Description

SUMMARY

Chef’s Warehouse (“CHEF”) seems to be a posterchild of the euphoric “reopen rally” and “dash to trash”.  More specifically, CHEF is a commodity business (distribution) selling a commodity product (food) to a decimated customer base (fine dining & upscale casual independent restaurants in urban markets).  Yet, CHEF’s share price has risen > 450% since its March low as shareholders seem to expect a very rapid recovery.  For the reasons below, I believe a quick rebound to 2019 earnings is unlikely and therefore CHEF’s share price has substantial downside.

PRICED AT A SIGNIFICANT PREMIUM TO THE INDUSTRY LEADER

CHEF mgmt provided 2020 guidance in Jan’20 and then updated that guidance in Feb’20. The Feb’20 update incorporated two acquisitions that closed in late Jan & early Feb.  Annualizing these acquisitions and adding to CHEF’s reported 2019 results implies pro forma 2019 EBITDA of $97mm.  Assuming this hypothetical $97mm of EBITDA, CHEF’s 2020 guide for D&A, SBC & tax rate, estimated interest expense given current cap structure, and diluted shares after the May equity offering, I estimate the company’s pro forma 2019 EPS is ~$0.70 implying CHEF currently trades for ~28x. 

For perspective, the largest & arguably best food distributor, Sysco (“SYY”), has historically traded for ~20x EPS and currently trades for ~20x 2019 EPS.  Due to SYY’s diversification across customer types & geographies, massive scale (industry leader with ~30x more sales than CHEF) and higher growth (2015-2019 EPS CAGR of 18% vs. CHEF’s 7%), I think SYY should command a premium to CHEF’s multiple and therefore CHEF should trade < 20x EPS.  More importantly, I believe it will be many years before CHEF actually reports my hypothetical pro forma 2019 EPS so CHEF should not be valued off this metric. 

CHEF UNLIKELY TO ACHIEVE PRO FORMA 2019 REVENUE FOR THE FORESEEABLE FUTURE

Historically, CHEF’s distribution to upscale casual and fine dining independent restaurants in large cities was a tailwind but that appears to have shifted into a major headwind.  CHEF’s 2019 10K reveals that ~25% of revenue comes from the New York/Boston market.  Both 1Q20 acquisitions are also based in Boston, so NY/Boston now represents > 35% of CHEF’s revenue.  Based on responses to an SEC query (filed 11.16.19) and adjusting for recent acquisitions, I estimate CHEF receives another ~20% of revenue from other East Coast markets (includes Philly, DC, and Miami), ~25% from the West Coast (includes LA, San Fran, Vegas, and Seattle) and ~20% from the Midwest/TX (includes Chicago, Dallas, and Houston).  Most of these cities have been severely impacted by COVID and now the George Floyd protests.  Based on OpenTable, I estimate reservations in CHEF’s markets remain down a weighted average of > 85%. 

According to an April survey by the James Beard Foundation, only 20% of restaurants in shutdown cities were “very certain or somewhat certain” that they could survive until normal operations resume.  To be clear, many independent restaurants have razor-thin margins at full capacity so < 75% capacity will certainly not be “normal”.  As one restaurant owner explained, many restaurants are only surviving right now because of deferred rent and government stimulus.  But as these benefits come to an end, he anticipated a “restaurant apocalypse” with many independent restaurants permanently closing. 

In addition to the recent shutdowns, COVID is having a long-term impact with many Americans now relocating from the cities to the suburbs.  This is a trend that should shrink CHEF’s market opportunity and extend the timeframe necessary to return to pro forma 2019 revenue. 

Furthermore, I believe the current crisis will result in CHEF ceding market share instead of gaining it.  Yes, some of its smaller competitors will go out of business, but CHEF faces multiple larger competitors.  Relative to CHEF’s pro forma 2019 revenue of < $2b, its public peers (SYY, US Foods, and Performance Food Group) each have $30-60b of sales.  Amongst private peers, I believe at least two produce > $14b of annual food distribution revenue (Gordon Food Service and McLane) and at least two more generate ~$3b of annual sales (Ben E Keith and Shamrock Foods).  These larger food distributors also sell to large restaurant chains, but earn their highest margins on independent restaurants.  Now, all of these competitors will likely be fighting over a smaller independent restaurant market.  

Also, CHEF claims to be unique due to the depth and breadth of its food products, but restaurants are cutting menu items/SKUs so CHEF’s supposed differentiation is becoming far less relevant.  To be clear, CHEF’s 2019 revenue mix consisted of ~45% center-of-plate proteins, ~20% dry goods, ~15% pastry, ~15% dairy/eggs, and ~5% oils/supplies so I don’t think the company’s offering is that unique.  Plus, given restaurants will be struggling to earn a profit due to capacity constraints and lower demand, they will likely be pressuring their distributors to cut prices.  As a result, CHEF could lose volume to both larger & desperate smaller distributors able & willing to offer lower prices OR CHEF could be forced to lower prices & therefore collect lower revenue.

