Thursday, February 20, 2014

La Cucaracha

BJs Restaurants (BJRI) was a growth stock darling for years. Between 2004 and 2011, BJRI traded at an average forward P/E of 37 times. Prior to the 2009 market collapse, its average NTM P/E was a hefty 48 times. Investors loved both 20-25% earnings growth and average units volumes that rose from $3.8MM to $5.7MM (square footage growth played a role).

So much for that. After an impressive 41% increase in 2011 (including a 53rd week), operating income fell 2% in 2012 and another 42% in 2013. Earnings have missed sell-side estimates six quarters in a row. Earnings misses are like cockroaches--see one and you are sure to see more. Investors who sold when the first cockroach appeared avoided a 57% slide in the stock.

Management has attributed revenue shortfalls to the following: customers staying home to watch the Summer Olympics, customers staying home to watch the political conventions and Presidential debates, intense price competition from mature casual dining chains, renewed unit openings from previously stalled competitors, competition at lunch from Chipotle, Panera and other fast casual chains, hot summer, cold winter, other severe weather, high gas prices, low movie attendance, higher taxes in California, pressure on comps from longer honeymoon periods, industry-wide restaurant sales weakness, fewer shopping days between Thanksgiving and Christmas, increased online shopping, and overlapping high school and college graduations in California.

To counter the above, BJ's has done the following: created a Beer Master program, added hand-tossed pizza, added television in some markets, added a rewards program, increased coupon mailings, tried a co-branded limited time offer, worked to increase speed of service, and cut back the total number of menu items while adding more sub-$10 options and healthier entrees.  Management plans to reveal the complete turnaround plan at a February 27 Analyst Day.

Change underway but little to show for it

BJ's has a new CEO and change is afoot. As the above list makes clear, management is trying a lot of different things to halt the slide in traffic, but these efforts have not come to much. The company's commercials were awful and likely did more to hurt than help the fledgling brand. If they had not been removed from BJ's You Tube channel, I would have embedded one here. Videos for The Big Poppa's Smokers LTO were also deleted. Management has a new creative ad agency and plans to introduce new ads this quarter. The company is also looking for a new Chief Marketing Officer. Good or bad, TV is a red flag for a nascent brand. Done wrong, it can be a margin-killing treadmill. Thus far, increased marketing spend has hurt BJ's margins without adding traffic.

Management also increased the use discount coupons. This too can be a brand dagger. Done wrong restaurant coupons signal desperation, shift the focus from experience to price, and attract bargain-centric, unlikely-to-be-loyal customers--another treadmill that can end poorly. Coupons can make the relationship with customers almost adversarial.

Management is working to simplify and streamline both the menu and food prep. The number of menu items has dropped from a CAKE-like 180 to 151. The company has pushed hard to grow the lunch day part albeit with a strong price emphasis--$5.95. A Two Can Dine for $20 deep dish pizza in-unit promotion encouraged customers to trade down and did nothing to lift traffic. New menu items like hand tossed pizza fizzled. A low price, $6.95, Brewhouse burger is currently being promoted and this is also having negative impact on average check. A new menu will debut at the beginning of March.

Management has high hopes for a new order-and-pay by smartphone or tablet option that will rollout later this year. They believe this could reduce table turn time from one hour to forty minutes and thereby reduce weekend lines and make BJRI's relevant to more occasions including lunch. I do not know if this will be a traffic driver but it sounds cool and I do hate waiting for the check.    I wonder if it will require a roving house geek to solve customer IT problems and how waiters will know if departing customers actually paid.

The brand means--CAKE with beer?

I don't know what BJ's brand means--beer is part of it. The concept does not lend itself to something clear cut like Buffalo Wild Wings--Wings, Beer, Sports. The new CEO appeared to be struggling with this in his first couple conference calls. It is fair to assume that the brand answer will be part of the analyst day presentation. The company's current tag line-- "Wow! I love this place."--is almost a rebuttal. "I thought it was going to suck. What a surprise." A new campaign will kick off next month with a new tag line: "At BJ's, we are pursuing amazing!" Let me know when you get there.

BJ's started out as a chain of pubs near beaches in California then evolved into a brewpub with in-house brewing and more recently into a Cheesecake-like upscale casual diner with a similar long menu but lower prices and a lot more beer. Management describes the concept as casual-plus--Cheesecake's quality at Chili's prices. Read that however you want.

