A Hedge Fund Research Portal Discovers a Short-trade Thesis for Restaurant Stocks

When Modern Trader attended the 2017 SALT Conference, one of the most impressive exhibitors was posted along the back of the room beside the broadcasting booths of Fox Business and Yahoo! Finance. There, Alap Shah and his team were displaying their powerful new research platform called Sentieo. 

Sentieo is a producer of an intuitive, powerful financial data platform with document search, research management, equity data terminals and more. The product is web-based, but also has apps for desktop, iPhone, iPad, android and an excel plugin. It wasn’t enough to simply review the product. We asked to see it in action. During our discussion, we quickly discovered that Sentieo had developed a tool that helped investment professionals and anyone in the research industry generate ideas and tell a story. 

In a conversation with Sentieo analyst Nicolas Carreras we also quickly discovered that the team had uncovered something very alarming about the state of the U.S. restaurant industry. Using Sentieo’s powerful search functionality, Carreras had put together a simple chart that asked, “Does the U.S. total restaurant industry claimed growth make sense?” (below).

In what would have taken analysts weeks to compile, Carreras cut through tens of thousands of pages of public documents like 10-Ks and S-1s to develop a list of 25 public restaurant companies and their public growth expectations in the years ahead. While the “Bun on the Run” companies anticipate a moderate 13.7% growth rate and low 1.1X multiple, we see some companies have pronounced eye-popping growth expectations. The sub-sector of 18 restaurants expects to grow their restaurant count by more than 150% in the medium term. Habit restaurants (HABT) only has approximately 172 restaurants but claims a potential for 2,000, which is only slightly more aggressive than Zoës Kitchen (ZOES), which has approximately 204 restaurants, but claims a potential for 1,600.

Compiled in the early spring, the data raises serious questions about the anticipated growth rates of companies and lofty valuations that are based on such significant growth expectations. 

 “At the moment, a significant number of [quick service restaurant] companies are forecasting significant expansion of store counts, which appears unrealistic given U.S. GDP growth without significant population growth,” says Carreras.

Many of these restaurant organizations are taking part in an industry already facing increased competition, massive demographic shifts and exposure to the downturn in retail. As former McDonald’s (MCD) President and CEO Ed Rensi explains (see “Ed Rensi talks burgers & business”), restaurant closings are outpacing new openings. In an industry already oversaturated, many of these figures defy common sense.

Following the restaurant count information, Carreras highlights the elevated price-earnings (PE) multiples and recent insider net selling action.“The [last 12-month and [next 12-month] PE multiples suggest a significant amount of growth in stores is already baked into the current price, leaving little room for upside with significant downside risks should the store count fail to materialize,” says Carreras, “Furthermore, insiders in the companies of recently IPO’d restaurants have been net sellers benefiting from the high-growth estimates and multiples.”

In addition to the high store count, a significant number of these restaurant companies also assume cash-on-cash returns of more than 20% with some claiming 50% in presentations to investors, potentially further fueling the multiples while simultaneously creating additional downside risks (see “Do valuations makes sense?” below). 

Carreras used Sentieo to save a significant amount of time, not only finding key details about Darden (DRI), one of the darlings of the restaurant industry, but approaching the analysis in a more comprehensive manner. 

DRI not only plans to expand at a breakneck pace with a growth-rate that significantly outpaces population growth, but DRI’s own restaurant count estimates appear inconsistent and potentially misunderstood by Wall Street. 

The company displays in its filings and presentations a concept by concept current store and potential store count providing a low/high new restaurant growth rate of 36.8% to 53.1% (see “Measuring growth,” above). However, the company also writes in other documents that new restaurant growth is roughly 2% to 3% per year. For the company to reach its low-target restaurant count assuming a growth rate at 2%, it would take 16 years. Assuming 3% each year of organic store growth, it would take 11 years to reach its low target, and 14 years to reach its high target. Alternatively, DRI would need to engage in mergers and acquisitions to reach the store count; however, M&A brings about inherent risks.

Sentieo also has a built-in tool that enables investors to use alternative datasets — Google search trends, Twitter mentions, credit card spend data — to help predict the direction of financial metrics. Sentieo has three main concerns about the restaurant sector: 1. A very high estimate for the total U.S. industry store count; 2. Multiples that already appear to price in a significant amount of the store growth expansion; and 3. Insiders selling shares while talking about the high-growth strategy.