Description

Wingstop is a very successful, fast growing and capital light franchise business that has been riding the fad of chicken wings. However, valuation is crazy and near term catalysts are likely to push the share price materially lower.

My short thesis is predominantly based on 5 points:

• Same-stores sales have decelerated from 14% in 2012 to 3% in Q2 2016. I expect the trend to continue with sales metrics turning negative in the upcoming quarters;

• Competition has significantly intensified – c. 50% of existing chicken wing joints have been opened over the last 5 years;

• Expansion potential is overstated – Wingstop is unlikely to reach 2500 units vs current 900.

• Roark Capital is exiting Wingstop position with urgency and has already sold down 75% of its pre-IPO stake.

• Wingstop is priced for perfection. To justify current valuation, Wingstop needs to continue growing at current pace for the next 10 years, achieve unrealistic operating leverage and same store sales growth. I see 45% downside with more realistic but still very optimistic assumptions.

Business Overview

Wingstop is a chicken wing restaurant franchise business, with 900 units out of which only 19 are company-owned and the rest are franchised. Franchising business is growing very fast with 130 new locations opened over the last year. 75% of the orders are take-away.

Wingstop concept differs from its largest competitor Buffalo Wild Wings. Wingstop restaurants are c. 3 times smaller and designed for take-away business, whereas Buffalo caters for eat-in public, serves alcohol and broadcasts sports events. Only 16% of Buffalo Wild Wings sales are take-away (however, take-away segment for Buffalo grows at 25% annually). Also half of Buffalo Wild Wings restaurants are company owned.

Wingstop was founded in 1994 and started franchising in 1997. In 2003 the company was acquired by Gemini Group, which sold it to Roark Capital 2010, which in turn took the company public last year. Thus public shareholders are the 4th owners of Wingstop.

After 22 years of operations, 12 years of business optimization by 2 PE groups, 850 US locations + 63 international – company is still only generating $16m in TTM profits.

Decelerating same store sales and intensifying competition

Despite the continued strong growth in unit count, same store sales are on steep deceleration for both company owned and franchised locations. Growth dropped from 14% in 2012 to 3% in the latest quarter. This seems to be industry wide phenomena as Buffalo Wild Wings saw directionally similar sales trends.

3/4 of the 2012-2016 cumulative growth of BWLD was driven by pricing rather volume. Wingstop management does not reveal the breakdown, but anecdotal evidence (browsing through old menus) suggests that Wingstop has been more aggressive in raising prices - during the period Wingstop prices have increased a cumulative 25%+ vs 15% for BWLD. Thus approximately half of Wingstop same store sales growth was driven by pricing.

It is unlikely these menu price increases can be replicated going forward. Wingstop used to be cheaper relative to other chicken wing chains - now prices are roughly at the same level.

Also, Buffalo Wild Wings used to increase prices by 3%-4% annually, however in the latest conference call management noted that this will not to be the case going forward:

“I'd also say that as we think about pricing, we took minimal, less than half a percent for our first menu price in May and our menu price in the fourth quarter will be negligible. We don't plan on a price increase in October. So I think that we will soon be lapping over our price increase from November 2015.”

On top of that BWLD is introducing half-price Tuesdays and has other promotional days – so Pricing pressure in the in the industry is quite evident.

Growth in volume is likely to stop as well. Competition has significantly intensified – having observed the success of Buffalo Wild Wings and Wingstop, high number of other chicken wing franchises as well as mom-and-pop joints started up all over the country over the last decade. 47% of chicken wing restaurants opened in last 5 years, and 25% during the last two years. Assuming limited number of closures, the chicken wing restaurant count almost doubled since 2011.

On top of that all major pizza chains started serving wings (reviews indicate quality is much poorer). Even McDonald's and Burger King joined in.

This sharp growth in supply of places that sell ready to eat wings stands in contrast with relatively stable consumption. National Chicken Council estimated that total number of wings consumed increased from 13.5bn in 2011 to 14bn currently. Food service channel accounts for c. 75% of these.

Also worth noting, that recent Wingstop growth was driven by large increases in SG&A, which shot up from $16m in 2012 to $33m in 2015 (+100%) whereas unit growth increased by only 50% (all new units are franchised). Even excluding one-off items related to IPO, the divergence between the two metrics remains. Roark was likely splurging on marketing to boost sales in preparation for IPO.

I expect Wingstop same-store sales growth to slow down further and turn negative in the upcoming quarters. This will also have an effect on attractiveness of the brand for new franchisees which will limit company’s ability to continue unit expansion at the current rates.

Expansion potential overstated

Wingstop management suggests the domestic franchise can be expanded to 2500 units vs. 830 currently. This figure is based on rudimentary mathematics by taking Dallas as penetration model:

• Dallas with 7m population has 82 Wingstops;

• Thus US with 300m population and slightly lower penetration (e.g. 30% lower) would result in 2500 units.

Dallas is an extreme outlier and cannot serve even as an approximation of potential penetration across US. Firstly, it is hometown of Wingstop where the first restaurant opened 20 years ago and where the company has entrenched relations with local population. Secondly, competition has increased significantly over the last decade – this further limits the number of potential Wingstops that can be profitably operated in other areas.

Moreover, chicken wing popularity differs across the states – with southern states being more used to the staple. WingStop’s three largest markets are Texas (35%), California (24%) and Illinois (6%). Same for Buffalo Wild Wings (9%, 7%, 6% respectively) plus its home market Ohio (8%). Its doubtful the brand will be able to export its success in the southern states across the rest of the nation.

