Of the ten fast food companies we follow, shares of Del Taco (NASDAQ:TACO) appear to be the most timely from a contrarian, value-oriented perspective. Several weeks back, we upgraded the stock to our highest "3" rating around $10 per share and their recent third quarter earnings report has dropped the shares to the $8 level. The selling looks overdone.
Del Taco is a slow-growing regional fast food chain with nearly 600 locations nationwide split roughly evenly between owned and franchised. Management has focused over the last five years or so on increasing average ticket by tiering their menu so as to not simply be seen as the lowest cost, most value-centric brand in the category. The results have been impressive, with average unit volumes rising $1.2 to $1.5 million. As pricing and menu mix has shifted higher, though, some lower-end customers have reduced visits, so same-store sales are rising despite overall traffic declines.
This near-term trend has presented an opportunity for investors. We estimate that 2019 EBITDA will come in around $60 million, giving the stock an EV/EBITDA ratio of just 7.5x with a modest leverage ratio around 2.5x. This compares with fully franchised peers like Jack in the Box (JACK) in the 13x EV/EBITDA range as well as other mixed system comps such as El Pollo Loco (LOCO) around 9x.
As a general rule of thumb, owned and operated chains fetch around 8x EV/EBITDA and global fully franchised players can be in the 15-20x range. Mixed systems are harder for investors to pinpoint, and therefore sometimes track toward the low end of the range, despite the fact that having lots of franchised units often results in less operational risk and better execution via local ownership. As a result, valuations in the 10-12x EV/EBITDA area are rather normal for chains that are split near 50/50 between owned and franchised units.
As for TACO, we believe fair value is at least the low end of that range at 10x EV/EBITDA, which equates to about $12.50 per share. With LOCO trading around 9x, we see no reason to think that TACO should be 1.5 turns below that level. Right now, Del Taco stock trades for a price that implies a 100% owned chain, despite the fact that franchise mix will rise above 50% in 2020 after the company sells off its West Coast locations.
To give readers a sense as to how cheap the stock is today, we like to calculate "steady state free cash flow" which is simply free cash flow generated from the existing system of restaurants assuming no new company-owned locations are built. Put another way, free cash flow plus capital expenditures for new unit buildouts. Over the past three years, on average, this figure comes to roughly $33 million annually. With just 37 million total shares, TACO today trades for just 9 times annual free cash flow ex-new development costs. Should the company ever be sold, we think a buyer would gladly pay a premium of 50-75% above that level.
Even without a buyer, we would expect development to slow down in the future as franchising more is a corporate focus. Along with refranchising proceeds and continued profitability, we would guess TACO management will reduce debt further and buy back stock over the coming 12 months. Assuming relative stability in the business, we do not think the stock will stay at a valuation of 7.5x EV/EBITDA or 9x recurring free cash flow. As a result, the recent weakness is giving investors a chance to buy cheaply at new 52-week lows. We reiterate our upgrade from earlier this month and expect the stock to get back into the low-double digits over the next 12 months, for gains of at least 50% from current levels.
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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.