Description

Thesis backdrop

The full service restaurant (FSR) sector is currently subject to high negativity. One company within that appears to be unduly punished is First Watch Restaurant Group (FWRG). FSRs (and QSRs) in general are currently out of favor as the cost of groceries became more affordable relative to restaurant menu prices. Additionally, secular trends in favor of more grab and go, quick-service meals have replaced the occasion of gathering around a table. Rises in labor costs have also hurt. Amidst this more difficult backdrop, a meaningful market preference has developed for (a) unit growth stories (b) health-focused offerings (as consumers become more focused on ingredients and diet) (c) value-focused offerings and (d) some preference for single brand concepts. These dynamics have led to a small group of winners within the restaurant space such as CMG amidst a wider list of either near-term trading losers such as MCD or longer-term fundamental losers such as Cracker Barrel or Red Lobster. While QSRs have generally been able to maintain positive comparable sales growth, FSRs have not and traffic has been a particular headwind. As the comp sales metric is crucially important for restaurant valuations, many of the stocks have been punished severely including PZZA, BLMN, etc.

Enter FWRG…  which possesses some characteristics which have been punished in the market, namely: 

- full service restaurant
- posted underwhelming but still positive +0.5% comp sales last quarter
- forced to lower FY guidance 

... but also possesses some characteristics that, in other cases, have been rewarded in the market: 

- strong consumer value proposition
- significant single brand unit growth opportunity
- high absolute revenue growth, whereas other struggling FSR groups are more on the decline curve
- health and culinary focus
- good employee relations

My long-term optimism on FWRG is most firmly routed in the concept’s value proposition which I think will allow comp-sales acceleration throughout 2023 while unit growth further differentiates from the peer group. Over time, I’d expect this to amount to meaningful absolute growth as well as a market re-rating. 

Concept overview

- Daytime focus, hours of operation only from 7am - 2:30 pm. Staffed by one-shift.
- Breakfast and fresh beverage focus, seasonal menu changes 
- everyday reasonable price strategy, local focus, no mass channel marketing 
- Multi generational appeal, but skews health / food focused and mid to high income
- 531 restaurants in just 29 states, no NY/New England/California or Pac. NW. 36% are in Texas and Florida.
- 432 are company-owned and 99 franchised, with ability to buyout 47 more franchises

Recent quarter

- Traffic declined -4.5% and price / mix up 5% for +0.5% comp
- very strong Florida performance in prior year period made for difficult YoY comparison
- Full year guidance was reduced from comps of 1-3% and 18-20% revenue growth down to flat-2% and 17-19% respectively, ebitda re-affirmed at 106-112 mm and capex reaffirmed at 125-135
- Opened 9 new restaurants, now 531 in total 
- traffic did improve sequentially throughout the quarter and while management took down the full year guidance, it seemed like the very recent trends more than supported the comp guidance for the next quarter (my interpretation of recent call’s Q&A discussion)

Investment merits and drivers

- Reasonably strong restaurant level operating margin of 20.8% in mrq
- Primarily a company-owned model which, when well-run, can be superior to franchised model given uniform vision and ability to efficiently enact change through the overall system
- $2.6 mm of AUV by year 3 at 18-20% RLM, creating 35% year 3 cash on cash returns for new restaurants
- labor and food input costs, which were subject to high inflation through ‘23, have returned to more normal levels and my view is for further potential improvement. FWRG hasn’t ever let themselves fall behind on wage adequacy and in my opinion, has underpriced their menu. 
- In general, I think the company is somewhat underearning, given low operating hours and food prices, and their solid employment proposition as compared to the broader industry which has generally pushed on each of these levers to increase company profits. The upside is that this creates a healthier concept and legitimizes the systemwide expansion opportunity. 
- Saving for last what I view to be the biggest opportunity is the company’s underpenetration relative to what I view as a proven successful concept. In just 19 states and 524 locations, the company’s long term goal is to quadruple units from current levels. “Our flexible box size of ~3,800–6,600 sq ft with an average net build-out cost of ~$1.6M allows us to fit in any real estate and supports visibility to 2,200 restaurants.“ For some reference comparisons, Olive Garden has over 900 locations, Longhorn Steak 560, Chili’s 1,600, TXRH 740 and each of these concepts tend to be larger in check size and square footage such that unit sales volumes are 1-3x FWRG. This cuts both ways for overall profitability but I think bodes well in the context of FWRG’s 2,200 unit goal as sales per geographic area are relatively underpenetrated. Of course, QSR unit counts vastly exceed all of these and point to the upside of well-recognized or well-liked concepts. On balance, the strong unit economics and my qualitative opinion of the strength of the concept at FWRG (culinary focus, local relevance) give me confidence that management’s goal is within reason and is supportive of a multi year horizon of double digit unit growth, which is fairly rare and a big part of what is being undervalued here.   

Peer comparison and valuation

There are various ways of looking at valuation, below I present one view of fiscal ‘25 ebitda multiples and that same year’s revenue growth against a broad set of industry peers. Not a comprehensive approach, but I observe that FWRG is unique in its valuation multiple vs. its revenue growth, which I think this is suggestive of the upside opportunity here. 

Fiscal ‘25 ebitda multiple | revenue growth
FWRG: 10 | 16
CAKE: 8 | 6
EAT: 8 | 3
BLMN: 5 | 4
DRI: 11 | 5
PZZA: 10 | 4
TXRH: 16 | 7
BROS: 26 | 22
CMG: 31 | 14
SBUX: 12 | 8 
SG: 100 | 16   
MCD: 15 | 6  

Risks

- large overhang risk as Advent International owns 27 mm shares, down from 42 mm shares in early 2023 year but still 45% of outstanding, which is a meaningful concern from a technical perspective. Some recognizable funds do appear to be building positions gradually as Advent sells.
- FSRs have often had difficulty maintaining and growing traffic / throughput as the concepts age and consumer preferences have changed. I think this is somewhat mitigated given the company’s granular location scouting process and and its local focus which creates more microlevel community ties than some of the more generic sit-down restaurants
- company has financial debt of 125 mm and 43 mm of cash at 3/31/24, and so net leverage is modest in context of 105 mm of forecasted ‘24 ebitda. However, with 130 mm of capex estimated for the year, the company will be FCF negative and so is not yet in the favorable position where its large potential growth can be self funded. 

Catalyst

- return to positive comps. comps ease pretty meaningfully in 2Q as 2-year traffic stack goes from 27% to 7%
- clearing of overhang risk (see above) though this will take time
- from an operational perspective, I think price increases should be implemented and would be well-tolerated. additionally, at least some lengthening of companies hours at some point in the future could be an easy victory and meaningful to comp trajectory.
- further, the brand and company management - with its culinary, affordability, and strong operating reputation - could likely have success with a pivot or adjacent brand or format in the future.
- FWRG has recently acquired, per pre-existing contractual agreement, one of its large franchise groups. I think the success of this transaction and retention of full economics will be beneficial to financial trending and overall perception.