Roark Capital is rushing for exit

Roark Capital is a private equity firm specializing in franchise businesses. It owns number franchising businesses including 16 quick/limited/full service restaurants chains. Roark’s exit from Wingstop seems rushed:

• Jun 2015 – IPO – 3.2m shares sold at $19;

• Mar 2016 – Secondary – 6.3m shares sold at $24;

• July 2016 – Dividends of $2.9 on 12.8m shares, by loading the company with debt;

• Aug 2016 – Secondary – 6m shares sold at $29.25;

• Roark Capital remaining ownership 6.8m (24%) or $197m;

• Cash received in the public offerings + dividends $409m;

This speedy exit looks even more surprising considering Roark’s strategy to hold on to their franchising businesses for the long term. This article provides insights into Aronson’s (Managing partner of Roark Capital) strategy:

“To Aronson, the standard operating procedure for private equity firms doesn’t make sense — not after getting to know the owners for as long as four years, investing heavily as needed to make the company perform, pushing and pulling to gain traction. When it’s finally working, why would you get rid of it, he asked. “How about holding it for a long time?”

In 15 years Roark has sold only 5 franchising companies with Wingstop being the first restaurant. These were held for more than 9 years and sold to PE groups rather than exiting through IPO.

WingStop’s exit after only 5 years by selling to the public clearly does not fit the pattern. My guess is that no other PE groups were interested and Roark wanted to exit while chicken wing market is still hot. This gives confidence that going forward business is likely to deteriorate and that Wingstop will not grow into its current valuation.

Valuation

By my estimates Wingstop is valued for perfection, especially keeping in mind decelerating sales figures and growing competition.

For valuation purposes I split Wingstop into company owned stores and franchise business. Company owned stores are not growing in terms of units (19 in total) and do $10m of gross margin. I lump that with $10m of SG&A and call it a zero from valuation perspective.

Franchise business is comprised of 894 restaurants. Each location generated c. $61k in annual royalties and fees. SG&A stands at $23m (excluding $10m as per above), interest expense is c. $4m per annum and effective tax is 36.5%. Net profit closely approximates FCF.

In the model below I assume company continues to open 130 new locations each year and reaches 2100 units in 10 years. I also assume royalty/ad fund fees per store grow 4% each year and that SG&A is also increasing at 4%.

Discounting FCF at 10% and using 3% terminal growth I arrive at $825m equity valuation, which matches the current market cap. However, the assumptions in this model are quite unrealistic:

• 130 new units every year. Although Wingstop managed to grow at this pace in 2015, and probably 2016, due to reasons outlined in this write-up I expect the unit growth to slow down significantly going forward;

• 4% growth in franchising fees, while same store sales are slowing down (3.1% as of Q2 2016);

• Most importantly, SG&A increase of only 4% annually when unit growth is projected 16% is way too optimistic. During 2012-2015 SG&A increased (+100%) at 2x rate of unit and revenue growth (c.50%).

Using slightly more realistic assumptions listed below equity valuation drops to $460m, 45% downside.

• Unit growth decelerating by 10 units annually;

• SG&A increase matching unit growth;

• Franchising fees per store growing by 2% annually.

Most importantly, with Wingstop being already so richly valued, I see very limited risk of the company achieving even higher valuation – if all goes according to management’s plan then $30-$33 per share seems to be the upper limit.

Takeover at current prices is also unlikely keeping in mind that Roark Capital was not able to find any PE buyers a year ago.

Risks

• My short is predicated on increasing competition and deteriorating sales metrics. If this does not materialize, Wingstop might remain overvalued for extended period and eventually, 10-15 years from now, grow into the current valuation.

• Wingstop has development agreements for 500 new locations. Management indicated that historically only 10%-20% of these agreements did not materialize in actual new units. However, this does not indicate the build out will be any faster going forward. Back in Jun 2015 the company also had development agreements for 500 new units and in the subsequent year only 130 new locations were opened.

• 78% of new unit development agreements are from existing franchisees thus unit economics are as favorable as company suggests (i.e. 30% cash on cash returns in the second year). I expect this to change once same store sales start decreasing.

• Franchisees currently pay 6% royalty fees + 2% ad fund contribution. Royalty fees have already been increased from 5% for all new development agreements signed after Jul 2014. Further increases in royalty fees might be possible, however with unit gross margins under 25%, franchisees are already contributing more than 30% of the unit profitability. Also if further royalty increases were be possible, Roark would have likely pulled it off for IPO window dressing.

• Wholesale chicken wing prices have been trending lower during Q3 ($1.7/pound) relative to Q2 and Q1 (c. $1.95/pound), but are roughly in line with the previous year. This will cause higher gross margins and increase in overall profitability of the company QoQ. I do not expect these lower prices to persist - there is seasonality in wholesale chicken wing sales due to Super Bowl and restaurants stocking up in preparation for it during Q4 and Q1.

• One of the franchisees is hip hop cash king Rick Ross, who is very actively promoting the brand and even created a hit about the chain. So there is a certain fan following among Wingstop consumers which certainly helps with expansion.

Catalyst

• Further slowdown in growth / decline in same stores sales.  

• Slowdown in new store openings.

• Another secondary in Q1 or Q2 2017 with Roark completely exiting the position.

• Buffalo Wild Wings announces earnings on 26th of Oct, this should serve as an indication of the sales trend for Wingstop. Historical correlation is high.