Description

We have spent time this year looking at broken IPOs and one of our favorite broken IPOs is Fogo de Chao (fogo-dee-shoun).  The reason we consider it broken is that went public at $20 per share on June 18, 2015, climbed as high as $26 briefly on low volume (illiquid stock), traded down in the $20s for some time, and then steadily declined below $15.  The sponsor TH Lee, a respected PE firm in Boston, did not sell shares in the IPO.  TH Lee owns 80% of the stock, and the daily trading volume is around $4 million.       

At this valuation, we feel that Fogo de Chao offers a great risk-adjusted return.  Please refer to the prior write-up posted by zbeex in July 2015.  It is a solid write-up and zbeex does a great job describing the business as well as explaining the dynamics that make it attractive.  We are posting an updated write-up as the stock has fallen from $22 at the time of previous write-up to $14.88 and we want to highlight the investment opportunity.  We also will describe unit economics in some detail as they are the primary driver of returns here.   

We arrive at a fair value estimate today of $22 (50% above today’s valuation), which translates into a year-end 2017 value of $26.  This is below zbeex’s original 2017 year-end target of $38.  That being said, many variables have a large impact on valuation: same store growth assumptions, multiples, and currency, for example.  Zbeex is probably correct in giving them more credit than we do with regard to the runway for future growth.  If you give them credit for eventually being fully penetrated, and then discount that back, you will arrive at a higher price target.  We do not see many reasons why the company will not be able to achieve a full build-out of its concept.  We are also not giving them credit for certain options like lucrative JVs, though JVs will be a real aspect of the company’s long term growth.  

The basic thesis is that (1) the company has the ability to compound for years to come since the concept is underpenetrated in the U.S., (2) unit economics are extremely compelling, and (3) the stock trades at a 9% free cash yield on a maintenance capex basis.

Let’s first establish the current valuation.  

My estimate for 2016 EBITDA is $58.5 million.  This is below consensus partially due to BRL currency declines and also because the street does not model in the fact that future locations will on average have a lower sales volume.  The lower sales volume stems from some smaller formats and partially due to management being conservative.  At this valuation, FOGO is trading at a level which implies 0-1% same store sales growth and no ability to reinvest in its business.  Over the long term, the company should be able to at least maintain SSS in line with inflation, while investing all of its cash flow in highly accretive store growth.     

My estimate for maintenance capex is slightly higher than what the CFO uses.  I include the cost of refreshes which occur from time to time.

Sustainable concept?

Many restaurant concepts come and go.  We feel it is a sustainable concept.  This is borne out by history as the first restaurant in Brazil opened in 1979, and the first location launched in the U.S. was in Addison (a suburb of Dallas) in 1997.  The company has never closed a restaurant.  This speaks to the longevity of the concept as well as the thoughtful site selection conducted by the company.    

I encourage you to visit the concept.  We have visited several locations and love the concept.  Prior to dining at FOGO, one criticism we had heard was that because it is a fixed price dinner, the restaurant brings out the poor cuts first to fill you up.  Specifically, a colleague had heard that FOGO “brings out pig butt, and then only after you’re stuffed do they bring out the edible food.”  This is not true at all.  They brought out terrific cuts from start to finish.  

The efficiency of the concept is great.  You immediately have access to the salad bar which has a great selection of salads, vegetables, cheeses, salmon, etc.  When you are ready to eat meat, you simply flip this medallion on your table from red to green, and the meats are brought to you.  When you have enough food and want to focus on eating, you flip the medallion back to red.  It is nice to control the pace of the meal, and given that steakhouses are not cheap, there is real value in being able to experience a wide range of meats.  It keeps it interesting and is very satisfying.  I realize these are all “soft” points but those were some the takeaways from our visit.             

Runway for growth

We visited the company in Dallas (corporate HQ is in Dallas) to understand their site selection process.  It is interesting to note that even in their hometown domestic market, they are underpenetrated.  They have only 1 location in the DFW area – in Addison, TX.  There is easily enough demand for additional locations in downtown Dallas, Plano, Arlington, and Fort Worth.  The same holds for many of their other markets.  The DFW metroplex is the 4th largest MSA in the country with 6.4 million people, yet they only have 1 location there.  While TH Lee’s large equity stake will be an overhang on the stock and limits the range of investors which can own FOGO, we do like that TH Lee is pushing them to accelerate the buildout and think in terms of return on incremental capital, not just same store sales growth.  We do think there was some complacency at FOGO prior to TH Lee coming on board.   

FOGO is unique in that it is a small player which already has a national presence.  Other concepts of similar size often take more risk as they expand as they do not yet know how well their concepts will fare outside of their regional areas.  There are many concepts in Florida or Texas or California, for example, which have had success in their niche markets but resonate less powerfully further from home.  FOGO’s locations tend to do equally well across the country.  

Unit economics

The compelling unit economics stem from the fact that you have a concept that works in a high-volume format with a streamlined prix-fixe menu and dual role gaucho chefs.  The gaucho chefs act as both cooks and servers, which mostly explains the 1100 bps gap in labor as a % of revenues of FOGO relative to peers.  The new locations will cost $4.5 million to build, and will ramp to $7 million in revenues over 3 years.  Year 1 contribution margins are around 22%; fully ramped contribution margins will be 27% for the new stores.  In the P&L below I distinguish between current locations and new locations.  There is about $25k of maintenance capex per store per year, and there is a $450,000 refresh every 7-8 years.  If you assume the location disappears after 10 years, you still get an IRR around 19%.  Of course, the location is still a valuable asset after 10 years.  The payback is slightly more than 4 years.  The company talks about a cash-on-cash return of 40%-50% but the statistic ignores maintenance capex, refresh capex, cash taxes, etc.  I am modeling in economic depreciation when computing taxes – in reality taxes will be lower since accounting depreciation will be much higher than economic depreciation.

