Description

CEC Entertainment (CEC) ($34.70)

CEC Entertainment (CEC) offers investors a free cash flow yield of 8% (based on free cash flow that is growing at 10%+ per year over the next several years), a strong balance sheet (net debt at 0.7x EBITDA), a very large share repurchase program ($400 million vs. $1.2 billion market cap), high operating margins (26% EBITDA margin) and high returns on capital (19% after-tax ROIC). CEC owns and franchises Chuck E. Cheese restaurants, and operated 507 restaurants in 48 states as of October 2005. 462 are owned and operated by the company and 45 are franchised. CEC offers customers a unique combination of food and games that has few truly direct competitors. Independent market research shows that the Chuck E. Cheese character is more popular among kids ages 6 to 8 than Mickey Mouse, Barbie, Barney, Spiderman, and scores of other characters. There were more than 75m customer visits in 2004 to CEC’s restaurants and over 2m birthday parties.

CEC restaurant units are typically located in shopping centers or freestanding buildings near shopping centers and generally occupy 7,000 to 14,000 square feet. Kitchen and related areas usually occupy 35% of space, dining area occupies about 25% of space, and playroom area occupies about 40% of space. Each restaurant’s playroom area has about 45 coin and token operated attractions, including games and rides. Food items include pizzas, salad bar, sandwiches, appetizers, and desserts (OK, we know the food is not that great, but we don’t think that is the point here). Food and beverages were about 66% of total sales in 2004, games sales were about 31% of total sales, and merchandise sales were about 2.5%. As of 12/31/04, CEC restaurants were most heavily concentrated in California (64 restaurants, 14% of total), Texas (54 restaurants, 12%), Illinois (22 restaurants, 5%), Florida (21 restaurants, 5%), Pennsylvania (21 restaurants, 5%), and New York (21 restaurants, 5%). Most CEC stores are leased.

CEC’s primary customer base generally includes families with children between two and 12 years of age. The primary advertising medium is television and the Company runs advertising campaigns aimed at increasing the frequency of customer visits.

CEC performance recently stumbled in Q3 (see below). We believe this provides an opportunity to create the investment at an attractive long-term valuation. CEC has consistently grown its units, revenues, EBITDA, cash from operations, and net income over several years and we think CEC will stabilize comp store sales and get back on a long-term growth path for EBITDA, EBIT, EPS, and free cash flow.

Importantly, CEC’s strong free cash flow allows it to concurrently grow its store base by 6% to 7% per year and reduce its share count by 6% to 8% per year. CEC retired about 17% of fully diluted shares outstanding in 2003 and 2004. It is this steady growth in units and concurrent reduction in diluted share count that we think will continue to occur over the next few years that forms an important part of our investment thesis. We think free cash flow can grow 10% per year and free cash flow per share can grow at 15%+ per year. It is growth in free cash flow per share that we believe will ultimately catalyze shareholder value.

We believe CEC offers investors a free cash flow yield (net income plus depreciation and amortization minus maintenance capital expenditures) of 8% at today’s prices, with a strong balance sheet and owner-oriented mgmt team. We come up with free cash flow of $100m, or about $2.80 per share of free cash flow ($100m / 35.5m shares). At current prices CEC is trading about 12x free cash flow that we think will continue to grow in excess of 10% per annum over the next few years – CEC currently has 507 company units and 45 franchised units in the U.S. and mgmt thinks there are at least 250 additional store development opportunities in the U.S. and Canada (e.g., there was only 1 CEC restaurant in AZ at 12/31/04).


Summary financial history

2001-4
FYE 12/31 2001 2002 2003 2004* 9mos 9mos. CAGR
Sales 562 602 655 728 556 562 9%
EBITDA 138 154 162 192 152 150 11%
EBIT 99 110 112 136 110 105 11%
Net income 61 66 67 83 67 63 11%
EPS $1.49 $1.55 $1.66 $2.15 $1.73 $1.72 13%

* Note: 2004 included an extra week (in Q4) (this added about 11 cents to Q4 EPS).

