But the ability to grow restaurant count double-digits annually while keeping strong AUV is a good indicator to me that location selection process has improved in recent years.

Finally, we need to ask if BJ's Restaurants is financially strong. Answer to that is a resounding yes. Cash flow for 2016 came in at $138 million. But great cash flows don't really mean much if management doesn't know how to use them. BJ's management is making great use of cash flows by investing them back into the business.

BJ's is primarily investing cash flow by opening new locations. Locations grew by 10% in 2016. These locations are excellent use of shareholder cash as current restaurant level cash flow margins are over 18%. What is also truly remarkable is that the company grew by double-digits using only cash flow, and still generated $30 million in free cash flow.

BJ's is investing free cash flow and using debt to buy back shares. In 2016, the company bought back 2.5 million shares. Since early 2014, the company has bought back nearly 8 million shares and it continues to be a part of management's ongoing plan to create shareholder value. Currently the stock has a float of almost 22 million shares.

Now, this company was debt-free until 2014, which I always saw as a positive. But debt today sits at $148 million. What's curious is a lot of this debt has gone to repurchasing shares. In a lot of ways it's a shareholder friendly move as the debt boosts earnings per share and interest rates have been at an all-time low. I'm still not a huge fan of the idea, but overall BJ's is still in a great position to meet all of its financial obligations.

So what now?

In answering our first two questions, it does indeed look like there will be some casualties in casual dining. And BJ's is in a great position to capitalize on its competitors' weaknesses. Whether or not the company executes its plan when that time comes is another question altogether.

In the meantime, considering the reduced expansion, what can investors expect from BJ's stock performance? To help us forecast this, we need to keep in mind that in the earnings call, management said that share buybacks looked good for capital allocation.

Let's assume that cash flow for 2017 comes in just a notch higher than 2016 (since there will be a bigger restaurant base) at $140 million. Pre-opening costs per restaurant are just over $400,000. Since the company will be opening seven less restaurants, that's a savings of $2.8 million. Considering 2016's free cash flow was $30 million, maybe BJ's will generate around $35 million in 2017.

If BJ's took every dollar of that free cash flow and bought back its stock at today's prices, it could buy back over 930,000 shares. That is 4% of the company's current float.

The company could also tap its credit line to go further into debt, which I don't think is a great idea. It does have a cash position of $22 million, but given the industry hardships of 2016, I think it's best for the company to hang on to that for a little security.

Trading around 20x trailing earnings, BJ's isn't overly expensive. But the company is slowing its growth plans as well and doesn't deserve a premium priced stock. Given small growth but factoring in the positive nudge from share buybacks, I think it will be difficult for BJ's to achieve 10% earnings growth in 2017.

In reality, it seems like BJ's could trade sideways for the time being. In no way is it a weak company, but given what we've seen, I don't think it's a buy. I'll be interested in checking back in with this company next year to see if this supposed shakeout is over and how BJ's begins capitalizing on it.

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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