Like the Queen Mary, P.F. Chang’s turn will be slow and gradual; a new direction for PFCB is – in our view – starting now.
TRADE: This is a tough call, but we’re positive on the near-term trade for PFCB. We’re confident that the current consensuses of $1.61 for 2012 is not reliable in that there are several estimates included in that number of $1.80 where, our guess would be, the analyst responsible has not updated his/her model for a while. Extracting those estimates from the basket brings the mean estimate down to $1.56. For that reason, I think a “miss” of $1.55 or $1.56 may now impact the stock as heavily as some may anticipate. More importantly, the plan to turn around P.F. Chang’s is taking shape and, as that visibility improves, so will the stock’s performance.
TREND: Regardless of what happens to guidance we are buyers of PFCB on down days over the next three months. We think that management will be articulating on the earnings call a comprehensive plan to fix the PF Chang’s brand with solid evidence that the plan is working. Given that PFCB is trading at 6.4x EV/EBITDA NTM versus one of the worst run companies in the restaurant space (RT) at 6.9x, we believe this aberration will close when management can articulate a comprehensive plan to right size the sinking ship. This move alone could add $3 to the stock or 15% upside.
TAIL: Our due diligence has convinced us that the company is undertaking strategies that will positively impact the consumer’s experience at and, therefore, perception of the P.F. Chang’s brand. If all goes according to plan, PFCB could be one of the best performing restaurant stocks in 2012. We believe there is possibility for a quarter or two of choppy results but, while some seem to be pricing this stock for disaster, our long term tail view is positive from here. As MCD and SBUX saw declines in their stocks as a result of missing extremely high expectations, we believe that PFCB’s stock could gain from any upside surprise in results or enough evidence that such a surprise might be forthcoming.
Nearly every restaurant concept gets a second chance; for the PF Chang’s brand its time is getting closer. There remains much work to be done but the risk/reward favors the longs at this price. Our focus has been primarily concentrated on what management is doing to the PF Chang’s brand and not Pei Wei. That is not to say that Pei Wei does not matter to the company but, given that sentiment on the name is so poor, our primary concern is to discern whether or not management can fix the P.F. Chang’s brand. If that is not addressed first and foremost, Pei Wei is irrelevant. P.F. Chang’s represents roughly 75% of the company’s revenues. For the stock to work, management has to rectify the issues at P.F. Chang’s. We believe P.F. Chang’s is turning around. Like the Queen Mary, the turn will be slow and gradual; a new direction for PFCB is – in our view – starting now.
Here is how I think about the set up for the company as we look out over the next couple of month and years.
THE COMPANY IS OPERATING FROM A POSITION FROM STRENGTH NOT WEAKNESS:
- Since the company owns its store base, it is more able to implement significant changes than some others in the space. The company has a strong balance sheet and generates solid cash flow; nearly $75 million FCF in 2012 and little funded debt.
- PFCB has a strong real estate position.
- Over the years, management has not compromised culinary standards at P.F. Chang’s so the challenge they face is more aptly described as enhancing the marketing message rather than trying to convert previously disappointed customers. The customer experience of P.F. Chang’s has not been compromised and that, while small, does make the turnaround easier.
THE ROAD TO RECOVERY (18 months in the making):
- DISCOVERY AND EVOLUTION: 2010 was the year of admitting to the real problems and 2011 was the year of planning for the future.
- IMPLEMENTATION AND EXECUTION: Now 2012 becomes the year of executing - new menu items, new look and new price points. The Irvine store will play a key role in this process.
- GETTING THE SYSTEM MOTIVATED: The onus in on management to get the employee base geared up for the changes, manage costs and driving consumer awareness of the changes taking place at PF Chang’s.
- CONTINUE TO EVOLVE: As a company, PFCB is not going to play defense, rather it is going on to be offensive in its strategy.
THE ISSUES THAT REMAIN ARE:
- Are the right people in place to execute the current plan?
- Can management menu engineer lower price points and not kill margins?
- How conservative is current guidance? Has management build in a margin of error for an inevitable road block on the road to recovery?
There seems to be very little confidence among the investment community that management can turn around the decline in traffic trends without a significant hit to margins. That skepticism may not be completely inappropriate but, if our view of the turnaround is correct, EPS and EBITDA will bottom at around $1.50-1.55 and $125 million, respectively. These represent numbers that are slightly below current consensus estimates (stripping out the outliers). If this is correct and management gains creditability in their ability to turn around the company, the stock could go higher.
The list of companies trading at a better cash flow multiple than PFCB include companies that are in far worse shape. For us, the one that sticks out is RT. RT is currently trading at an EV/EBITDA multiple that is 0.5x higher than PFCB. If PFCB can trade in line with RT there is $3 of upside. If PFCB can trade at an average multiple of the group there is nearly $9 of upside. None of this is going to happen until management can convince the street they are on the road to recovery.