Cash from operations 122 136 159 166 137 111 11%
Capital expenditures -114 -111 -94 -80 -59 -58
Share repurchases -13 -32 -83 -114 -104 -88

Net debt 48 58 70 78 81 105
Shareholders equity 337 360 364 361 342 348

EBITDA margin 25% 26% 25% 26% 27% 27%
EBIT margin 18% 18% 17% 19% 20% 19%
ROIC (after tax) 16% 16% 15% 19%


Company units (per end) 350 384 418 449 438 462 9%
Franchised units 50 50 48 46 50 45
Avg. revenue per unit 1,634 1,641 1,628 1,695


Comp stores 2.6% -1.0% -0.3% 2.0% -3.0%
Average diluted shares 42.8 42.3 40.4 38.5 38.7 36.7 -4.5%

Valuation numbers *

P / Rev (LTM) = 1.7x
P / EBITDA (LTM) = 6.5x
P / EBIT (LTM) = 9.4x
P / FCF (LTM) = 12x

LTM EBITDA = $190m
LTM Revenues = $734m
LTM EBIT = $131m
LTM FCF = $100m
FYE 12/05 Est. EPS = $2.04
P = $1,235m
Net debt = $105m

* Note: 2004 included an extra week (in Q4) (this added about 11 cents to Q4 EPS).

Unit economics

Mgmt says it costs about $1.8m to open a new unit, including about $850,000 for equipment and games and $950,000 on the building, seats, etc. Mgmt maintains CEC earns a 25% cash-on-cash return on its new units and new units are profitable relative quickly. Average revenue per restaurant of $1.695m and CEC’s EBITDA margin (25%) imply a $423,000 return on investment (23.5%). The capital spent on these new units is growing the business and should further increase consolidated free cash flow.

Cost structure / high fixed cost business

Labor expense is the largest cost component at about 27% to 28% of sales. Other expenses include rent (about 50% of Other expenses category), taxes, and other fixed cost type items associated with the store base. Other expenses are generally about 17% to 18% of sales. Food, beverage, and related expense is about 12% of sales. SG&A expenses are about 12% of sales. CEC’s cost structure has a large portion of fixed and semi-fixed costs and results in high EBITDA and EBIT margins of about 25% and 18%, respectively. Mgmt believes it needs about 1% to 2% comp growth to leverage margins. Margin leverage primarily occurs with the Other expense and SG&A expense categories. Mgmt does a good job controlling expenses. Mgmt knows that driving incremental sales growth is very important to this high fixed cost business.

CEC spent $26m on advertising during 2004 (about 3.6% of sales). Advertising is primarily on television, including Cartoon Network, TBS, and Nickelodeon. CEC uses coupon drops to drive incremental sales. Mgmt plans to increase the frequency (and value) of coupon drops from 13 times per year (every 4 weeks) to 16 times per year in 2006 in an effort to drive more traffic thru the chain. Mgmt has also added two additional coupon drops to Q4 in 2005 to drive addition traffic.

Capital expenditures

CEC expects to spend about $90 to $95m on capital expenditures for the fiscal year ended 12/31/05. The major components are as follows: $58m for 32 new units at $1.8m each (6% unit growth); $30m for major store remodels; and $10m for store maintenance capital expenditures. We consider all capital expenditures other than new stores to be maintenance capital expenditures. While mgmt claims to get a high return on major store remodel investments, we believe this is imbedded in the chain’s comp store sales numbers.

CEC expects to spend $90 to $95m on capital expenditures during the fiscal year ended 12/31/06, opening 30 to 33 new units (6% unit growth).

Balance sheet

CEC has a strong balance sheet (as of 10/2/05). Working capital requirements to grow the business are typically negative (although we have not included this source of cash flow in our free cash flow estimates).

Cash $11
Accounts receivable $18
Inventories $14
PPE, net $576
Total assets $632

Payables & Accruals $64
LTD $116
Deferred rent $59
Deferred taxes $34
S/E $348


Share repurchase program

CEC’s share repurchase program is one of the major positives for us regarding this investment. CEC has consistently repurchased it shares in recent years, including about 17% of fully diluted shares in 2003 and 2004. The Company repurchased $114 million of stock in 2004, representing about 3.2 million shares (8.2% of diluted shares outstanding) at an average price of $35.60. During 9mos 2005, the Company has repurchased $88 million of stock (6.7% of diluted shares outstanding). During Q3, CEC repurchased $24 million of stock, representing 751,000 shares at an average price of $31.95.