In short, I don’t foresee CHEF rebounding to pro forma 2019 revenue for many years due to significant closures of independent restaurants in urban markets, consumers fleeing these areas, a more competitive landscape, diminished product differentiation, and pricing pressure from restaurants.

LOWER REVENUE SHOULD RESULT IN FAR LOWER PROFITS

On CHEF’s 1Q20 call, mgmt claimed only ~33% of operating expenses are fixed but I have my doubts.  First off, mgmt wouldn’t disclose this when asked on CHEF’s 1Q18 call.  More importantly, SYY stated 33% of its operating expenses are fixed but it owns ~80% of its distribution centers and trucks.  Meanwhile, CHEF leases > 95% of its DCs and fleet so the company’s leases and therefore fixed costs should be much higher than SYY.  Nonetheless, I conservatively assume only 33% of CHEF’s operating expenses are fixed.  Coupled with assuming CHEF recaptures 90% of its pro forma 2019 revenue by 2022 (which seems unlikely), flat gross margin, SBC declines w/EBITDA, flat D&A, flat interest expense, and 28% tax rate, I estimate the company would still only be generating ~$0.30 of 2022 EPS implying CHEF trades > 60x P/E.

Supporting my estimates is the fact that a key to distribution is route density.  This is particularly true for CHEF with an average order value of only $1k (per 11.16.19 filing).  It is unlikely CHEF’s restaurant customers will close in clusters of a geographic region.  Instead, each region will likely have fewer restaurants.  Therefore, CHEF should need the same number of drivers, trucks and distribution centers to serve its regions but will have fewer customers going forward.  Clearly, lower revenue over the same fixed costs equates to less profitable routes and lower profit margins. 

On top of route density, another key to distribution is scale.  With lower revenue, CHEF should have less purchasing power so its suppliers will likely charge more per product, which should reduce CHEF’s gross margins (though not factored into my 2022 estimate) and further squeeze CHEF’s profit margins.

ACQUISITIONS & GROWTH INITIATIVES ADD RISK TO CHEF’S TURNAROUND

As discussed above, CHEF closed two acquisitions just weeks before COVID decimated the restaurant industry.  Based on combined annual revenue of ~$225mm, these acquisitions represent mgmt’s largest ever.  Mgmt will now be trying to integrate these acquisitions during a very challenging environment.  Furthermore, CHEF was in the process of expanding its warehouses on the West Coast and installing a new ERP system across its disparate businesses.  Mgmt has put the integrations, expansions, and ERP implementation on pause, but I doubt they can delay these projects for too long.  I think the distraction of successfully executing these initiatives further reduces the chances that CHEF will return to pro forma 2019 profits for the foreseeable future, especially given management’s track record as highlighted below.

CHEF MANAGEMENT HASN’T PROVEN THEY CAN ORCHESTRATE A SHARP RECOVERY IN PROFITS

CHEF last reported a ~7% EBITDA margin in 2013.  Since then, mgmt has been promising a return to 7% margins but was still not close as of 2019 (~5.5% margin).  In Nov’14, mgmt indicated CHEF would approach 7% margin at $1.2b revenue.  CHEF reached ~$1.2b of revenue in 2016, yet margin remained at ~5%.  In Jun’17, mgmt outlined reaching 7% margin by 2020 but guided to < 6% before COVID.  Due to margin degradation, CHEF mgmt increased revenue at a 13% CAGR from 2013 to 2019 but EPS expanded at only a 3% CAGR.

As another example of milestones not achieved by CHEF mgmt, they guided to being close to break-even in Texas by 2020 on their 3Q19 call.  One quarter later on the 4Q19 call, mgmt stated they hoped to be break-even in 2021 or maybe not until 2022.  CHEF mgmt proved incapable of delivering on its profit targets during a roaring economy with the tailwind of independent restaurant openings in large cities.  As such, I doubt mgmt can execute well in the current environment where tailwinds have quickly reversed into headwinds.  

Whether they execute or not, CHEF’s founding brothers, who act as Chairman/CEO and Vice Chairman, will likely continue to be compensated well.  In addition to combined annual salaries > $1.4mm, CHEF pays the brothers > $500k per year to lease an owned warehouse and CHEF covers > $100k of annual costs for a private jet.

ESTIMATED FAIR VALUE IMPLIES > 65% DOWNSIDE

Applying a generous 20x (SYY’s historical multiple) to my 2022 EPS estimate of ~$0.30 implies CHEF is worth < $7 per share implying > 65% downside.  Lower profits coupled with restaurants likely delaying supplier payments should lead to CHEF burning cash this year and next.  But for conservatism, I assume interest expense is flat over the next few years.  The fair value above also does not account for the time value of money.  Applying an appropriate discount rate of 10% then implies CHEF should be trading for ~$5 per share implying ~75% downside.

Catalyst

I expect restaurant closures to accelerate as rents comes due and stimulus programs fade.  In turn, I expect 2Q-4Q20 results and mgmt commentary to temper expectations of a quick rebound.