Yard House, also based in Orange County and now owned by Darden, appears to be a BJ's knock-off. It has fully embraced beer as its defining element along with a "state of the art" sound system that blasts classic rock "hand selected" by its founder and former Huntington Beach bartender, Steele Platt. Yard House is using Darden's cash flow to expand quickly including in some BJs' markets in Florida and California. The average check is above $20 versus BJ's $14 but the atmosphere is comparable.

Like BJ's, Yard House tends to open in malls, on pads outside malls, and in the middle of chain-restaurant row. This expansion strategy may be part of the problem for BJ's as these locations clearly brand the units as chain restaurants. "Chain" is a huge obstacle to making any restaurant appear even vaguely cool or hip. This is hard to correct after the fact. BJ's only gets to enter a market once. Approximately 40% of BJ's locations are in malls or on pads outside malls.

Sharing a growing number of markets with Yard House isn't going to help BJ's turnaround. Since the primary point of differentiation between the two is price, the natural tendency may be to use a price centered marketing message which could harm the brand (whatever it means). That said, market overlap is limited at this point.

BJ's Valuation Conundrum

BJRI now trades at 52x my 2014 estimate of $0.51 or at 40x the consensus estimate of $0.66. Either way, that is pretty expensive for a stumbling turnaround story. Total enterprise value to EBITDA (LTM) now stands at 10.4x.

The 2012 earnings decline re-branded BJRI for investors as a broken growth-stock. Thus, its prior share price and P/E became somewhat irrelevant. Investors aren't going to pay a premium for growth if the growth isn't there. Then with the steeper slide in earnings last year, BJRI became a turnaround story.    Until there is evidence of a turn, investors might reasonably be expected to use private market value as a valuation guide. When earnings are falling or stumbling around, P/E is kind of useless. And with BJRI in particular, P/E is even less helpful because it has huge non-cash expense in the form of depreciation.

Private market value is easy to at least ballpark for BJRI because a fairly direct comparable, PF Chang's China Bistro, went private in 2012 and this year Chuck E Cheese accepted, but has not closed on, an offer from Apollo. PFCB was sold for 8.5 times EBITDA and Apollo's CEC offer equals 7.5 times. This range suggests that BJ's private market value, using 2013 EBITDA of $73.7MM, is more or less $19-$22. Note that EBITDA did not fall as much as EBIT in 2013 because DA (depreciation and amortization) exceeds EBIT (earnings before interests and taxes). Using 2012 EBITDA of $83MM (Pre-earnings meltdown) and the same multiples suggests a similar PMV: $21-24. For discussion purposes, let's call private market value $22.

Barring a turnaround, going private is a best case scenario for BJRI investors. Thus, I would expect BJRI to trade at a discount to $22 as public investors would likely want a positive return in the event of a buyout (I don't think I am out on a limb here). As it stands with BJRI trading at $26, a buyout could result in 15% loss and that, again barring a turnaround, is a best case scenario. Clearly somebody expects a turnaround and/or there is another scenario.

The other scenario

Almost every public restaurant company is trading at a premium to its private market value given the metrics above. Activist, value investors are nevertheless, taking large positions then making public appeals for change. Public restaurant chains getting pressure from activists include: Tim Horton's, Darden, Bob Evans Farms, Famous Dave's, Ruby Tuesday, and Cracker Barrel.

Add BJ's to that list. Luxor Capital, an activist hedge fund with assets of $7 billion, filed a 13-G on January 17 that revealed a new 6.1% share of BJRI's outstanding stock. Luxor appears to be a value player with a "penchant for distressed companies" according to Insider Monkey ( Luxor is currently active in Punch Taverns (PUB.L) debt restructuring battle. It had a stake in Tim Hortons at one point during Scout Capital and Highfields Capital push to get more capital returned to THI shareholders.

The activist investor playbook for restaurants includes slowing or ceasing company-owned unit expansion, selling company-owned units to franchisees, selling and leasing back owned real estate, replacing under-performing management, increasing leverage, and then using the capital created by those changes to increase buybacks and/or dividends. The poster child for this playbook is Dine Equity. Activists replaced the management at IHOP, implemented this playbook, then rinsed and repeated when IHOP bought the much larger Applebee's.

Not all of the activist campaigns have been this successful. Tim Horton's complied but the stock is basically flat. Ruby Tuesday's fate is far from certain. Cracker Barrel has a big new investor but little incentive to put itself up for sale since it trades at premium to its likely private market value.