There are two significant initiatives that the company is working on that, we believe, will help get P.F. Chang’s on that path to regaining investor confidence. The first is implementing new price points at lunch and the second is bringing excitement back to the P.F. Chang’s concept. The new store in Irvine, CA, is critical to the latter as the company looks to bring the concept back to its former glory.
REINVGORATING THE ASSET BASE
Since the store in Irvine is one-of-a-kind, and not representative of the true direction the company is going, the challenge is determining which elements in Irvine will translate into the Bistro system and how many can be implemented at once. It appears that the PFCB remodel program will not just be changing out the carpets and tables, but creating a new environment for employees and customers within the four walls.
As we experienced during dinner at the recently scrapped Irvine store, the staff was visibly excited about what was happening at the store level. Creating an environment with a high energy level will be critical in getting the employee base motivated to embark on the changes that need to happen to stimulate customer traffic again. We have seen this work at Chili’s over the last eighteen months, and we think that the same can happen at P.F. Chang’s.
Management believes and we agree that “it will be important to introduce several new initiatives at once and give the employees that sense of pride that you might not get if you introduce initiatives one at a time.” Management is seeking to reinvigorate the employee base and restaurant at once and, if done correctly, this will completely change the customer experience.
The changes that are about to unfold at the Bistro are going to be significant and incorporate a number of different initiatives. While some of the design elements will require closer consideration, there are some less drastic but impactful initiatives like an upgraded music system, a new look for employees, upgraded wine list, new specialty cocktails, craft beer and new menu items that will help elevate the customer experience. Sushi is on is on the radar screen and the company should be testing some products soon. The focus is on stepping up every element of the bistro from food, to the bar experience and the employees.
THE NEW MENU
The key aspect of getting customer traffic is lowering menu prices at lunch, to compete more effectively with other parts of the casual dining landscape. For instance, P.F. Chang’s is forced to compete, in some markets, with the effective $6 lunch price point that has shaken up casual dining so much over the past year. For the past three months the company has been testing 20 lunch combos under $10. We expect the company to launch the test to the balance of the system in 2012.
In the Phoenix market, the company is testing the new lunch menu and seeing some success. In a departure from its past the company is testing TV as a medium to tell consumers about the new lunch menu. We believe this test is being met with success and that this will be an integral part of the company strategy when they launch the new menu in 2Q12.
The company currently has a new Pei Wei Asian Market under construction. For me, if there is a future for Pei Wei, the new incarnation will likely be it. Chipotle’s management is confident that they can translate their company’s operational efficiency to the Asian category. PFCB management needs to assume that CMG’s confidence is well-placed and prepare accordingly. The fast casual category has taken share from competitors across the restaurant space, particularly at lunch, and Pei Wei has to be altered in a way that the concept can be competitive if CMG’s strategy plays out.
This prospect is not lost on management but, despite the pending changes to the service style at Pei Wei, management is expecting to open 16-20 locations in the Los Angeles, Florida, D.C., Baltimore, and Philadelphia markets. Why management is making this decision, to grow the Pei Wei unit count, confuses us, but as we pointed out earlier, Pei Wei is not the crux of the overall story.
A SMALL POSITIVE - GLOBAL BRAND DEVELOPMENT
The GBD business unit encompasses home menu frozen products, International Bistro Restaurants and Pei Wei International Restaurants (coming in 2012) and select alternative venues which for now which is airport Pei Wei locations. In 2011 the business went from break even to making $0.06 in EPS and should accelerate in the coming years. The company opened eight international restaurants in 2011, bringing the total restaurant to 17. By the end of 2011 the company will have four partners operating the 17 international Bistro locations with a presence in Hawaii, Mexico, Kuwait, the UAE, and Puerto Rico. By the end of next year that will grow to six partners/affiliates which are expected to open 10 to 15. The new restaurants will be in the Philippines, Lebanon, Jordon, Chile, Canada, and Bahrain.
What we know:
- Incremental pre-opening costs due to increased unit growth. 16-20 FY12 openings versus 5 in 2011. 3-5 new Bistro units in FY12. All in, incremental pre-opening costs will cause roughly $0.06 in EPS pressure in 2012.
- Labor pressure, particularly at Pei Wei as the new store development is ramped up
- Commodity inflation of 4-6%
- G&A in the range of $78-$79 million
- Somewhere between $0.20 and $0.24 of incremental year-over-year pressure just based on the change in share based compensation in 2011 versus 2012.
What we don’t know:
- Revenue assumptions including SSS trends for both brands (January is looking better for the industry)
- Operating margins
- Tax rate
- EPS range
What a game we play. We can do all this work and over the next two weeks it’s come down to what guidance is for 2012 and what management’s tone is when discussing the initiatives that they are putting in place to resurrect the brand. PFCB’s CEO, Rick Federico, is one of the most respected restaurant CEOs I know. He has built a great company and now he has an opportunity to achieve what Howard Schultz and Steve Jobs have done: turn around the company he founded.
Mr. Federico took a big risk with his “Irvine project” given how expensive it was to carry out but a few years down the road, management may look at Irvine as the anchor without which the brand could not have been turned around.