BJ’s is a restaurant chain with 115 units, operating primarily in California (56 units), Texas (24 units), Florida (9 units) and Arizona (6 units). The units are quite large, averaging 8,300 square feet, with sales of just over $5 million per unit. The food offerings are basic “American” fare, with pizza, pasta, burgers and salads the largest sellers. BJ’s also brews its own beer and features massive flat screen televisions in the bar section of the restaurant. The chain has grown steadily over the past few years, adding an average of approximately 15 units per year. Profitability has been consistent, with EBITDA margins of 12-13% over the last 7 quarters.
BJ’s is a solid, well-run company with decent future growth prospects ahead of it. However, the valuation has become disconnected with any rational or historic norms. BJRI currently trades at $48, which is roughly 17x EV/TTM EBITDA.
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Our short thesis is based on the following truths:
- There is no historical precedent for a restaurant chain of its type sustaining valuations of this level for any material period of time
- The company is valued as if it had already achieved 6 years of mistake-free, industry-leading growth and margins. Thus, the catalyst for price revision will be the smallest mis-step.
- The pace of unit growth is definitively limited due to the high expense, operational complexity and potential geographic limitations of the concept.
- Additional costs are likely to enter the system and hamper margins and cash flow. Significant items include workers comp, advertising, and increasing maintenance capex.
- There is nothing particularly new or distinctive about the concept.
1. There is no historical precedent for a restaurant chain of this type sustaining this valuation for any material period of time.
Look at a listing of restaurant industry valuation multiples, and you will see a consistent clustering of companies in the 6-8x EV/EBITDA range. If you further look historically at their trading multiples versus growth trajectories, you will see a striking pattern repeated: early-growth-stage valuations in the 10-15x range that quickly give way to 8-10x and then ultimately settle at 6-8x. There are very few exceptions to this pattern, particularly in the casual dining segment (as opposed to fast-food). A particularly relevant example to consider is PF Changs, which in late 2003 was similarly the investor’s ‘darling’ of the restaurant industry, with 117 units, adding approximately five per quarter, and sales per unit of approximately $4 million. Based on frothy, unrealistic expectations of sustained growth, the company stock touched a peak of a valuation of 20x EV/EBITDA. Though the company continued to grow from there, the multiple only went in one direction, and did so quickly. By early 2004 the multiple had dipped to 15x, by early 2006 it had dipped to 10x, and today it trades at the industry average of 6x. Cheesecake Factory followed the same trajectory, with a 2004 multiple ranging near the 20x dipping and then dropping steadily to 15x then 10x less than 2 years later. Red Robin peaked at 15x in 2004 before quickly dipping to 10x and then 8x. Same goes for Buffalo Wild Wings. In fact the same goes for just about any other public restaurant chain we can find (the sole exception being fast-food concepts Chipotle and Panera, which have very different unit dynamics).
||Avg revs per unit
||Dropped from 17 > 9x from Dec ’04- Jun ‘06
||Dropped from 15 > 8x from Jun ’05 – Dec ‘06
||Dropped from 18 > 7x from Jun ’05 – Jun ‘08
||Average dropped from 13x in 2007 to 8x in 2010
||Dropped from 11 > 8x from Feb’04 – Feb ‘05
||Hit 10x in 2006 before settling into 6-8 range since then
||Hit 10x in late 2007 before settling into 6-8 range since then
||Has been at 17-20x for most of 2012
Note: This point is best illustrated by graphing EV/EBITDA multiples for each company vs its revenue growth rate over a multi-year period. Graphs not included here due to formatting issues.
2. The company is valued as if it had already achieved 5 years of mistake-free, industry-leading growth and margins. Thus, the catalyst for price revision will be the smallest mis-step.
Let’s do some basic math and project out the next 5 years of BJs. Let’s pretend that they continue to be able to identify enough locations to open up 15 units each and every year with the same robust $5 million run-rate. And that comps continue to be positive, with a solid 3% each and every year. And that none of the margin issues we outline below occur, allowing the company to maintain healthy EBITDA margins of 12.8%. And that no other material mis-step occurs, there is no economic downturn, etc. At that point, certainly the company will inarguably no longer deserve an astronomical multiple, but rather be solidly in the traditional zone of 7-8x. Here is how that would play out (see below). The stock price in this scenario would work out to $42. So it appears that the company is materially overpriced even if one gives them credit for five additional years of strong growth.
3. The pace of unit growth is limited due to the high expense, operational complexity and geographic limitations of the concept.
