Buffalo Wild Wings, Inc. (BWLD) - Our Conclusion:
At the moment, based on management's statements on the Q4 conference call in early February and their appearance at UBS' conference in early March, we suspect that sales trends have "stabilized", which is our term. If we read the "body language" correctly, sales were better in January than in Q4 (though might have still been down modestly), then February was weak again, industry wide. However, January and February turned out, March Madness comes a little earlier this year, and management seems cautiously optimistic that trends will improve at least modestly from the dismal Q4'16 level. Based upon the stock action, today, Monday, 3/20, perhaps the mid-Madness weekend wasn't great, but it doesn't change our thesis. Furthermore, we hear, from "channel checks", that there is at least modest interest from existing franchisees to expand territory, so BWLD could have some success in their re-franchising effort. In the meantime, the balance sheet remains under leveraged. Per the Q4 conference call (linked below), the company expects free cash flow of $160-170 million in '17, and expects to buy back $450-500 million of stock, after repurchasing $232 million in '16. Since the current market capitalization of their equity is about $2.7 billion, the buyback in '17 (at $475M) would be about 18% of the shares outstanding, if shares can be bought at this price. Since the enterprise value of BWLD is approximately 10x trailing EBITDA, we consider the valuation to be reasonable. This no doubt reflects the company's weakened competitive position over the last several years, but could prove to be a long term bargain if operational improvements can in fact be implemented. We believe the reward/risk ratio is attractive at current levels.
Buffalo Wild Wings Inc. is the owner, operator and franchisor of Buffalo Wild Wings restaurants (its principal concept) in the bar and grill sector. The signature specialties are boldly flavored made-to-order chicken wings and a wide selection of domestic, imported and craft beers. The restaurants are designed to have a neighborhood feel with extensive multi-media systems to appeal to both sports fans and families. In 2016, BWLD's 1,240 system stores (631 company, 609 franchised) generated sales of $3.8B (of which 20% was from alcoholic beverages), mostly in the US and Canada, but also in Mexico, Saudi Arabia and the Philippines. The typical company-owned store built in the last 3 years is 6.1K square feet, while the sizes of all company stores range from 3.9K to 11.2K sqft and generated $3.1M annually, on average. The AUV of franchised units in 2016 was $3.3M, 3.8% higher than company stores. At an average cash investment of $2.6M (including pre-opening expense), our estimate of cash-on-cash returns is ~22% for company stores (assuming the 5-year average store level EBITDA margin of 18.5%).
For the 5 years 2011-2015, before the relative weakness during 2016, the company grew rapidly and profitably. Unit growth CAGR of 10.0%, combined with 20 consecutive quarters of positive comps averaging 5.5% for both company and franchised units, drove revenues, EPS and Free Cash Flow at CAGRs of 24.9%, 19.2% and 31.9%, respectively. In 2015, signs began to appear that the brand is maturing and confronting a new set of challenges to sustain growth. While sales continued to grow, it was driven mostly by new store growth, as comps slowed on weakening traffic. Margin expansion also slowed. As reflected in the comps table at the end of this note, comps in 2016 grew increasingly negative for both company and franchised units throughout the year. Initially, the decline was offset by price increases in the 4% range YOY, but traffic continued falling in the 5.5% range. In 16Q4, despite a price increase of only 1.4%, traffic still fell 5.4%. Both the company and franchisees slowed store growth to 5.5% in 2016, down from the HSD-LDD pace in earlier years. Profitability also fell. Store level EBITDA margins fell to 17.7%, down from 19.4% in 2014. Consolidated EBIT at $136.7M in 2016 was down from $138.5M YOY and EBIT margin at 6.9% was down from its recent peak of 9.0% in 2014. (Consolidated EBITDA, with lower proportion of fixed expense, has continued to grow, although the 2016 EBITDA margin at 14.5% in 2016 is also below the recent peak of 15.4% in 2014.)
