Description

Summary

AFC Enterprises Inc. (AFCE) is the franchisor of Popeyes Chicken and Biscuits, a quick service restaurant chain.  VIC members may recall that in 2004 the company shed its other brands (Church’s Fried Chicken and Cinnabon) which resulted in a special dividend and the focusing of all its efforts on Popeyes. 

Popeyes is the number 2 chicken QSR concept behind KFC and currently has 1,506 domestic franchisees, 61 company-operated restaurants and 314 international franchisees.  There is capacity and, more importantly, the demand to easily double the current number of restaurants over time.  The company is 97% franchised which translates into 100+% returns on fixed assets and exceptional free cash flow.

In addition to the market’s recent flight away from small cap stocks, the stock is down for several reasons:  the company took 6 months to fill the vacant CEO position (filled in October); same store sales (“SSS”) are shaping up to be ~-2.5% for ’07 after posting 1.6% in ’06, 3.3% in ’05 and 1.3% in ’04 for domestic franchisee and owned restaurants; and the company recently guided down ’07 EPS to 0.78-0.80 from 0.81-0.85 per share as well as guiding to the lower end for new gross restaurant additions of 155-165 units.  It should be noted that 2007 was the first time since 2002 that management had given guidance and was too aggressive.

Recently, the company completed its CEO search and selected board member Cheryl Bachelder, former President and COO of the KFC subsidiary of Yum! Brands.  She also has been the VP of Marketing and Product Development at Domino’s.  Bachelder had been a board member at AFCE for less than a year before the previous CEO stepped down and then put her hat in the ring for the position.  Her experience in the chicken QSR segment as well as the franchise model from Domino’s made her a very strong candidate.

At 12.5X consensus ’08 EPS and 11X ’09 EPS (my estimate), AFCE is a compelling value.  Admittedly, the company is in a bit of a turnaround.  SSS will in all likelihood be down 5 quarters in a row, new management will be tested to make menu improvements and the robust development pipeline needs to be managed to keep unit expansion growing.  However, as a pure play franchise company, the perception of the direction of SSS impacts its stock price more than SSS affects its earnings.  Additionally, the menu changes required to address the gaps are fairly straight forward and the new franchisee/restaurant pipeline is already well developed.  The chain gets high reviews from its franchisees and its customers mitigating some of the challenges.  The CEO’s background coupled with the fact she was a board member first provides additional comfort.  There does not appear to be a high degree of difficulty in fixing the company often found in other turnarounds.

Restaurant Concept

Popeyes was founded in Louisiana in the early 1970’s with a Cajun/Creole bent.  The authentic New Orleans heritage is represented in the food with flavorful chicken recipes as well as sides like red beans and rice, mashed potatoes and Cajun gravy and chicken sausage jambalaya.  This mix appeals to urban environments as well as smaller towns and suburbia. 

Customers generally view Popeyes as a home meal replacement.  Most of the dining takes place off premises—estimated at 80% of total sales.  Analysts estimate that 65-70% of total sales are done via drive-through which is above the industry average of 60%.  Roughly 65% of the revenue is dinner and 35% lunch—which is skewed more towards dinner than the 60/40 average for the industry. 

The opportunity to improve the menu and directly affect sales is fairly clear for several reasons.  First, boneless chicken has been growing more quickly as a category than bone-in (it is perceived as more healthful and is more portable), and Popeyes needs to add more boneless to its menu.  Second, the company needs to add snack day-parts (menu items for between meals) and “value” pricing items on its menu as McDonalds and other successful QSR players have recently done.  With a lower economic demographic and the changing eating patterns in this country, this part of the menu is lacking.  Third, the company needs to add late nights and breakfast to its arsenal more widely where applicable.  Management has indicated that although store-specific, meal additions has been successful depending on the location of the store.  Store re-imaging began in 2000 and is 85% done (the rest is due to be completed in 2008). 

I view it positively that only menu changes and not time and capital consuming PP&E changes or big changes to the restaurant concept need to occur to get SSS headed in the right direction.  Additionally, the company needs to improve its store level operations, especially drive-through service levels.  This is very important given that drive-through is such a large portion of sales.

Same Store Sales

The company is almost entirely franchised so SSS only has a more marginal impact on earnings than it does for direct owners of restaurants.  That said, comps ultimately do affect franchise royalties and earnings (though less significantly than an owned-restaurant company).  They also determine whether or not it is attractive for people to make the investment to become a franchisee or open additional units.  Speaking with analysts and management, it seems that poor comps in 2007 are the result of three key elements:  1) The company went off message in their marketing by emphasizing clean and contemporary to draw a younger demographic which went too far astray from their New Orleans/flavor emphasis and meal replacement message.  This alienated the core customer who is more interested in the food quality, taste and price.  2) Management was caught flat footed with a poor value offering versus the rest of the QSR category.  Other QSR options seemed like a better deal and the company lost some market share.  3) Marketing has been stagnant.  The head of marketing for the company left in October and a consultant is running it until the position is filled.  CEO Cheryl Bachelder addressed these elements in her first quarterly conference call and cited them as top priorities.

Valuation

AFCE currently trades at 14X ’07 consensus EPS estimates and 12.5X ’08.  Free cash flow approximates Net Income as there is little capex.  I believe that the company will do $1.00 per share in ’09 based on the increase in franchisees.  Using the current 14X multiple creates a stock price target of $14 per share in 18-24 months.  Comps trade in the 20X forward range.  I think a higher multiple, more in line with comps, is warranted for the following reasons:  AFCE is more of a franchisor rather than restaurant operator and as such has considerably less capital intensity; the company has been a prodigious buyer of its own stock with free cash flow; net restaurant units are growing; and the franchise revenue is remarkably stable.  Slight improvements in SSS and early signs of improved menu changes would create a more favorable perception of the company and increase the multiple to the 15-20X where it had been previously trading.

The biggest driver of growth in earnings is adding new franchised restaurants.  At maturity, a franchisee will do north of $1.1MM which creates approximately $55k of earnings (using a 5% franchise fee) with little incremental corporate cost as well as generating a one-time $35K startup fee.  Gross new franchised units added were 139 in 2006 and 155 (est.) this year.  Roughly 2.5 to 3% of franchised restaurants drop out each year or roughly 50 per year.  These numbers were somewhat skewed over the past few years due to a problem with the Korean master franchisor which has now abated.  Analysts estimate that net adds are going to be in the 50-75 unit range per year for the next several years given the that the development pipeline seems robust in spite of the management turnover and weaker SSS.  Bachelder also mentioned in the last quarterly call that growth is important to the company but has not announced 2008 targets yet.  She anticipates giving more information on openings and earnings guidance for 2008 on the Q4 call.

Risks

1. QSR is driven by the more economically sensitive demographic of the consumer.  Gas prices, threats of a recession, etc. could all hurt the turnaround.
2. New management could fail in reviving the brand and improving the menu harming franchisee relationships.
3. Expansion plans could flounder if management cannot improve SSS interest in unit openings could wane.
4. Avian flu could break out and harm perception (real or perceived) about the safety of eating chicken.
5. Continued commodity prices could harm demand due to price increases.
6. Competition for this demographic in the QSR segment is brutal and the company needs to stay sharp.
7. It could become too difficult a financing environment for franchisees to support growth.

Catalyst