Ratings key: Stocks rated 1-3 (highest) based upon fundamentals and growth outlook, public market’s current valuation and consensus expectations.
Chipotle Shares Break Below $400, Getting Closer to an Upgrade
Investors continue to slowly appreciate the negative view (that we have supported) on the valuation of Chipotle Mexican Grill (CMG) shares. The stock recently closed below $400 on a weekly basis for the first time since January. Some analysts are concerned that news about the company that’s testing queso dip in New York (after previously vowing never to serve it due to unnatural ingredients and preservatives) signals business continues to be weaker than the bulls on the stock have been hoping for.
Queso or no queso, we don’t think it matters. Consumers are not going to flock to the chain more than normal just to get some cheese sauce — it’s not exactly a unique product. We continue to maintain our #1 rating on CMG due to elevated valuation. Even at the current sub-$400 quote, it still carries an EV/EBITDA multiple of 13X our 2018 EBITDA estimate of $835 million. There are no 100% owned and operated (i.e. non-franchised) chains that fetch that price on Wall Street. We simply do not believe the days will ever return where the company gets a higher valuation than every one of its competitors.
Chipotle is just another fast, casual restaurant company, plain and simple. Very good food? Sure. Solid value for the money? Yes. But unique in its space? Hardly. So at what price level would we upgrade the company to a neutral rating? Unless our estimates change after this next quarterly financial release, we are holding to our 12X EV/EBITDA “top of the fair value range” figure, which equates to $367 per share (roughly 7% below the July 14 price of $395.83). At that level the stock would be richly priced, but not exorbitantly so. Of course, we could argue 8-10X makes more sense given how much they seem to be struggling right now, but we’ll cut the bulls some slack. After all, there is no reason to think the stock will get “cheap” anytime soon (if it hasn’t yet, then when would it?).
Kona Grill Negotiates Credit Line Changes
With shares of Kona Grill (KONA) having sunk to the $3 range, the company has renegotiated its credit line with its lenders to provide more financial flexibility to close certain underperforming locations and alter lease terms if it deems such actions appropriate. In the amended line of credit, KONA is getting looser leverage terms in return for a 0.5% increase in interest rate and a shorter maturity date (2019, extendable to 2020 if certain conditions are met). The investor base has clearly lost confidence in the chain’s ability to post consistent profits after a handful of newly opened, poorly performing units have dramatically eaten into the company’s cash flow. Rent abatement deals have been struck for two locations, but more may need to be done. The next quarterly report will be telling, as the company’s best results tend to come during warm weather periods, such as outdoor patio use increases.
We continue to rate the stock a “3” based on the fact that the company has more than a decade of successful operating history and only two quarters of subpar results behind it. While it is possible the chain is permanently impaired, we are not ready to take that stance. However, if things have not gotten better by year-end, we will probably revisit our positive view, even with such a low stock price.
Darden Reports Strong Quarterly Results
Darden Restaurants (DRI), led by the Olive Garden (>50% of total sales) and LongHorn Steakhouse (>20% of total sales) chains, continues to post industry-leading same-store sales increases. The company reported its latest quarter, with same-store sales of +3.3% and forecast forward 12-month same store sales of +1-2%. With most chains facing low double-digit declines, Darden is clearly using its scale to offer guests one of the best value propositions around (e.g. attractive price points without sacrificing perceiving quality).
The company also announced a 12.5% increase in the annual dividend, to $2.52 per share (2.7% yield) and expects sales this coming year to see a boost from the recently acquired Cheddar’s brand. The shares are reacting well, trading up 5% to $94 and change each.
We recently downgraded DRI to a 1 based on extreme valuation. At 13X trailing 12-month EV/EBITDA, Darden shares look quite expensive. In fact, we cannot recall a time when the stock has traded at this much of a premium to the underlying profitability of the company. Going back 10 years DRI has never ended a single year trading at more than 12.5X EV/EBITDA.
While we understand investors’ delight with Darden’s recent results, we say the stock fully reflects this performance. As is the case all too often, we expect that a reversion to the mean is on the horizon, as competitors catch up on the execution front. Simply put, a company like DRI in a highly competitive space, that is growing units at 2% annually and same-store sales at 1% to 2% annually should probably not trade for 13X cash flow. As a result, we are not backing away from our recent downgrade from a “2” to a “1”.
Upgrading Chuy’s to 3 on Growth Outlook, Reasonable Price
We are upgrading shares of Chuy’s (CHUY) from a “2” to a “3” after the company’s share have tumbled from the low 30’s at the start of the year to the low 20’s. Chuy’s has a lot of things going for it, including strong unit-level returns, a debt-free balance sheet, unit expansion potential and a valuation that now resembles that of a more mature dining company.
Mexican casual dining chain Chuy’s was founded in Austin, Texas in 1982, was acquired in the 2000s, and has since grown from eight units to 82 units during the past decade. The company offers a strong value proposition ($14.50 average check including alcohol) and has maintained strong unit-level profit margins (18% to 21%) over a long period.
The growth trajectory has been both strong and steady, with between eight and 12 new units opened annually from 2011 to 2016. In 2017 the company expects to open 13 units, with a long-term growth rate of 15% annually (doubling the location base every five years or so). Cash flow from existing units recently began to exceed the costs to build new locations, which resulted in net free cash flow of $1 million in 2016. That figure should only increase as more and more units are opened.
We currently estimate EBITDA of $45 million in 2018, which would put the company’s forward EV/EBITDA multiple at just 8X. While that is not dirt cheap — around the sector average — we believe it represents good value given Chuy’s plan to grow its unit base by 15% annually over the long term. Typically, high-growth businesses in the dining sector can attain valuation premiums of 10% to 50%, which is not factored into CHUY’s share price currently.
In terms of price, we would not be surprised if Chuy’s regained a 10X EV/EBITDA multiple over the next 12 months, which would equate to 20% to 25% upside.