Buffalo Wild Wings is a chain of company-owned and franchised restaurants which sell Buffalo chicken wings, alcohol, and other food/beverage items in a sports bar setting.  The company is 10% off its 52 week high and is up 42% YTD on the heels of reporting Q4 and Q1 earnings beats and a small miss in Q2 that was dismissed as a temporary G&A issue.  The earnings beats were margin-driven as opposed to revenue-driven, as BWLD benefits from a food cost tailwind, as chicken wing prices have fallen to levels not seen since 2003 and were down approximately 35% year over year in Q1 and 32% yoy in Q2.  Chicken prices have generally fallen due to oversupply, but chicken wing price declines have been far more dramatic.  This is in the context of pronounced commodity inflation across every other food input (e.g., as of  the end of Q2, beef +approx. 25% yoy, cheese +approx. 10% yoy, coffee +approx. 60% yoy).  While inflation has moderated for most commodities in Q3 to date, most are still up significantly year over year, with chicken being the big exception to the rule.  So BWLD has had an input cost tailwind at the very same time that every other restaurant company has had margin pressure from input cost headwinds, which has made BWLD a consensus long and a popular place for consumer and restaurant dedicated investors to hide.  BWLD appears to be over-earning however, as food costs in the first quarter and second quarters of 2011 were 27.9% and 27.2% respectively, as opposed to 30.4% average over the prior 6 years, with a range of 29.0% to 31.6%.  The chicken producers are getting killed because chicken pricing is down at the same time corn futures have been up as much as 80% year over year (corn is used to feed chickens).  In order to boost pricing, chicken producers have started to reduce egg sets in the mid single digits to bring down supply.   Most food analysts expect chicken pricing to firm by 2012, as the lead time for eggs to become chicks is about 3 weeks and for chicks to reach slaughter size 6-12 weeks depending on the breed.  There is also an inventory of frozen wings to work through, but by 2012 those will be depleted.  Simply put, right now BWLD is over-earning and at risk of missing 2012 estimates.  While it may seem early to be shorting on 2012 earnings risk, the stock could come under pressure as soon as chicken wing pricing starts firming, which could happen as early as Q4.  Also, with a current year P/E of 23.5 and a one year return of 31%, BWLD can't afford to miss earnings.

The other reason to start shorting BWLD now as opposed to waiting until later in the year is the continued uncertainty over the outcome of the NBA lockout situation.  There has been virtually no progress in the contract negotiations between the owners and players since the lockout began.  Speaking after the latest round of negotiations which took place on 9/13/11, Lakers guard and union president Derek Fisher said, "We're not marching towards a deal at this time or at any time we can predict.  We can't come out of here thinking that training camps and preseason are going to start on time at this point."   While it is hard to quantify what effect an NBA strike would have on BWLD earnings in the next several quarters, it is fair to say it would be comp headwind, especially if it lasted a long time, as BWLD is dependent on basketball games to draw traffic after football season ends early in Q1.  Sellside estimates for 2012 are dependent on a +3% comp, which could be challenging if the economic environment remains weak and competition remains high in the category, impeding price increases.  If there were to be a prolonged NBA strike, a 3% comp in the first half of 2012 seems nearly impossible absent a pronounced improvement in the consumer economy (employment and wage levels, housing prices, consumer confidence).

Current Valuation Metrics:

Short Interest/Liquidity:

• 2.2 mm shares as of 8/31/11 or 12% of the float
• 6 days to cover
• Current short interest is up a little bit since recent trough on 4/15/11 but more or less average for the stock in terms of shares and days to cover
• Average daily volume for the last year is approximately 378,000 shares/day

Company Description/Background:

Buffalo Wild Wings was founded in 1982 and had 730 stores as of the end of 2010, of which approximately 260 are company-owned and 470 are franchised.  The average ticket at a BWLD is approximately $10.  Chicken wings make up 21% of sales and are bought in the spot market, boneless chicken wings make up 19% of sales and are contracted through March 2012 at flat pricing, alcohol makes up 23% of sales, and other food/beverage make up 37% of sales and are under contract for the remainder of the year with 3% cost increases.  The relatively high mix of alcohol is good for margins since alcohol margins tend to be high, although the downside is alcohol sales tend to be more volatile with the economy as alcohol is a more discretionary item.  BWLD has a geographic concentration in the Midwest, having its roots in Ohio (although currently headquartered in Minneapolis), with early store development centered around the Big 10 schools.  Recent growth has been more in company-owned stores than franchises, which carries some risk as new stores are generally being built in newer regions such as California where the brand is less established.  New store productivity has however been very strong the last few quarters.  Annual unit growth is projected to be 15% with a target unit count of over 1000 stores.  Unit growth that is among the best in the restaurant and retail sector is a big part of the bull case.

Downside to 2012 Estimates if Chicken Wing Prices Increase:

Food costs averaged 30.8% in 2007, 29.8% in 2008, 30.2% in 2009, and 29.0% in 2010.  For the first half of 2011, with the benefit of chicken wing price deflation, food costs were only 27.9%.  Most sellside estimates for 2012 are using a food cost that is only slightly up, in the 28.0-28.5% range.  If food costs partially normalize back to the 29.0% level, earnings would come in at $3.00 versus the current $3.26 estimate, assuming BWLD couldn't offset the input cost increases with pricing.  Given the highly promotional environment at the Bar & Grill chains that they compete with, it is unclear they would be able to push through pricing.  There is also increasing competition coming from above, as higher end chains such as Morton's, Ruth's, and McCormick and Schmick's roll out discounted happy hour menus and bar dining menus, hoping to capture the more cost conscious customer.

