Famous Dave’s (DAVE) – Initiating at Neutral “2” Rating

Today we initiate coverage of casual barbecue chain Famous Dave’s (DAVE) with a neutral “2” rating.

Famous Dave’s has had trouble competing in the restaurant industry even as the economy has been recovering since the Great Recession. After peaking at 194 locations nationwide at the end of 2013, DAVE has been shrinking considerably, with only 147 units open as of the most recently reported quarterly period.

When we examined the company’s financials it quickly became clear that the business model is seeing rapid margin erosion and that company-operating locations are actually barely earning a profit on a four-wall basis, before accounting for any administrative expenses.

Consider that in 2007, 44 company-operated locations collected $108 million of sales and earned four-wall margin of $15 million, a 14% margin. While below publicly traded peers, such margins are sustainable provided that administrative costs are held in check and there is not a large debt load that is expensive to service.

Fast forward to 2017 and company-operated units had dropped to just 16, which collectively brought in sales of $49 million and earned four-wall profits of just $1.8 million, for a margin of 3.6%. Simply put, as the business model stands now, the company cannot profitably run their locations, as indirect costs would far exceed their sub-4% four-wall margin.

This helps explain why the company has been refranchising company-owned locations in recent years. Owned locations peaked at 54 in 2013 and have since been cut by 70%. It is concerning that the 16 remaining locations that DAVE held onto are still earning sub-par returns. After all, typically companies will sell their worst units and keep the cash cows. In this case, there appear to be few, if any, cash cows.

Today, DAVE is a 89% franchised chain (131 out of 146 locations owned by franchisees), which will reduce costs, operational risk, and maximize overall firmwide margins thanks to high margin, recurring royalty income. The obvious issue, however, is whether the franchisees can operate the locations more profitably than DAVE’s management could. After all, with a 5% royalty rate on gross sales, a franchisee would be losing money if their locations earned sub-4% four-wall margins.

In fact, it appears that many franchisees are struggling to operate profitably. Since 2013, the company has shed 37 locations, either via outright closure or sales to franchisees. However, over the same time period, total franchised locations have shrunk from 140 to 131. Normally, refranchising efforts result in fewer owned units and more franchised ones, relative to the starting point. With both owned and franchised locations dwindling in number, it appears to us that the fundamental business, regardless of who is running the restaurants, is in questionable health. This view would be disproven if franchised locations stay flat, or ideally, begin to grow.

From a financial health perspective, DAVE appears on fairly strong footing. The refranchising effort has allowed the company to boost its balance sheet quite handsomely. In fact, as of 9/30/18, cash onhand exceeded debt by about $1 million, making leverage a non-issue.

At the current stock price of $4.50 per share, DAVE is being valued in the market at roughly $40 million. We would expect 2018 full year EBITDA (earnings before interest, taxes, depreciation, and amortization) to come in around $6 million, giving the company an EV/EBITDA multiple of less than 7 times, extremely low for a mostly franchised business.

The two biggest questions for investors, in our view, are:

1) Can the company maintain its current location counts and profit levels, or will be chain continue to shrink?

2) What is the right valuation multiple to assign the business, relative to its outlook for growth?

On the first question, we have our doubts and would want to see tangible evidence that franchisees are making money and that the odds of future new unit development are higher than a further shrinking of the chain over time.

As far as valuation, we would likely value a stagnant chain of this caliber at about 10 times EV/EBITDA. If annual EBITDA was $6 million, this would equate to a stock price of about $6.75 per share, or an impressive 50% above current levels.

The reason we are not ready to assign our highest “3” rating, however, is because we do not have a high level of conviction that DAVE is on the path to maintain or increase its current 147 location system size. For those that do believe such a level is sustainable, the stock is very cheaply priced and likely has 50% or more upside potential in the intermediate term (1-2 years).

To give you an idea of what things could look like if the company contracts further, a 10x multiple on $5 million of annual EBITDA equates to a stock price of $5.50 per share. EBITDA of $4 million gets you to the current price of $4.50.

Accordingly, the current market price for DAVE assumes that $6 million or more of annual EBITDA is not sustainable long term. For those that disagree, the stock is undervalued. While we admit the bar is not set very high at all, our lack of conviction as to DAVE’s future prospects makes it hard for us to justify a “3” rating, even though we acknowledge that plenty of upside exists should the company execute well going forward.

We will continue to monitor operational progress at DAVE and will be sure to update investors to all material news releases in the future. Please let us know if you have any questions, or would likely any clarification with respect to this coverage initiation report.