Dave and Buster’s (PLAY) Initiate at “2”

Today we are initiating coverage of dining and entertainment chain Dave and Buster’s (PLAY) with a neutral “2” rating. From a fundamental prospective we like the company’s unique business model in a crowded dining and entertainment sector, but the shares have rallied sharply from the high 40’s to the high 50’s since their last quarterly earnings report, which gives us pause due to what now appears to be a full and fair valuation. Should the stock decline, we would be looking to upgrade at an attractive price (around the $48 level or so), given PLAY’s market positioning and current growth trajectory.

We have not covered PLAY in the past, due mainly to the fact that more than 50% of revenue (>57% in 2018) comes from games and entertainment, as opposed to food and beverage (>42% in 2018). However, given our shrinking coverage universe (due to continued M&A activity), we are expanding our reach and feel PLAY fits nicely into the theme of consumer entertainment experiences. Just as a night home streaming Netflix and ordering in can provide a more than satisfying consumer experience, we believe PLAY locations offer a similar balance of food, beverage, and fun.

Very quietly, PLAY has grown at roughly 10% annually in recent years, doubling its location base from 61 in 2012 to 121 at year-end 2018. Such growth is poised to continue, as the company sees an eventual market opportunity of 230 units in the U.S. and Canada alone. PLAY is also testing out different box sizes for its locations, as traditional mall locations in big cities are getting saturated. A smaller location in medium sized cities can still bring something new and exciting to the area, along with strong returns on capital.

We like how PLAY stacks up in two core areas; unit economics and further growth potential, whereas valuation is fair given the recent share price appreciation (~20% in recent weeks).

First, PLAY is earning EBITDA margins in excess of 20%, well above that of traditional restaurant chains. This is due to a higher markup on food and beverage (much like the cinema sector, but not as egregious), as well as strong pricing power given the selection of gaming options within their locations. Due to the self-service nature of much of the gaming offerings, labor costs also run lower (sub-25%) on a unit-level basis. We like the strong unit economics, which resembles the movie theater model, but unlike the movie space, PLAY should be able to create an environment that is harder to emulate at home, which is AMC’s challenge with Netflix, etc.

Second, we see no reason PLAY cannot continue to grow units 10% annually, given they are relatively small (121 locations vs thousands of movie theaters, for instance). With more than 350 million people living in the U.S. and Canada, PLAY can double its location base and still only have one for every 1.5 million residents, which is far from market saturation. The company could reach that size by opening 15 locations per year for the next 8 years.

Lastly, with regards to the valuation of the stock and the ability of them to grow the business within current cash flow, we find the current price full and fair. We estimate that PLAY’s existing unit base generates roughly $180M-$200M in free cash flow. Construction costs are being supplemented by impressive tenant allowances offered by landlords ($40-$50M annually), which allows PLAY to grow without issuing more debt or equity. In fact, the company actually generates roughly 5% of revenue in free cash flow each year, after accounting for new location buildout costs. This allows them to repay debt and repurchase shares, to create more shareholder value than unit growth alone would provide. Leverage is reasonable at less than 1.5x annual EBITDA today, so stock buybacks should continue.

At the current price of $58 per share, PLAY trades for about 12x our estimate of existing unit free cash flow ($2.2 billion equity value against $180-200M of FCF), as well as around 9x EV/EBITDA, slightly above the dining sector average. Given that PLAY offers more growth potential, higher margins, and less competition, on average, relative to traditional restaurant chains, we would be attracted to the stock if we could get it for 8x EV/EBITDA, or around $48-$50. The reason we are being a bit picky here is because the company does tend to locate units near large shopping centers, and enclosed malls are seeing traffic pressures. We think their non-traditional model of games and food will set them apart from many dining establishments, but at the same time we don’t expect the company to maintain a premium valuation consistently due to mall traffic concerns among investors. As such, we think it is a good play (pun intended) but only at the right price.

As a result, we like the risk/reward of PLAY in the high 40’s but a recent rally to $58 puts our initial rating at “2.” We would peg fair value in the $60-$65 per share range based on current financial projections, and will upgrade accordingly should the stock price fall back in the near to intermediate term. Quarterly earnings have tended to be unpredictable and more volatile compared with peers (our guess is due to less guest frequency given higher spend per visit versus traditional restaurants), so it is quite reasonable to expect there will be attractive opportunities to take a more constructive view of the shares in the future.

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.

Initiating Coverage of Biglari Holdings at “3”

We have been looking for companies to add to our coverage since our universe dropped below 40 some time ago. Today we are adding to that group by initiating shares of Biglari Holdings (BH) at our highest “3” rating. While we have monitored BH for a long time, and chose not to cover it due to the company’s desire to become more than a pure-play restaurant play, we believe recent events coupled with a dramatic share price decline (current price $206) offer a unique opportunity.

BH began as a holding company for the Steak N Shake (SNS) brand, a midwestern born burger chain with more than 400 owned locations, 200 franchised units, and roughly $800 million of annual revenue. Since then it has added two hedge funds, managed by CEO Sardar Biglari, as well as some smaller divisions (insurance and publishing). By far the two largest assets are SNS and an 18.15% stake in publicly traded Cracker Barrel (CBRL) — currently rated “2” by DSO.

