Description

FOGO DE CHAO (Nasdaq: FOGO)

FOGO is a recently IPO’d Brazilian steakhouse with a unique concept/model that is highly profitable. With a long runway for growth, the company has the ability to redeploy its cash at very high rates of return. By simply continuing to execute on a proven rollout strategy, Fogo shares provide approx. 70% upside over the next 2 to 3 years with an ability to compound capital at attractive rates for many years to come.

Company overview

Fogo de Chao is a leading Brazilian steakhouse with 37 restaurants – 26 in US, 10 in Brazil and 1 JV in Mexico. Fogo applies an authentic Brazilian concept into an award-winning fine dining experience. The unique model drives meaningful traffic and AUV and utilizes operational and financial advantages to generate best-in-class margins and returns. With only 26 stores in the US, the company is poised for strong US expansion in addition to international growth opportunities and recent initiatives to drive comp-store sales. Fogo opened its first restaurant in Brazil in 1979 and has never closed a restaurant. Management has no plans to franchise given the attractive economics of company-owned stores.

Unique Concept/Model = Best-In-Class Metrics

Fogo de Chao offers a churrascaria dining experience with fixed-price all-you-can-eat continuous service served by gaucho chefs.  Gauchos serve as both chef and server which eliminates the need for a large kitchen support staff. Fogo’s authenticity comes not only from its Brazilian origin, but from its continued ability to source trained gauchos from its Brazilian operations. Approximately a third of US gauchos were brought to the US on long-term cultural visas and train local staff on cooking and serving techniques. 

Guests start with the Market Table (self-serve salad bar) and continue with high quality meat sliced table-side by gaucho chefs who walk around the restaurant with different cuts. The Market Table is filled with high-quality offerings, including fresh vegetables, Brazilian hearts of palm, and imported cheese and cured meats. The meats served by the gauchos are cut to the diner’s preferred temperature and while delicious, usually aren’t prepared with much more than salt.

Fogo restaurants average 137k guests/yr (~2x most fine-dining peers) and generate ~$8mm AUV (vs $4-6mm for comparable-sized steakhouses). With an average check 25% below peers, Fogo delivers a compelling value proposition for guests and upside opportunity (through driving alcohol sales, appetizer and dessert add-ons).

Because of the model, Fogo has an inherently lower cost structure relative to other full-service restaurants/steakhouses:

• Gaucho taking on the task of both chef and server significantly reduces labor requirements. Simple cooking techniques, streamlined food offerings and the self-serve Market Table also reduces staffing needs. Labor as a % of revenue is 21% for Fogo compared to 32% for its peers.
• In-house butchering provides higher yield on meat cuts and variety of protein provides meat flexibility. Despite a 20% increase in beef prices over the last two years, Fogo has reduced COGS by 170bps through introduction of margin accretive new products and mix shifting offerings.

Combining high AUV and a lower cost structure, Fogo restaurants generate a 33% contribution margin (compared to ~20% for peers).  Since 2007, mature restaurants (open 3+ years) have generated an average cash-on-cash return of 50%+

The only other national churrascaria, Texas de Brazil, lacks authenticity as it does not have any Brazilian locations. Its restaurants generate approximately half the AUV compared to Fogo locations and are ranked equal or lower than Fogo in the 11 markets where they compete. While there are other churrascarias throughout the US, they tend to be small, family-owned operations.

Real estate expansion (10% CAGR + JV)

Fogo opened its first restaurant in Brazil in 1979 and entered the US in 1997. As a founder-operated business, the company expanded slowly over the next decade but focused more on cash generation rather than growth. Since 2007, the company has been owned by two PE firms which oversaw the expansion from 11 to 37 stores.

The company currently has 26 locations in the US and I believe they can open up to 100 stores in the US providing a long runway for growth (management thinks they can open 100+ more stores). As a point of comparison, in the US alone there are 122 Ruth’s Chris, 66 Morton’s, 60 Fleming’s, and 53 Capital Grille locations. Our research contacts also indicate that Fogo is a desirable anchor tenant for upscale developments which provides them an advantage in securing great locations. The company plans to open 5 stores per year in the US and 1 store per year in Brazil (10% real estate CAGR). The company has opened 2 in 2015 with 4 more under construction. The company has 5 sites under lease for 2016 openings and is on track to deliver similar growth in 2017.