With BJRI, the obvious activist recommendation would be to stop opening stores, at least until the concept is fixed, lever up, and return capital to shareholders. The company is unlikely to abandon its current business model and become a franchiser. Overseas franchising is an opportunity though.

Other large shareholders of BJRI include T. Rowe Price (14%), Jacmar (11%), Manning & Napier (6.8%) , Baron (5.3%), and Citadel (4.9%). Jacmar is a private food distribution company that provided capital to BJs at a critical juncture in 2001 and at one point owned 66% of the company. James Del Pozzo, the President of Jacmar, is on the board. While we surmise that Citadel, a recent investor, would be receptive to shaking things up, it is tough to gauge the response of long time holders like T. Rowe, Baron or Jacmar.

Free cash flow could be meaningful

BJ's 2013 adjusted net earnings of $24.6MM were small relative to its $73.7MM of EBITDA. Until the 10K is released, let's call full year free cash flow negative ($5.0MM). The company has no debt. If BJ's stopped opening new units, free cash flow would leap to more or less $80 million (Note that the company spends $10-14 million per year to maintain existing units). Free cash flow would then amount to an attractive, but not extraordinary, 10% FCF yield.

Without opening units, BJRI could then buyback ~$80 million of its shares per year. It could also easily and cheaply borrow up to 3x EBITDA--$220 million. This would allow the company to buy back ~28% of its stock then continue buying in more or less 10% per year. It might also choose to return capital to shareholders via dividends but this is less tax efficient.

All of the above assumes that management can at least halt the side in restaurant economics which is no sure thing. If they do that and figure out how to right the ship,  the company could change course again and restart its expansion. With this approach, private market value could become a kind of floor to cap downside risk and shareholders would still have an option on a turnaround.

No need for the angry activist letter

On its February 18th conference call, management embraced this scenario as a viable option if it cannot halt the slide in per unit economics. Greg Trojan, CEO, stated that the company "would explore alternative uses of capital to create value for shareholders" if unit level economics do not improve. The company would also consider walking away from some of the new units planned for 2014 that have not already entered the construction pipeline.

Back to Tim Hortons--much ado about nothing?

Tim Hortons has been there done that. At THI, investors were frustrated by earnings shortfalls on both sides of the border though this was coupled with a 36% ROE and lots of free cash flow. Unlike BJRI, Tim Hortons already returned capital to shareholders with both a hefty 39% dividend payout ratio and $200-250MM annual buybacks (relative to a $8B market cap or ~2% of the outstanding shares). Starting in May 2013 Scout Capital and Highfields Management began agitating for change. In a letter to management, Scout advocated increasing leverage to 3x EBITDA then using the proceeds to buy back more stock. They also advocated a switch to franchising in the US where returns on invested capital had thus far been deplorable.

After a new CEO came on board, the company agreed to lever the balance sheet to 3x EBITDA and use the proceeds to increase THI's planned buyback to 10% of the public float in the 12 months ending August 2014 . Management also said it was receptive to franchising its US locations though it was primarily focused on increasing revenue at the existing units. THI went from $54 before the Scout and Highfields positions were disclosed to $58 just after then reached a peak of $61 in October. THI's earnings continued to underwhelm and, with a pullback in consumer discretionary stocks in 2014, its stock is back to $52.

For a long term investor, such as T. Rowe Price which is THI's second largest investor and BJRI's largest, Tim Hortons' dust-up with activists amounted to little. The activists showed up made noise and left. The stock did a round-trip over nine months though the halt of capital flowing to the US business would be a smart move. Tim Horton's management further upped its dividend last week.

Fade to black? It happens

Ever notice a closed restaurant? They do that..a lot. Quick serve restaurant chains can weather a few bad years and come back or at least stick around--here's looking at you Burger King. And, plenty of casual dining chains have made the transition from fast grower to cash cow. But, the majority of casual dining chains that roll over tend to keep rolling...downhill. Be sure to visit Chi-Chi's the next time you are in Kuwait or Belgium. Ruby Tuesday's painful failed transition from fern bar to dinner house is a more recent example. One BJ's unit is literally built on the foundation of a demolished Don Pablo's.

Call this post an analyst day preview as I no longer have a position in the stock. BJRI seems somewhat immune to earnings misses at this point. The next catalyst for the stock may be the analyst meeting this week or, more likely, activist noise.

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