The result of this share repurchase has been something we really like to see in our investments – a steadily declining share count over several years. Average diluted shares have declined from 42.3m in 2002, to 40.4m in 2003, to 38.5m in 2004, to 36.7m for 9mos 2005, and to 36.0m for Q3 2005. CEC is, in effect, slowly going private.

CEC implemented a major expansion of its share repurchase program in July 2005 in the amount of $400 million. This share repurchase program represents almost 33% of the market value of CEC – it is rare to find such a large program as % of outstanding shares. We would not be surprised to see share repurchases continue at $80m to $100m per year over the next few years. Mgmt is conservative about incurring additional leverage to repurchase shares, but has been modestly increasing debt to fund share repurchases in recent quarters. We feel strongly that CEC is over-equitized and that mgmt could comfortably take on much more leverage to repurchase shares – think AutoZone. Currently CEC has a credit line of $200 million, which is not much more than 1x LTM EBITDA. A more aggressive share repurchase program, coupled with additional leverage on the balance sheet, could produce much higher ROIC and increased shareholder value. We also think CEC and its brand equity and its substantial free cash flow could be a good candidate for an LBO or a purchase by a strategic buyer.

We estimate that CEC could reasonably repurchase $80m to $100m of stock per year (6% to 8% of shares outstanding) while simultaneously growing new units by 30 to 33 (about 6%) per year. Given stable comp store sales, we think the result over the next few years is that free cash flow can grow 10%+ per year over the next few years and that free cash flow per share can grow 15%+. We think this will ultimately produce meaningful shareholder value from current levels.


Q3 problems / Mgmt plan / Q4 and 2006 guidance

CEC’s Q3 revenue was down 2.2% due to a comp store sales decline of 5.1% partly offset by weighted average increase of 21 units. Q3 net income declined 23% to $16.3 million and diluted EPS declined 20% to 45 cents versus 60 cents prior year. Mgmt has cited 3 major factors for these poor results: 1) very poor consumer acceptance of the Super Chuck Summer program (this included advertising for a pizza and 8 tokens for $4.99) – consumer acceptance was lower than expected (surprise, surprise, the kids watching the advertisements didn’t really care much about the cost of the pizza) and the program was pulled and replaced after only 2 weeks, resulting in a poorly coordinated campaign versus a strong campaign prior year; 2) higher gas prices which were almost 35% higher versus prior year – mgmt believes this negatively impacted spending by CEC’s lower, middle income customer base (annual income of about $40k to $70k per year); and 3) Hurricanes Katrina and Rita (these appear to be less of a significant factor).

Mgmt is aggressively responding to these issues by: 1) enhancing value and experience for customers, including price and experience – a new coupon program has been tested successfully and the frequency (and value of offers) of coupon drops will be increased in 2006 to 16 from 13 – mgmt believes this will drive more traffic into units (mgmt is also adding 2 additional coupon drops in Q4 to drive more traffic); 2) continued investment in the major remodel program (typically costs about $300,000 to $350,000 per unit, but does vary some) which increases square footage and skilled games – 140 total units will be remodeled in 2005 for about $28m; 3) improved prizes for kids; 4) improved television advertising and return to use of some 30 second commercials versus 15 second spots for last 10 years; and 5) continued focus on improved operations thru interaction with store managers.

Comp stores appear to have started to respond to these new programs. Comp stores were actually +2% during the first 3 weeks of Q4. However, mgmt remains cautious and has given comp store guidance for Q4 of flat to -3%. Q4 EPS is expected to be 30 cents to 36 cents.

Mgmt’s full year estimate for 2005 is $2.02 to $2.08, close to prior year excluding an extra week in 2004. 2006 EPS guidance is for EPS growth of 10% to 12% - this assumes comp store growth of 2%, stable commodity prices, and 30 to 33 new units. (It also assume some share repurchases, but mgmt won’t disclose the amount). We think comp store growth targets will be helped as CEC starts to cycle the poor quarterly comp results of 2005 in 2006.

Mgmt’s preliminary guidance for Q1 2006 is 93 to 96 cents versus 86 cents prior year. While we are not yet convinced mgmt has resolved the problems of Q3, we do think they are at least on the right track and expect comp stores to stabilize in 2006, obviously helped by cycling some pretty ugly quarterly comp results in 2005. We think time is on the investor’s side at these price levels. And mgmt’s continued aggressive share repurchases during an awful Q3 might speak to their confidence level in resolving these issues. While CEC has grown nicely over the last 5 years, we would point out that it has not always been in a straight line.