At its 2016 Analyst Day, management laid out its long term plan. The plan targets a system of over 1,700 BWW units in the US and Canada and expects to sustain revenue and profit growth with continued menu innovation, investment in service improvements (eg "FastBreak" lunch, "Guest Experience Captains" and payroll increases), upgraded store formats (the rollout of "Stadia" entertainment design), technology (a system-wide POS with a platform for table-top ordering and gaming devices and for online & mobile ordering apps), and loyalty programs (eg "Blazin Rewards" program launched in 2015). The company is also exploring investments in emerging restaurant brands and has a minority interest in Pie Squared Holdings, operator and franchisor of PizzaRev, a California-based fast-casual pizza restaurant concept, as well as rights to operate PizzaRev restaurants in certain states. It also has a majority interest in Rusty Taco, Inc., a Texas-based fast-casual street-style taco restaurant with both company-owned and franchised locations operated under the R Taco banner. At the end of 2016 there were 8 R Taco units and 2 company owned PizzaRev units (operated as a franchisee).
Though the company has levered up in the past year, it is still strong financially, with a solid balance sheet. The company has noted that its leverage is lower than all but one (NASDAQ:TXRH) of 14 casual and family dining peers (especially the heavily franchised). As such, it announced a more aggressive capital strategy to increase share repurchases and possibly initiate a dividend, to be financed by higher debt as well as internal cash flows. It adopted a new leverage target of 1.5X debt to EBITDA, and in early October expanded its credit facility to $500M. At the end of 2016, the ratios of debt to EBITDA and lease-adjusted debt to EBITDAR is 0.7X and 2.4X, respectively, well below the leverage ratios of 50% or less franchised peers. In 2016 cash flow from operations was $285.8M, which, net of $119.4M capex, left free cash flow of $140.9, or a FCF margin of 7.1%. Together with debt, these cash flows financed $232M of share buybacks in 2016.
In BWLD's 16Q4, system-wide sales increased 0.8% to $941M, with unit growth modestly outweighing the same store sales decreases of 4.0% and 3.9% at company and franchised stores respectively. Company revenues were also up 0.8% in Q4 to $494M, with growth in units once again offsetting lower royalties and company store revenues. Menu price adjustments taken during the TTM were approximately 1.4%, so traffic was down about 5% in both company and franchise locations. Average weekly sales at company owned locations were also lower. Cost of labor In company stores labor was 90 bp higher, to 31.8% of sales. Unfortunately, contrary to most other restaurant chains, cost of goods was higher as well. CGS was up 160 bp, to 31.1% of sales, reflecting higher chicken wing prices which were up 9.9% to $1.99 per pound in Q4. Operating expenses were 30 bp higher, as were occupancy costs. Restaurant level EBITDA (which most restaurant companies call "profit") declined a fairly dramatic 300 bp to 15.6% of restaurant sales in Q4, the worst quarter of the year (which was down a more modest 90 bp at 17.7%). Free cash flow in the quarter was $44.8 million and $126.9M of stock was repurchased in Q4.
The sales weakness in Q4 was obviously not a big surprise and reviving sales momentum is now "job 1". As pointed out in earlier notes, the company's reliance on price to support comps has likely contributed to the traffic declines. In 2014, quarterly company and franchise comps averaged a fairly steady 6% and 5.3%, respectively. However as 2014 progressed, the YOY pricing for company-operated units tended to increase while traffic held fairly steady at around +4.5%, until Q4 when it dropped to +2.5%. In 2015 the trend continued, as YOY price increases averaged around +4%, but comps steadily dwindled due to falling traffic, dropping to negative 3.1% by Q4 when comps were +1.9% (and price 4.0%). These trends worsened throughout 2016, no doubt due to general competitive pressures and ongoing macro conditions. Additionally, a dip in the number of NBA NHL playoff events and sluggish NFL interest this past fall (despite an unusually exciting 7-game NBA finals), as cited by management, may have also contributed to the decline in traffic. Price increases creating customer pushback likely oversimplifies the cause of the declines, as some of the price increases reflect a variety of menu adjustments, such as introduction of a greater variety of higher-priced alcoholic beverages. Still, it seems likely that factors other than price (service?, food quality?) have contributed to the loss of traffic over several years. Pricing and traffic information isn't available for franchisees, but franchisee comps (as shown in the table below) are lower than company units, suggesting even more severe traffic declines than with the company units. Further, symptoms of deeper issues may be indicated by the slowdown in franchise investment. Franchise unit growth in the past 2 years, which had kept pace with company store 50 unit annual rate, dropped to 42 units in 2015 and only 30 added in 2016. These figures exclude the approximately 50 franchised units the company repurchased in 2015.