Despite other businesses, the intrinsic value of BH (and hence the stock price) is really driven by operating results of SNS and CBRL. SNS has recently seen its business slip quite a bit, with EBITDA margins falling over 8% in 2016,m to 4% in 2017, and to 3.3% during the first quarter of 2018. While CBRL’s stock price had held up well, BH shares at $206 each imply a total equity value for BH of some $650 million. It is this valuation that caused us to bring the name to our subscribers’ attention now.

Given that CBRL is public, it is very easy to value BH’s 18.15% stake. At the current price of $165 per share, BH’s ownership is worth $721.5 million, or roughly $230 per BH share. Put another way, the market is now valuing the rest of BH (everything but the CBRL stake) at negative $71.5 million.

We would value SNS at 8x EV/EBITDA, which based on 2016 operating results would add another $109 to BH’s per-share value. However, as sales and margins have dipped over the last 12-18 months, that valuation equated to just $22 in 2017 and if Q1 2018 margins hold for the rest of this year, only $7 per share. We suspect it is reasonable to think that SNS will be able to regain some of its profitability due to sales initiatives, but to be conservative will assume a long-run EBITDA margin of 4%, equal to 2017. After all, labor cost increases in recent years are almost certainly permanent.

Taken together, BH’s 100% ownership of SNS and its ~18% stake in CBRL would then be valued at $252 per share, about 22% above the current price. In addition, CBRL pays a $4.80 annual dividend, of which BH’s share is $21 million, or another $6.67 per BH share.

As you can see, BH stock appears to be materially mispriced at present. Accordingly, we believe it is worthwhile to initiate coverage at “3” today.

Initiating Coverage of Freshii at “2”

With the JAB Holdings acquisition of Panera Bread Company having closed this week, we have decided to add a new company to our coverage universe.

Freshii is a fast casual chain focused on healthy food that offers a variety of dishes such as bowls, wraps, burritos, salads, and soups. The chain’s first location opened in 2005 and after years of fast growth currently has over 300 locations globally, with 99% owned and operated by franchisees. Unit growth continues to be torrid, with over 150 units expected to be opened in 2017 alone and >800 system-wide locations expected to be in operation by the end of 2019.

Freshii went public in January 2017, selling shares at $11.50 (CAD) on the Toronto stock exchange. Investors can buy the Canadian listed shares under the symbol FRII.TO or opt for the U.S. dollar denominated over-the-counter stock trading under the symbol FRHHF. The stock soared in the early days post-IPO (peaking at over $15 CAD) and has since dropped by roughly 30%.

Perhaps the most interesting thing about Freshii’s business model is their focus on keeping build-out costs extremely low for franchisees. The company targets an initial cost of $260,000 in local currency to build a new location and that includes the franchise fee. Such a low cost is relatively unheard-of in the restaurant sector (A typical Chipotle unit costs 3-4x as much to build, for instance). This low cost is attainable because of the company’s goal of offering only the freshest, most healthy food offerings. As a result, a Freshii location does not require any ovens, grills, fryers, freezers, or microwaves. Such limited equipment requirements makes it very easy for franchisees to open relatively small units for a lot less money than competitors. This is clearly a unique competitive advantage.

While Freshii appears to be a unique concept, the chain does face challenges. The food offerings, while creative and healthy, are likely most suited for a younger, more urban customer. That niche market will limit the company’s ability to blanket the world with units and generate high per-unit sales. In fact, the average Freshii location produced less than $500,000 in revenue in 2016. Those economics can work fine due to the low start-up costs, but it does mean that high volumes are not the goal here. As a result, location selection will be the key to the chain’s success. Overbuilding and/or choosing locations lacking the core target customer are likely to be problems for franchisees.

Another challenge for Freshii will simply be the pressures that come with being a young public company. Management has already guided investors to more than 800 locations globally by the end of 2019, but it is equally important to open high quality, profitable locations as it is to “hit the numbers” for public investors who grade you every three months. The risk here, of course, is that they step on the gas to hit their targets for new unit openings and in return become less rigorous in their process for green-lighting proposals from franchisees.

Shortly after the IPO, when Freshii stock was trading well above the initial price, the shares did not seem to offer much value to investors. For instance, at the end of the first quarter there were roughly 300 locations open. At a build-out cost of $260,000 each, that would imply roughly $80 million of hard assets, versus a company that was valued at $450 million at its peak shortly after the IPO. Such a disconnect, which afforded most of the company’s value to units not yet in existence, would have garnered a “1” rating from us. However, the recent stock price decline has brought things closer to reality.

We are initiating coverage of Freshii with a neutral “2” rating based on the belief that the concept is unique and clearly has a place in the market. It remains unclear how large that market is, and whether the chain can maintain its early success as it grows larger over time, but the low build-out cost should attract plenty of interested franchisees.

At current prices, the market is valuing Freshii at $250 million USD. The company is guiding investors to 2019 system-wide sales of $285 million USD, on which they expect to earn EBITDA of $16 million USD. While ~15x EV/EBITDA based on 2019 estimates is not cheap (hence no “3” rating), we no longer think the company’s valuation is excessive given their growth aspirations. We think after several more quarters of publicly filed financial statements are released, it will be a little easier to gauge sustainable profitability levels and therefore get a better handle on the valuation.

At the very least, Freshii is a new, exciting concept with lots of potential within certain customer demographics.  It should certainly be on dining stock investors’ radars, and therefore we are pleased to begin coverage today.