Bojangles is a broken IPO that I believe is relatively cheap on its medium-term earnings power.

The company has a small market cap ($580 million) and an even smaller float (~$175 million) as it’s still 70%-owned by Advent International.

While the shares don’t look overtly cheap at 16x 2017E EPS, there are two elements to the investment thesis that I think the market is overlooking:

·         Bojangles operates a defensive business model (Same-Store-Sales grew through the last recession(1) )

·         The company will deliver high-single-digit unit growth for the next few years

I think the shares are ultimately trading below 12x 2019E EPS, using what I view as conservative modeling assumptions.

Background

Bojangles is a regional quick-service restaurant business, founded in 1977 and competing in the chicken LSR category.  It operates 396 Franchised restaurants and 295 Company-Operated restaurants in the Southeastern US, with the vast majority (~67%) of restaurants in North Carolina and South Carolina.

The brand equity for the business is extremely high in the Carolinas and the concept really does have a cult-like following.  The company is known for its made-from-scratch biscuits (baked every 20 minutes), never-frozen bone-in fried chicken, its sides (“fixins”) and its Iced Tea.

The concept is unique from many other QSRs in that, on average, just under 40% of a unit’s volumes come from the breakfast daypart (their fresh biscuits are used to make delicious Bacon, Egg and Cheese breakfast sandwiches).  Management has an investor deck slide that shows that on average their Company-Operated units do ~$650,000 in AUVs before 11am alone.  This is higher than McDonald’s, Starbucks, Dunkin’ or Panera.  The company is strategic with its restaurant locations and generally attempts to obtain sites on the “driving to work” side of streets to facilitate breakfast sales.  While the breakfast daypart is getting increasingly crowded as all QSRs attempt to replicate McDonald’s success in improving the asset utilization of their boxes- and convenience stores increasingly roll out breakfast offerings- I still view this daypart exposure as a meaningful competitive advantage.  Having a strong breakfast presence leads to loyal and habitual customers and helps to immediately cover the fixed costs of operating the restaurant.

For what is really a traditional QSR box, the restaurants do very impressive Average Unit Volumes.  The average franchised store did $1.92 million in AUVs in 2015.  This compares to Popeyes at $1.4m.  The high AUV number is skewed by some very high-performing North Carolina units ($3m+) and the median Franchise AUV in 2015 was $1.7m.  Still, the combination of the breakfast daypart exposure, the relatively low average check ($6.97, though skewed lower due to breakfast) and higher unit volumes makes for an attractive QSR concept.

The shares have suffered since coming public at $19/share in a hot IPO market in May 2015.  Shortly after the IPO, restaurant multiples (which were at cycle-highs) quickly retreated and Same-Store-Sales decelerated.  The shares have sold off again recently after the company reported Q2 earnings that featured a number of alarming comments:

·         Franchised Same-Store-Sales declined in Q2 (down 0.2%)

·         Company-Operated Same-Store-Sales growth for Q3 is tracking negative quarter-to-date

·         Adjusted EBITDA growth was guided to go from up double-digits in the first-half to negative in the back-half of the year

·         The company is continuing to call out a tightening labor market as well as headwinds from the Department of Labor overtime regulations

·         McDonald’s all-day breakfast is pressuring the morning daypart, and leaking into lunch as well (the Company has always served breakfast all-day, everyday)

·         Competitive discounting is having a bigger impact on adjacent markets versus core (customer is much more loyal in core markets)

·         Comments about adjacent markets being more susceptible to cannibalization from new restaurants

·         Vague, open-ended comments about ramping up service and hospitality efforts through targeted labor investments (table service, more full-time vs. part-time workers)

The quick-service restaurant competitive landscape is currently the most competitive it has been in a long time.  In many ways, the competition currently is worse than during the financial crisis.  This is a little surprising given that overall industry restaurant unit growth hasn’t been alarmingly high since the financial crisis (at least per NPD Recount data).  A big part of the reason for the weakness has been an ever-widening gap between food-at-home inflation ( or rather deflation) and food-away-from-home inflation.  Restaurants are facing escalating labor pressures and are attempting to offset these through taking price.  At the same time, the price of food in the grocery stores has been deflating.  The QSRs are seeing lower food costs as well, and this has led to a lot of promotional discounting.

I expect that even with substantial labor pressures (and labor investments) and a competitive environment, earnings will continue to grow for Bojangles.  While they will fall short of their mid-teens long-term EPS growth algorithm this year and next year, unit growth and financial deleveraging can deliver an attractive compounded earnings growth even with minimal same-store-sales growth.

New Unit Economics

The company is also a bit misunderstood given its focus on utilizing build-to-suit leases for most of its new company-operated and franchised restaurants.