In terms of plans for 2017, 15 company owned units will open, all in the US. Franchisees will open 15 locations in the US and 20 units internationally. The company estimates that same store sales will grow at 1-2%, restaurant level margin (EBITDA) will improve 20-30 bp, chicken wing prices will rise by 3.5-4.5%, operating income growth will be 9-11% over 2016 (including the 53rd week), capex will be about $100M, share repurchases will be $450-500M, free cash flow (before share repurchases) will be $160-170M, and earnings per diluted share will be $5.60-6.00. Our assumption is that the eps guidance is before the effect of share repurchases.
To revive comps and traffic, management is looking to UFC and soccer to expand BWLD's customer base, both initiatives that play to its experiential strengths. The fifteen minute ("guaranteed", or free) lunch generated positive comps at that daypart in Q4. We have in the past expressed our doubts about the profitability of that effort, but at least it has attracted some old and new customers. Half-Price Wing Tuesdays have been effective, obviously dealing with the value perception problem. 480 locations now provide the Blazin' Rewards loyalty program, with full rollout expected by the end of Q2. Third party delivery was installed in 100 company locations in Q4, and the check is 30% higher than normal takeout. A "boneless blitz" on December 14th, promoted entirely on social media, was essentially a BOGO promotion, and "generated an extraordinary increase in sales and traffic." Overall, the Company obviously has to achieve a balance between "every day value" and a Limited Time Offer cadence, at the same time improving service and quality. The initiatives described above, and others, point to an intensive effort to improve the competitive position. In terms of store development, a smaller version of the recent 5,400 sqft prototype will be among the 15 new company units to be built in 2017. The "Stadia" remodel will be implemented in 23 company locations as well. Lastly, possibly in response to Marcato Capital's suggestion (described below), management has announced its intention to franchise about 50 current company locations.
A significant development in recent months has been the position taken by Marcato Capital, last reported at 5.6% of the equity in BWLD. While the Company goes about its business to improve sales and profitability trends, Marcato has issued a number of "white papers", of course pointing out their opinion that the company has not performed well operationally, creating a stock that is undervalued relative to its potential, and making a raft of suggestions to improve the situation. Marcato points out that top management has consistently sold the stock earned through option grants ASAP, has hardly ever bought stock in the open market, and has presumably been less than astute in reacting to industry wide and concept related operational issues. Predictably, Marcato feels that returns to shareholders can be enhanced through leveraging the historically conservative balance sheet. They have also encouraged BWLD to adopt the currently "fashionable" asset light model of franchising, with the objective of selling off company operated locations, using the proceeds for dividends and share repurchases. We discussed this approach in a previous BWLD note, on December 7, 2016, basically saying that it doesn't seem like a great idea to sell the essential company assets, namely the company stores, at what could prove to be the bottom of their operating performance. Lately, Marcato's approach has included the nomination of four new Board Directors. Responding to Marcato's suggestions and "agitation" is no doubt a distraction of sorts, but we view it generally constructive for the broad shareholder base. Management is clearly focused on improving the operating trends of the last twenty four months. Any reasonable degree of success on this front should take BWLD materially higher. The presence of Marcato, and possibly other activist investors provides a degree of downside support, and a takeover bid at a premium price remains a possibility. We elaborate on this conclusion at the beginning of this discussion.
Disclosure: I am/we are long BWLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.