To their credit, management has consistently set rational targets for growth (currently up to 15 new units in 2012) which the market seems to ignore, leaving BJ’s priced for much loftier growth than is possible given issues specific to the business. These include the following:
- Expense: Each BJ unit costs approximately $4.3 million to get started. This includes $3.8 million to build the large, complex units (net of landlord TI) and an additional $500k in opening expenses such as marketing. With roughly a 20% unit operating margin on $5 million of sales, it takes the company over 4 years to make the money back on each historical unit. This is a reasonable, if unspectacular return rate for a restaurant (venture investors, for example, look for a payback period of less than two years). The company-stated growth rate of 15 units per year thus absorbs a whopping $65 million of cash flow (on annual revenues of just $600 million).
- Operational Complexity: The growth rate is constrained by the effort and attention required to open each and every BJs unit. First, is finding suitable locations - at 8,000 square feet with significant traffic flow requirements, BJs has by design restricted itself to a limited choice of real estate options. Build out takes several months and a significant team of BJ employees on-site. Each unit must hire a sizeable staff. To do this at even 15 units per year presents a significant operational hurdle.
- Geographic Limitations: To-date, 75% of BJ’s units are located in just 5 states. So what appears as n underpenetrated concept is already heavily penetrated in its core geographies. The company is likely to face significant challenges in attempting to grow out of its comfort zone. The most obvious of these are the economies of scale. To open the 37th restaurant in California, little is required compared to opening the first, second or even fifth restaurant in Ohio. New food suppliers and storage facilities are required. Familiarity must be gained with unknown details of local real estate. As the company mentioned in their latest call, store opening costs in new geographies “may incur greater pre-opening costs than our restaurants in mature trade areas, in which we already have our support infrastructure in place” And of course, perhaps most importantly, it will cost money to build brand awareness in the desired customer base. Most Californians will have at some point passed by a BJ’s. Not so in Topeka. Finally, there is the issue of climate. Warm-weather based restaurants are by definition less likely to face customer inhibiting seasonal dips. As the company proclaimed on its last call, “remember that almost 90% of the restaurants in our comp base are located in CA, NV, TX, AZ, FL and other states that really didn’t experience sustained severe winter weather”. Will the restaurant in less weather-friendly Duluth be able to hit the same $5 million comp?
4. Additional costs are likely to enter the system and hamper margins and cash flow. Significant items include workers comp, advertising, and maintenance capex.
To-date the company has yet to experience several cost spikes that have heretofore been inevitable for restaurants hitting a certain scale:
- Adverstising: In its latest quarterly call, the company CEO discusses the company’s impeding entry into systematic advertising. They maintain that they will be prudent and efficacious, adding “they’re only considered to be expenses from a financial accounting perspective. From a business perspective, these are really investments” Interesting. Further, one might wonder, what is it that is tempting the company to feel the need to start now?
- Workers Compensation: Any experienced restaurant executive, especially those with a heavy concentration of units based in California, will have some stories to tell about unexpected workers compensation expenses as the chain grows. BJ’s may just be just beginning to experience this, as they mentioned explicitly in their last call, with a jump in their workers comp insurance renewal rates for 2012 adding 10-30 basis points of cost.
5. There is nothing particularly new about the concept.
- Maintenance Capex: The company has yet to really experience the inevitable costs that comes with refreshing large footprint units that are beginning to age. More than half of the units are still less than five years old. This is yet another unsustainable element in the company’s economic footprint.
It’s hard to introduce something new and exciting into the world of casual dining. One could argue that BJs does particularly little on this front. Yet to hear the management talk, you would think that they had just discovered the sandwich:
“We have a major advancement coming on our pizza that will be set for rollout shortly where we’ve worked on the presentation and how we stage the toppings that has enabled us in tests to sell more pizza”
“All of our new restaurants now feature a large, impressive entry statement, high ceilings with detailed contemporary decors. And when we combine our contemporary casual-plus interiors with our broad menus, signature pizza and beer, we have a unique, differentiated positioning that should give BJ’s many years of solid new restaurant growth to come”
“The seasonal beers have just been incredible. And every year as we develop this portfolio of seasonal beers, and I think we’re up to about half a dozen now, every year that we offer them, our guests anticipate them…. So it’s a real competitive capability that we have in the BJ’s concept and I think it kind of falls under our positioning as the premier retailer of craft beer on tap in casual dining”
This for a restaurant that serves pizza, burgers, salads beer, and has a large television. Pleasant, to be-sure, but far from ground-breaking. And far from sustainable. When the novelty of its ‘newness’ wears off, one will be looking at a slightly larger version of Applebee’s. There simply is not one single example of a large-scale casual restaurant brand that has defied this natural trajectory.
In sum: We like the business. The food is pretty good. The stock is significantly overvalued. We look for any speed bumps along the way to trigger a recalibration to a more sensible and sustainable valuation.
-The smallest mis-step: on SSS, margins, etc. The stock is currently priced for perfection (and more).