Buy wings, sell burritos

The recent selloff in Buffalo Wild Wings (BWLD) shares (17% relative underperformance to the S&P 500) following the initial positive reaction from the June Annual Shareholder’s Meeting would indicate to us that investors have lost faith in the $3.2 billion system sales/$2.1 billion market cap experiential brand.

Some anxiety can be attributed to the departure of long-time CEO Sally Smith and the new activist nominees elected to the board. Smith intends to retire in 2017 and we await further potential changes in corporate leadership. In our view, the positives (operational changes, refranchising, capital structure reforms, global total addressable market opportunity) continue to outweigh the negatives and the recent price action is an overreaction to operating miscues (see “BWLD bottom?” below). 

BWLD still possesses a differentiated customer experience with global growth potential and at current levels — BWLD is trading at 8.3x EV/2018 EBITDA, or a 10% discount to its historical average, and we recommend buying shares ahead of the recovery. 

Restructuring

In our opinion, refranchising will extend well beyond the initial 83-store proposal, which included markets in Canada, Pennsylvania, South Texas, Washington D.C., and the Northeast U.S. region. However, based on a broader market analysis, we no longer factor in refranchising during 2017, but we model a 75% franchise mix by the end of 2019 through a combination of 300 refranchised restaurants and accelerated global franchise development. 

We found during previous direct market access offerings, franchisees were hesitant to bid based on the right of first refusal and therefore we expect broader interest with new leadership. Refranchising has meaningfully expanded multiples for fast food concepts and we highlight the pace of which DineEquity Inc. (DIN), McDonald's (MCD), Wendy’s and Sonic (SONC) went through their company-operated transformations. DIN draws the highest correlation to BWLD given the casual dining comparison. DIN achieved a 99% franchise mix in 2012 up from 84% as of 2007 through the sale of 500 restaurants to franchisees. A higher franchise mix should support greater leverage, we model 3x net debt to EBITDA by 2018.

Pairs Trade

Speaking of  competitors, even though Matthew Difrisco rates BWLD as a strong buy at current levels, some traders may wish to take out sector risk and trade it to outperform the broader restaurant sector. This raises the possibility of a pairs-trade and the question of what stock to short versus BWLD? Difrisco gave us Chipotle (CMG), his only current restaurant stock “sell” rating.

Short Side

Same-store sales appear to have fallen off roughly 700 basis points to start Q2 2017 (after impressive Q1 same store sales numbers) and expenses relating to greater marketing and labor limit operating leverage for the remainder of 2017. In spite of the better-than-expected results, management continues to view 2017 targets of $10 in earnings-per-share and a 20% restaurant margin run rate as “stretch goals.”

Despite a strong Q1 for average restaurant sales, volumes remain below pre-crisis 2015 levels and just a modest improvement over Q4 2016 levels. Digital ordering and catering continue to show out-sized growth. In early April, CMG’s largest marketing campaign “As Real as it Gets” was rolled out, with its first ever national TV spots. The campaign does not appear to be materially benefiting same store sales. 

The 20% restaurant margin remains a stretch target but management is more confident it can be achieved over the next three quarters, implying a further 230-basis point expansion from Q1 levels. 

We are raising our 2017E EPS to $8, up from $6.93 and lowering our 2018 estimate to $11, down from $13. Our 2017 same store sales estimate is now 10.7%, up from 8.2%; and our restaurant margin estimate is 18.2%, up from 17.5% prior. We model development in 2017 to slow to below 9%, in line with guidance for 195 to 210 new locations along with the Q1 2017 closure of the 15 ShopHouses. 

We see substantial valuation downside along with a muted earnings outlook. We are raising our price target from $315 to $330 as we now assume a 30x PE (25x previously) to our 2018 EPS outlook.    

The greatest risk to our target is a more meaningful same store sales and earnings recovery in 2017.

Sustaining double-digit same store sales through 2017 could re-establish the brand’s superior

positioning and validate management’s longer-term ambitious expansion targets.

The Skinny

BWILD is trading at $123.05 as of July 11, so Difrisco’s $180 target represents close to a 50% premium. CMG is trading at $396.26 as of July 11, so Difrisco’s $330 short target represents roughly a 15% premium (see “Winging the spread,” above). If both stocks hit Difrisco’s target on a 1-1 spread it would produce more than $12,000 in profit on a 100-share spread. While it would be unlikely for both stocks to move to those targets, and do it at the same time, there is a lot of room for error, assuming BWLD outperforms.