Description

Chuck E Cheese owns and franchises children’s themed restaurants and arcades intended to appeal to a primary customer base of families with children between 2 and 12 years of age.  In 2012, the stock declined from a high around $40 high to a low of ~$28 as the company pulled back on advertising in advance of the rollout of a new marketing campaign, including an updated design for Chuck E himself, a new website, the addition of a digital campaign and a focus that shifted from mostly targeting children to targeting both children and moms. However, this pullback in advertising was handled sloppily and led to a drop in same store sales and earnings in Q2 and Q3. In the Q3 call, management reported that they were beginning to see some stabilization in sales as they reapplied a portion of the advertising.

The new dual advertising emphasis between children and moms is designed to achieve a balance between prompting children to nag mom to take them (nag factor) and letting mom know that the restaurant is safe and clean (they are, in my view, amazingly clean).

Earnings in 2012 are tracking to decline from $2.87 in 2011 to ~$2.65 in 2012 due mostly to declines in Q2 and Q3 (Q4 may be down to flat yoy, at best, though it is seasonally the smallest quarter by far). Launch of the new advertising campaign, gaining back some ground on margins lost from the sales decline and continued use of free cash for buybacks should drive earnings to $3.00 to $3.10 in 2013. Applying a 13 p/e on recovered earnings yields a $39 stock. (P/E has ranged from 10 to 15 over the past three years.) At 5.5 EV to my 2013 EBITDA, the stock would trade at $41. (The stock was trading at 5.5 ev/ebitda before the problems.) The average of the two yields a $40 stock, or 21% upside.

Solid business model

CEC drives ~half of revenues from food/beverages and half from entertainment/merchandise. Birthday is about 15% of revenue and the company’s demographic sweet spot is children 3 to 7 years old.  The differentiation from other kids’ party locales is the brand promise, security, and cleanliness guaranteed with the franchise name, as well as entertainment package that offers branded tokens and game tickets that encourage repeat visits.

Though the business is not likely to produce high same store sales given it is driven by the population of young children and not menu innovation or fashion cycles, it is a pretty steady business in that it generates stable EBITDA year after year and management, after reinvesting in new stores, uses cash to steadily retire shares. I’m not crediting management or the business itself as best in class. It may very well be that opening less stores and retiring more shares would be a better allocation of capital, but the fact remains that excess cash is put to use to consistently and materially lower the share count.

New marketing campaign and remodels should provide lift

The company is in the midst of rolling out the update Chuck E Cheese brand icon.  The modernized mouse, and in particular, the ad strategy overhaul should help drive incremental traffic. (However, our thesis mostly hinges on the notion that reapplying advertising in 2013 that was not applied in 2012 on easy comps should provide some sales lift regardless of the newness of the campaign.)

As noted, marketing reallocations were a negative driver in 2012.  The Company attempted to transition from marketing more to mom, versus the kids.  Advertising spend was reduced too far at 50% reduction in children’s shows during July 2012 as final changes in advertising were made. Comp sales were hit and advertising was re-adjusted to 75% of last year levels which helped stabilize sales. The new children’s campaign launched in July 2012 and advertising targeted at moms was scheduled to start going into Aug-Sept.   A new enhanced website has been launched which provides menu coupons and promotions, and enable parents to book birthday parties on-line.

Recent flu concerns are fleeting and at worst one-time. We do not see the current scare as comparable to the 2009 swine flu epidemic. When the swine flu hit in 2009 comps were down 3-5% for 2 quarters and then rebounded in the worst macro period on record.

Catalysts going forward are showing that they are making progress in returning to positive comps in Q4 and begin rebounding in 2013.

Valuation

Earnings in 2012 are tracking to decline from $2.87 in 2011 to ~$2.65 in 2012 due mostly to declines in Q2 and Q3 (Q4 may be down to flat yoy, at best, though it is seasonally the smallest quarter by far). Launch of the new advertising campaign, gaining back some ground on margins lost from the sales decline and continued use of free cash for buybacks should drive earnings to $3.00 to $3.10 in 2013.

Assumptions include an increase in sales per store of 1.3% in 2013 (Q1: 0%, Q2: 2%, Q3: 2%, Q4: 1.5%) and that EBITDA margin recovers only slightly from 21.38% to 21.52% (compared to 22.83% in 2011), and that the company buys back $12M in stock at $35 avg, reducing share count to 16.0M at end of year. (It would not be surprising if they buy back more stock as their capex needs are coming down somewhat in 2013.)

Applying a 13 p/e on recovered earnings yields a $39 stock. (P/E has ranged from 10 to 15 over the past three years.) At 5.5 EV to my 2013 EBITDA, the stock would trade at $41. (The stock was trading at 5.5 ev/ebitda before the problems.) The average of the two yields a $40 stock, or 21% upside.

Investors gain an additional $0.91 cents in dividend along the way (2.8% yield).

Basic financials appear below:

Risks:

Comp sales remain flat to negative. 475 of 500 stores are mature (in the comp base) as of end of 2011.

Stronger winter 12/13 flu season impacts winter comps.  However, I see this as an periodic ongoing issue that passes.  

Catalyst