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    MARKET EDGES

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The restaurant business is a cash business, and a large number of publicly traded companies generate a significant amount of cash each year. Therefore, any analysis of a restaurant company should revolve around the company's cash flows and how management spends it. The restaurant industry's 10 largest companies have reached such a size and maturity that their cash-generating capabilities have surpassed $13 billion. In the current restaurant environment, the redeployment of cash flows is an important factor in stock price performance and thus valuation. Properly managing cash flow will allow any restaurant stock to outperform its peer group over a sustainable period of time. A key component to sustainable, consistent growth and a premium valuation, therefore, is the proper balance between cash reinvested into the business and cash returned to shareholders.

A restaurant company with strong, sustainable trends will maintain a proper balance between debt and equity and will pursue a prudent level of unit growth (growth capital expenditures) while keeping up with maintenance capital requirements. At the same time, the company also must recognize the importance of keeping the concept relevant to the consumer. This puts a premium on initiatives within the four walls of the restaurant to drive incremental customer visits, which is critical to the overall health and perception of the concept. If the company has any cash left over, returning it to shareholders should be a top priority.

A common mistake that restaurant companies continue to make involves taking an overly optimistic view of a given concept's long-term prospects, which leads to excessive capital expenditures and ultimately erodes shareholder value. The point is, what might appear good for a company (or a stock) in the short term might not always benefit the company in the long term.

On the other hand, we have seen companies slow new unit growth in order to focus on their core business. This decision also has significant implications for shareholders, as a company will likely see a significant increase in its operating performance and its return on incremental invested capital as a result of increased sales and margins at existing restaurants combined with investing less capital in unprofitable stores in a mature business.

We have witnessed, more often than not, companies maintain an accelerated rate of new unit growth, putting significant pressure on the organization. That pressure comes in three primary forms. First, the company's real estate division might be pressured to find quality locations and invariably will compromise its standards in order to satisfy management guidance driven by a desire to meet Wall Street's performance projections. After two to three years of compromises, sales in the new units will begin to suffer and the company will miss its targeted return hurdles. Another part of the new unit underperformance can be attributed to the fact that the company cannot hire enough qualified managers and/or lacks the time to properly train them. Third, it is also possible the concept cannot survive in the highly competitive restaurant industry.

Most mature restaurant companies have enough operating cash to fund unit growth beyond their means. This fact implies that the prudent companies have cash left over to allow for incremental EPS growth from some sort of financial engineering, which leaves the board members of the leading restaurant companies with some very difficult decisions to make. These decisions range from the need to provide growth for the company's employees to maximizing value for shareholders. Unfortunately, these options do not always go hand in hand.

As I said before, over the long-term we are most focused on the rate at which companies deploy new capital in the business. We have developed a framework to help measure how senior management of any given company is deploying shareholders' capital. This approach is even more important in difficult times. In today's uncertain environment, most people do not want to touch a stock until there is better visibility on the top line. Unfortunately, easy comparisons do not necessarily mean results will improve in 12 months, as we have seen.

We acknowledge that same-store sales growth is a significant indicator of a concept's health, which affects the potential opportunity for growing total sales through new unit openings. The important components of computing same-store sales are broken down in transaction-level metrics: pricing, mix, and traffic trends.Typically, we find that the company with the highest multiple usually has the strongest same-store sales trends and nothing else seems to matter, leading us to believe that "best in class" restaurant companies do not receive premium valuations. Although same-store sales trends are important, investors must consider other factors when valuing a restaurant stock and determining whether a restaurant company is "best in class."

We have a number of measures that we consider when looking at a restaurant company, but four that are more important. Most of the criteria do not provide good or bad news in isolation. Instead, they lead us to ask questions in hopes of discovering in what direction a company is heading. Given that the restaurant business is typically a cash business, we do not focus on revenue (except for same-store sales, which are the most important indicator of a concept's health). Instead, we have centered our efforts on how management spends its cash flow. Specifically, we are focused on cash flow from operations, operating margins, and capital expenditures. Importantly, we look at these numbers not in isolation, but in how they relate to other parts of a company's financials and to other companies in the industry.

Cash flow from operations (CFFO). Is the company generating enough cash from its operating activities to continue without accessing new external sources of cash? We define CFFO as cash from operating activities less capital expenditures, less the benefits from the exercise of employee stock options and adjustment for one-time gains/losses or restructuring items. Most of the larger restaurant companies we follow generate free cash flow after significant investment in the growth of the core business. Some of the smaller companies we follow do not generate free cash flow. The lack of free cash flow is not necessarily a negative, as long as the company burns cash within the limits of its available resources.

Net CFFO/Net Income. Importantly, we are looking at the proportion of earnings yielding cash. This higher ratio relative to the industry can indicate more conservative accounting, signaling a sustainable level of income. At a minimum, we believe that a mature restaurant company should have a CFFO/net income ratio of 0.6 or better. Any ratio that is nearly flat or negative raises a big red flag for future returns.

Operating margins. In the restaurant industry, operating margins measure a company's cost efficiency relative to the revenues generated within the four walls of the restaurant. Generally, margins that are declining because of slowing sales trends tend to be more important than a one-time step up in costs. High margins with stable or declining revenue growth should be examined carefully. Importantly, we are looking for margin differences relative to competitors with similar box (store size) economics. Is the trend in margins consistent with other competitors in the industry?

Capital expenditures to depreciation ratio (CE/DR). This ratio can measure whether or not management is conservative in its accounting policies relative to others in the industry. In addition, it is an indicator of the company's annual cash cost of capacity. In general, the small-cap restaurant companies' CE/DR is high because of the significant amount of new assets put into the ground each year to sustain growth.

We will follow up in the next couple of days with more company-specific comments.