The typical store requires about $700,000 for the building, $625,000 for land, $385,000 for Site Development and $120,000 in “soft costs”.  These $1.835m in costs are funded by Real Estate developers who then lease the property to the company/franchisees for 15 years.  There is then ~$310,000 of equipment costs.  Franchisees that operate more than one unit can finance ~70% of the Equipment Cost over 5 years.  Pre-opening expenses are said to be $60,000.

The company is targeting $1.5m AUVs in year 1 in adjacent markets (a discount to their systemwide $1.8m average given lower brand awareness).  At $1.5m, Restaurant-Level Margins are only ~15%, versus 2015 Company-Owned Restaurant Level Margins of 18.2%. Adding in an allocation for marketing (4% of sales for franchisees) brings the margins down to 11%.

So before paying a royalty fee, a new unit should generate $165k in EBITDA.  Assuming a 7% Cap Rate (management uses an 8% in their presentation though the FDD says in reality it’s lower than this), gets you to $128k in annual rent.  So on a fully-capitalized basis, you’d have $293k in EBITDAR and $2.2m of Total Investment (including pre-opening expenses): or a 13.3% fully-capitalized return, before any sort of Maintenance CapEx.  Not super-attractive, but manageable.  However, the build-to-suit leasing model makes the actual cash-on-cash returns very attractive, albeit highly levered and risky (locked into a location for 15 years).  Even assuming much higher preopening expenses, no equipment financing and the 4% royalty fee, a franchisee should still be able to achieve 30%+ Levered IRRs on their initial capital.

It’s worth noting that the heavy use of build-to-suit financing leads to comparability issues versus other QSRs.  EBITDA Margins are inherently lower given the large rent expense, and CapEx is inherently lower as well (CapEx is only ~2% of Revenue and CapEx/EBITDA is only ~16%).

Unit Growth

The majority of Bojangles’ unit growth (~70-75%) is coming from “adjacent” markets versus their “core” markets.  While growing through contiguous geographies is the right strategy for new-market growth, investors have a negative view on traditional QSRs being able to make this transition, which is probably only further amplified given the struggles that another recent IPO (El Pollo Loco) has endured.  However, I would note a few comments on the growth outlook:

·         The company has been delivering on unit growth, profitably (Total store count went from 377 in September 2007 to 691 currently, a 7% CAGR over 9 years, through 2 different PE owners)

o   (El Pollo Loco added a net total of 39 units between 2011 and 2015, or a 2% CAGR)

·         The company has a solid franchisee base across 10 states with 49 franchisees operating multiple restaurants.  In addition, the top 3 franchisees operate 150 restaurants and have been opening new units in adjacent markets

·         Franchisee SSS (which skews more towards adjacent markets) out-performed Company-Operated SSS in 2014 and 2015

·         The development pipeline is fairly robust with ~100 sites approved or under construction

·         The Unit Economics of restaurants in “adjacent” markets, to me, don’t look that bad.  A few stats:

o   28 of the 47 (60%) franchised restaurants in Virginia do north of $1.6m AUVs

o   11 of the 59 (19%) units in Georgia do >$2m AUVs, 29 more (49%) are between $1.4m and $2m

         §  The Atlanta, GA market is a good case study of where getting critical scale (and associated marketing budget) has led to a virtuous circle of higher AUVs and more units

o   23 of the 39 (59%) restaurants in Tennessee do >$1.2m AUVs

o   7 of the 29 restaurants in Alabama do >$1.6m AUVs

o   Less than 5% of the system is currently at AUVs under $1m

·         New Unit productivity, while having taken a step down year-to-date, still doesn’t look particularly unhealthy to me- likely in the ~$1.45-$1.5m AUV range

·         Same-store transaction/traffic growth has been relatively healthy, given the environment

·         Per Technomic, the Chicken LSR category grew 9% in 2015

Valuation

While the next few quarters may be difficult for the company (as labor pressures surface at the same time Same-Store-Sales are struggling), I believe the company will ultimately navigate through the near-term headwinds and return Comps to positive growth.

Below, I am assuming significant labor de-leverage, minimal Same-Store-Sales growth from 2017-2019, modest store closures and weak new unit productivity (sub-$1.5m AUVs at low margins).  With these assumptions, I still see Bojangles earnings power increasing quite a bit over the next couple of years and think that earnings still exceed $1.35/share by 2019, putting the shares at ~11.8x 2019E EPS.  For a defensive, differentiated, low-ticket QSR concept with over half of the stores franchised, I think this would prove to be an attractive valuation.

Moreover, if Same-Store-Sales ever recover even back to the 3%+ range (which isn’t inconceivable as the company starts to innovate its menu a little bit more over the next 12-18 months), I could see the company doing ~$1.70/share in earnings/FCF in a few years, which would put the share below 10x medium-term EPS/FCF.