In terms of growth beyond the US and Brazil, the company opened its first JV in 2015 (Mexico City) and will open its second JV in 2016 (Dubai). JV economics are extremely attractive as Fogo does not put up any capital (contributes management/expertise/gauchos) but receives an initial opening fee, 3% trademark royalty, and half of the profits after the JV partner recoups their initial investment (usually 2.5 years). The JV partner gets to partner with a proven concept and generates a mid-20’s cash-on-cash return. Each JV unit will contribute $1-1.5mm to the Fogo bottom line with no capital costs. Management has also indicated an interest to enter other international markets, including Canada and Australia, but does not intend to use a JV structure due to the higher returns available from owning the restaurants.

Comparable-store growth

Management has recently implemented multiple initiatives to drive comparable restaurant sales. These initiatives should drive at least low-single digit comp-store growth.

• Alcohol – Alcohol accounts for 15% of revenue compared to 25-30% for peers. Fogo only recently began offering wine by the glass and is also experimenting with happy hour offerings. Caipirinha is Brazil’s national cocktail (similar to a mojito) and plays well on the authentic experience. It may seem obvious but alcohol is also a high margin sale
• Upsell opportunities – Though the menu if fixed price, there are optional add-ons which can increase the average ticket, such as dessert and recently-introduced seafood offerings
• Corporate/group sales – The Company recently built out a sales team to target corporate/group dining and has experienced positive results to date (12% of revenue growing at 13% comp-store).
• Lunch – Fogo is still figuring out lunch. The company has expanded Sunday lunch times and is testing out a Saturday lunch option.

Management/ownership

TH Lee is the private equity sponsor which took the company public. Fogo raised $90mm in the IPO to refinance debt and for corporate purposes. THL did not sell any shares in the IPO and still owns 80% of the equity. 

THL presumably took advantage of a strong IPO market in deciding to IPO now but we see the decision for them not to sell any shares as a positive one. Moreover, some insider buying (with no selling) in the IPO is also a positive.

Larry Johnson (CEO) started with the company as Corporate Counsel in 1996 (when they started in the US). He became CEO in 2007 and led the expansion from 11 to 37 stores. He is actively engaged in the development of the new locations and signs off on each new site.

Beef Prices

As a steakhouse, rising beef prices has been a headwind for the company. Despite meat accounting for 57% of food/beverage costs (17% of revenue), management has been able to deal with this headwind by mix shifting offerings (such as more chicken/pork or strip steak instead of ribeye). By introducing margin accretive products and utilizing waste reduction initiatives, management has been able to reduce COGS by 170bps over the last three years despite the beef headwind (+20% over same period)

Current signs indicate that beef prices may have peaked and should begin declining. Jan 2015 data showed the first growth in the herd since 2007 and recent heavy rains in TX will provide grazing conditions to further support herd expansion. Futures indicate a 5-6% y/y decline in cattle prices by year end and a similar decline in 2016 which would add a couple of percent to contribution margins.

Valuation

At $22, FOGO has a $640mm market cap and $788mm TEV. The company currently trades at 10.1x 2016E EBITDA and a 7.4% FCF yield (after maintenance capex). Given the significant runway for profitable growth, high FCF generation, and ability to redeploy cash at high rates of return, this valuation provides an attractive entry point into a surprisingly very good business.

If you look out to 2018, Fogo will have 55 stores generating $400mm+ of revenue and $100mm+ of EBITDA, and still a long runway for growth. At 11.5x forward EBITDA, the stock price will be $38 by 2017 year-end, representing approx. 70% return.

11.5x is a reasonable multiple based on the growth trajectory relative to the risks. When we look across the entire restaurant sector (which currently trades at ~11.5x forward EBITDA), we believe FOGO should trade at a premium to the average due to its ability to grow at above average rates with superior unit level economics/returns. FOGO will also have more substantial international JV operations providing another attractive leg for profitable growth.

Other Notes

• Brazil accounts for ~20% of revenue though this % will decline due to strong US expansion. There may be near-term volatility due to tough comps (World Cup drove +12% SSS in Brazil in 2Q-3Q 2014), economic slowdown, and currency risks. Fogo, however, will receive a benefit from the Rio Olympics in 2016, receiving a similar benefit as the World Cup in 2014.
• In conjunction with the IPO, the company paid off/refinanced its debt. The interest rate will effectively be lowered by ~2% and total interest expense will fall by ~$10mm.

Catalyst

• Continued strong execution and store growth (top line growth and margin expansion)
• Sell-side initiations
• International JV deals announced
• Share repurchases