FOGO's average unit volume is about twice the full-service average. The labor costs are around 20% of sales versus 31-32% - this accounts for the bulk of the differential in restaurant contribution margin between FOGO and peers. We spoke to real estate developers who had worked with FOGO - they like having FOGO in their locations as the high unit volumes draw larger crowds to their venues.    

Model assumptions

Here is our restaurant schedule, which details the timing of buildouts.  Note that the company is building about 5 locations per annum in the U.S., and we assume no new locations in Brazil.

Below is the P&L based on the above store schedule. We separate out the pre-2016 (i.e. current) locations from the newer locations.  The reason for doing so is that the company told us the newer locations are budgeted to have lower sales.  This was partially due to slightly different formats, but also due to conservatism.  So the new locations are run assuming $7 million in stabilized sales.  The “newer restaurant equivalents” is basically taking into account that it takes time for a new store to ramp, and that new stores are built throughout the year.  

You will note that I assume a 4% contraction in same store sales in 2017, followed by a flat comp in 2018.  Growth then resumes at 3% on a comp basis.  I am modeling in a slight economic slowdown during the period.  I keep margins flat on both the way down and the way up.  I am assuming they can take costs out on the way down, and then assume no operating leverage on the way up.  Most likely they will get operating leverage.

For the Brazilian locations, we assume 3% growth in comps.  Keep in mind that this is in USD.  We also assume the currency stays flat.  Over the long term, I believe that assuming a flat BRL-USD rate from here on out is conservative, but I am not a currency forecaster.          

Valuation

Our DCF valuation is based on the above P&L.  In out years (post build-out), we take EBITDA margins up to 21%, so we eventually give them some credit for moderate margin expansion.  150-200 bps of margin expansion is not unreasonable upon doubling the revenue base.  

We assume capex of about $30 million per annum through 2020, after which we assume 2% SSS growth and no new locations.  They can grow the store base for more than 5-6 years, but 5-6 years is what we are willing to underwrite.  To put this in perspective, after 5 years they will have 56 stores in the U.S.  The company is fairly confident it can reach well over 100 locations eventually.  But as any student of restaurants knows, as a concept become more penetrated, site selection becomes less obvious and requires more skill as there is also a risk of cannibalization.  The management team claims they do not worry about cannibalization and that a higher density of FOGO locations in an area results in higher awareness which drives increased visits in the aggregate.  Chicago is their only market with more than a year of data with more than 1 location.  Management was expecting 1-2% cannibalization, but saw that guests were increasing their frequency due to the increased convenience.  Time will tell as they further expand if this holds in other markets.  FOGO is building a third location in Chicago in 2016.  

We use assumptions which correspond to a 15-16x exit P/E multiple, which yields us a $22 stock price for today’s intrinsic value.  We think our new build economics are realistic, and that the growth and margin assumptions are fair.

JV Economics

We are not modeling in more JVs, but over time they should add real value.  The first JV restaurant opened up in Mexico City in Q2 2015.  They recently signed a JV partner in the Middle East to open up the first Middle East location in 2016.  

JV is a bit of misnomer as FOGO is not committing initial capital.  The JV partners puts up all the capital, and once the JV partner has recovered the initial capital outlay, the cash flow is split 50/50 between FOGO and the JV partner.  In addition, FOGO still receives a 2.5-3% royalty.  This arrangement is generally more attractive than a straight-up franchise agreement.         

Risks

Liquidity.  Getting in and out of the name can be costly.  We advise legging into the position over time and holding it for several years.  As TH Lee exits and the valuation improves, we would expect liquidity to improve.

Weak economy.  This is of course a risk as this is a consumer discretionary name.  A weak economy will hurt SSS growth, and these names in the short to medium term tend to trade based on SSS momentum.  Many of the investors in the restaurant space are momentum investors.  We are not bullish on the economy, we simply feel SSS can keep up with inflation over time.  The ability of the company to reinvest at high rates of return is the most important driver.  Even if SSS came off, the unit economics and IRRs for new location builds are very attractive.  Fortunately, leverage is modest and the company is appropriately capitalized to weather a downturn.

SSS growth.  They are making changes to improve their SSS growth.  In the U.S., it was close to 3% in Q3.  However, there are restaurant concepts which post more impressive SSS statistics.  Time will tell how successful management is in driving SSS comps.  They are doing more business on weekends, driving lunch, working on expanding alcohol as a % of total check (FOGO under-indexes when it comes to alcohol), and driving increased business and group events.  I am not willing to underwrite SSS growth much in excess of inflation, which is why the unit economics on new stores has to be compelling.  Some of the concepts with more robust SSS statistics are new concepts – I derive some satisfaction from knowing that FOGO has been operating for decades.  Because FOGO is focused on its value proposition, it tends not to take pricing in excess of inflation.      

What would cause you to change the thesis and exit?

If the unit economics on new stores are no longer attractive, then it is time to exit the name.  The core of the thesis is that high return on incremental capital driving sharply increased cash flows.  

Catalyst

New locations flowing through the P&L and highlighting the accretive growth. 

Improved SSS through initiatives tied to weekends, lunch, alcohol, and group events.

Increased liquidity which enlarges the investor base.