Mgmt & moat

Mgmt owns a meaningful stake in CEC and appears motivated to enhance shareholder value. (Although we would note that mgmt has been pretty liberal with their option programs – there are currently about 5.1m options o/s at $23 average price). Perhaps we have played one too many games with our kids in the restaurants, but we believe that CEC is not just another restaurant chain. CEC provides a unique combination of food and entertainment that has few direct competitors. There is really no national competition – most competitors are regional. CEC has also created, through years of cartoon advertising on television, significant brand equity. CEC’s business model is also simple and highly profitable with high returns on invested capital. In summary, we do think there is some “moat” around the business which should allow it to continue to achieve good returns on capital for several years into the future.


Comp Store Sales by Quarter
Q1 Q2 Q3 Q4 Year

2005 -1.8% -2.1% -5.1% -3.0%
2004 5.0% 0.1% 0.4% 3.1 2.0%
2003 -2.9% -1.5% 5.3% -1.4% -0.3%
2002 -2.2% 3.9% -2.7% -2.5% -1.0%



EPS by Quarter
Q1 Q2 Q3 Q4 Year

2005 $0.86 $0.40 $0.45
2004 $0.80 $0.38 $0.56 $0.41 $2.15
2003 $0.67 $0.36 $0.49 $0.30 $1.82
2002 $0.63 $0.36 $0.39 $0.2 $1.64


What’s it worth?

We think CEC will be able to use its strong cash flow to simultaneously grow its store base by 30 to 33 units per year (about 6% per year) and also repurchase $80m or more per year of common stock (about 6% to 7% of fully diluted shares outstanding per year) for the next few years. We think CEC can complete both activities primarily from free cash flow while adding only modest additional leverage to the balance sheet. We would like to see CEC be more aggressive in using its balance sheet in a share repurchase program but we don’t think mgmt has plans to do this.

We believe that CEC’s current free cash flow equals net income plus approximately $20 to $25m of depreciation and amortization expense (the amount total D&A exceeds our estimate of maintenance capital expenditures). We estimate that maintenance capital expenditures are currently about $35m versus D&A of about $58m. We believe that capital expenditures will continue to significantly exceed D&A over the next few years (as they have for the last 5 years) and that D&A will continue to grow faster than maintenance capital expenditures. We expect free cash flow to grow both from increasing net income and an increasing portion of D&A expense over the next few years. Based on net income of $90m (7% annual growth) to $98m (10% annual growth) and an incremental $30m of D&A which exceeds maintenance capital expenditures, we get about $120m to $128m of free cash flow in 2008. Based on our expected annual reduction in share count over the next few years, we would not be surprised to see a diluted share count of about 30m for CEC in 2008. (This assumes basically a continuation of the 2m+ annual decline in diluted share count of the past couple years). This would result in free cash flow per share of $4.00 to $4.30. We would not be surprised to see CEC trade at 15x our range of $4.00 to $4.30 of free cash flow per share in 2008, or $60 to $65 per share. This would represent an IRR of about 20% to 23% per annum from today’s price.

Risks

Mgmt is not able to stabilize comp store sales.
Higher gas prices permanently depress restaurant traffic.
Economy slows down further.

Conclusion

We think CEC is a very strong cash flow generating machine that should be able to significantly grow free cash flow and free cash flow per diluted share over the next few years. We believe this has the potential to result in a significantly higher stock price versus today’s levels. CEC’s current valuation at 12x free cash flow is attractive for a stable, billion-dollar business with a well-known brand name, a differentiated product (food and games combination), and growing free cash flow per share.

Disclaimer: We own shares of CEC. We may buy or sell these shares at any time without notice. The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment. We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst

Potential Catalysts

a) Stabilization of comp store sales growth beginning in Q4 and into 2006 driven by new marketing program discussed above and easier comp store comparisons.
b) Continued aggressive share repurchase program (repurchases totaled $110m in 2004 and will probably exceed $100m again in 2005 – vs. a current market cap of about $1.2 billion).
c) Continued new store expansion at about 30 to 33 units per year over next few years (about 6% annual growth in chain)
d) High returns on invested capital, combined with continued shrinkage of diluted share count, should allow free cash flow per share to grow at 10% to 15% over next few years.