Recent Events/Background:

Q1 earnings beat: On April 26, 2011, BWLD reported Q1 earnings of 82c versus 74c consensus.  Company store comps were slightly above consensus at 3.9% versus consensus 3.4%, with the comp driven by a 2.4% price increase.  Price increases will be 1.9% in Q2.  Franchise comps trailed at 1.6%.  The beat was primarily driven by the cost side, where cost of sales were down 266 bp year over year, driven by the 36% decline in the price of wings.  Chicken wing prices are down 32% year over year in April and May, so this tailwind will continue into Q2.  Despite the beat, full year guidance was not raised and instead maintained for at least 18% EPS growth, which implies earnings of at least $2.48 per share.  By not raising guidance after an 8c first quarter beat, which was driven by factors that should persist into Q2 at the very least, management was clearly low-balling guidance.  The street knew this, as consensus was at $2.66 going into Q2 earnings, well above management's guidance.  Management left the guidance at a low enough number that they could have made their numbers even if 4-6 weeks of the football season had been lost to a delayed start of the football season, which was a legitimate fear as of the time of the Q1 report. 

Q2 earnings disappointment: On July 26, 2011, BWLD reported earnings of 58c which fell short of the consensus of 60c.  Revenues however beat expectations by 4% on solid comps of 5.9% in owned stores (versus consensus 3.6%) and 2.7% at franchisees (v. consensus 1.6%) and the company indicated that Q3 was off to a good start, with the two-year trend in July accelerating to 7.1% from 4.0% in Q1.  While the company acknowledged that comps get tougher over Q3, the miss was largely written off because of the strong sales.  The miss was attributable to 8c of headwind from higher G&A costs related to store growth planning and investments, and was therefore overlooked by BWLD's growth hungry investor base.  The stock did not react to the earnings miss and only started to weaken when the overall market did in early August.

NBA Lockout: The NBA players' contract expired on June 30 and they are currently on lockout.  The most recent negotiations ended yesterday (9/13/11) and did not go well.  Training camps are supposed to start October 3^rd, with exhibition games starting October 9^th, and the regular season starting November 1.  So we will have better visibility on what will happen with the NBA within a month.  Any cancelled games would be a comp headwind for BWLD.  While this is not a reason in itself to short the stock, it is a free implied put at the current valuation level.

Valuation Target:

Fair value for BWLD assuming no disruptions from the NBA lockout, based on 18x my $3.00 2012 estimate is $54.  My main variance from consensus here is in cost of sales (food costs).  18x is comparable with what its earnings growth rate should be given 15% unit growth and a low single digit comp, and is also consistent with a comp set of restaurant stocks.  This $54 target assumes a benign economic environment and no macro headwind bigger that what is currently present.  If the economy got worse and/or the NBA strike occurred in conjunction with a slightly worse economy, and comps were subsequently flat and food cost pressure surfaced as I expect it to, and you could have $2.75 in earnings and a stock around $50 without multiple compression, or mid $40s if the multiple compressed to 16x (still a healthy multiple).  Mid $40s would probably only happen in a bear market.

As far as upside risk, if I am wrong on input costs and they make the $3.26 number next year, a 22-23 multiple gets you $72-75, which is consistent with the target prices of the most bullish sellside analysts (with the exception of the Davidson analyst, who is an outlier at $87).  I am not sure how much longer people will be paying 20-25x P/Es for consumer discretionary companies if the economic data continues to be weak.

I would be much more aggressive between $66 and $70 then at current levels, but I am not sure it will get there (and my VIC deadline is coming up), so I am presenting this idea at the current level recommending a half position here.

Catalysts:

1.    Rising chicken prices late in 2011/early in 2012 cause earnings estimates for 2012 to drift back down towards the $3.00 level from the current $3.26.

2.    NBA strike happens and causes some missed games.

3.    Comps decelerate in Q3 because of a tougher prior year comp, lower price increases, or a marginally weaker consumer

4.    General macro - the consumer weakens on the margin.  There are other restaurant I would like to own that are cheaper, currently under-earning, or better positioned in terms of demographic served...BWLD is a good subsector hedge for the general macro risk to owning any other restaurant company.

5.    As food inflation starts cooling off, other restaurant stocks will become attractive relative to BWLD as they will have a catalyst for margin expansion whereas BWLD is already at peak margins.

Risks:

1.    BWLD is unlikely to miss earnings in 2011 unless there is a marked consumer deceleration between now and the holiday season.

2.    It may be too early to be playing a potential 2012 miss based on rising chicken prices.

3.    Chicken wing prices often diverge from chicken prices for periods of time, so if chicken prices go up but chicken wing prices lag, the company can probably make its 2012 numbers.

4.    Company has 15% unit growth which is so hard to come by these days that investors may look through earnings revisions or misses because they are desperate for unit growth.

1.    Rising chicken prices late in 2011/early in 2012 cause earnings estimates for 2012 to drift back down towards the $3.00 level from the current $3.26.

2.    NBA strike happens and causes some missed games.

3.    Comps decelerate in Q3 because of a tougher prior year comp, lower price increases, or a marginally weaker consumer

4.    General macro - the consumer weakens on the margin.  There are other restaurant I would like to own that are cheaper, currently under-earning, or better positioned in terms of demographic served...BWLD is a good subsector hedge for the general macro risk to owning any other restaurant company.

5.    As food inflation starts cooling off, other restaurant stocks will become attractive relative to BWLD as they will have a catalyst for margin expansion whereas BWLD is already at peak margins.