Description

Fogo has been written up twice on VIC (by Wavelet and Zbeex, both in 2015).  Despite the stock’s poor performance since it went public in June 2015, we believe that both Wavelet and Zbeex will still compound very well over the long-term.  The current stock price, provides an excellent entry point for a business that should compound at a high rate for over a decade.

• FOGO’s recent weakness is explainable and understandable. The company should show improved comps next year.

• Fogo has a competitive advantage over other restaurants that allows it to yield excellent returns (unlevered 20+%).

• The company’s culture and success are difficult for others to copy and duplicate.

• Steakhouses are an extremely durable business.

• FOGO’s valuation is very compelling, at just xx FCF, for a company that should compound FCF at over xx% for the next xx years.

• FOGO has some low hanging fruit to improve unit economics.

Fogo’s Recent Weakness creates a buying opportunity as business should improve in 2018:

Last quarter Fogo was hit by a series of seemingly unrelated random events that lead to a fall in sales and earnings. For starters, while the company has less than 40 restaurants in the U.S., it had restaurants in every hurricane effected area in 2017:  two restaurants in Houston, one in South Florida, and one in Puerto Rico.  Additionally, its two restaurants in Atlanta and two more in southern Texas experienced hurricane related knock-on effects. The effects here (with the exception of potentially Puerto Rico) should be very short-term with sales recovering in weeks. In addition to weather problems in the U.S., in Brazil (where Fogo has nine restaurants) a very weak economy and large rise in crime led to a steep decline in meals eaten out, especially in light of the prior year’s Olympics aided results.  The Brazilian situation is unclear, but minimally the segment’s earnings and sales have likely bottomed.

There are more temporary problems.  Steakhouses in general have been weak for the past couple of years. Despite a strong economy The Knapp index for high-end steakhouses YoY sales has averaged just 0.3% from 3Q15-3Q17 and negative thus far in 2017. Steakhouses have had their ups and downs before, we discuss the durability of the industry below. We do not expect this downturn to last and already comps were 3.6% in 4Q with FOGO up 2.7%.

Before Fogo’s recent weakness it had already encountered some problems right after going public. The 2015 group of new restaurants did not produce results in line with previous openings.  The subpar results were because of isolated problems at its Houston, Las Vegas, and Puerto Rico restaurants.  Houston encountered large local economic downturns shortly after opening.  In Las Vegas the company opened a second location off the strip in a shopping center that wasn’t fully developed yet. As of 3Q17 only Vegas wasn’t profitable and the 2015 group has been comping better than the other units.   

Given the relatively immature base of Fogo’s U.S. restaurants we would expect the company to have comps roughly 1% higher than the industry.  However, while FOGO has beaten the industry this year, the margin has been about half that and essentially 0 last quarter. This it turns out is largely from self-inflicted short-term pain that should lead to long-term gain. Fogo has seen excellent economics when opening more than one unit in a metropolitan area.  This phenomenon is common in the restaurant industry as more units increase brand awareness. However, Fogo experiences negative compass for the first 18 months in an existing unit, when they open one up nearby. The company had four of these units last quarter, shaving around 1% of comp sales. This should start to reverse next year.

As you can see, most of Fogo’s recent woes should provide an excellent springboard for improved results next year. We believe that the company is well positioned to beat consensus EPS of $0.83 for 2018.

Fogo’s Competitive Advantage:

In our study on the restaurant industry, the most important factor that appears to drive restaurant success is efficiency. In all of our work we found no examples of a more efficient operator being displaced by a less efficient one. If you know of an example of this, please say something as we would love to know. There are of course many examples of efficient operators pushing out less efficient ones, from MCD beating out the drug store fountain, to soft serve ice cream leading to the growth of Dairy Queen, and to the assembly line processes driving growth for Chiptole and Subway. Ray Kroc used to say that he put the hamburger on the assembly line.

Fogo is more efficient because of the type of restaurant it is--a Brazilian Churissica, which turns tables twice as fast as a normal steakhouse. The efficiency is quite simple.  To start, Fogo’s patrons are served soon after sitting down.  At a typical restaurant a lot of time is spent looking at the menu, ordering, and preparing food, but for the most part at Fogo everyone gets the same thing, unlimited meat (there are some more limited options such as one meat or just salad bar) and salad bar. Food is also served quickly at Fogo, and a customer is essentially stuffed after an hour. There is one downside to this quick and fulling service, which is less is spent on alcohol and dessert.  Another efficient practice at Fogo is that its waiters (Gauchos) are also the cooks, which eliminates a lot of staffing expenses. The labor savings is substantial, a roughly 10% cost advantage vs. peers.  Fogo’s food costs are also slightly lower than peers.

Even in a down year like 2017, Fogo produces excellent economics with restaurant margins close to 30% and an unlevered return on new build restaurants of over 18% (levered returns at previous debt levels would be infinite!).  Fogo’s returns trail only Del Frisco Grill among all publicly listed restaurant companies we have seen.

As further proof of the great economics, Fogo has the best franchising deal we have ever seen. The company has been entering into JVs where the partner puts up all the initial capital and pays a 3% royalty once the partner has been made whole cash flows are split 50/50. The company has already signed up JV partners in Mexico and the Middle East, and it is currently searching for one in Asia. We have spoken to people familiar with these negotiations, and there was no shortage of partners lined up.  Fogo is particular in looking for partners with restaurant experience and an ethos that matches the company’s, and it has sought outside help with finding more JV partners and we expect that it will likely announce another deal this year.

Additionally, we have found that while restaurants in general are much better businesses than commonly perceived, it is our belief that high-end restaurants are a good business upon establishing a brand name. The brand name typically comes from the founder and not necessarily the restaurant brand itself.  A well-known restaurateur will have several advantages over lesser known entrants.  For starters that person gets access to better properties at lower rents.  These deals can be 20-year-long leases, and the better ability to pay should lower rent.  An established restaurant can also increase the value in the accompanying space. We have seen hotels spend as much as $10 mln (whether any of this was clawed back in the rent is unknown) to cover design and construction costs of a desired restaurant in its space.  The advance press for a well-known restauranteur is another advantage, as it can pull patrons from restaurants within the brand. In Fogo’s case, it can tap into its large customer lists either online or through word of mouth when it adds an additional location to a city. But perhaps Fogo’s largest advantage is the ability to attract the best staff.  The front of the house is obvious, they are primarily paid in tips, so the more customers the more compensation.  The back of the house, chefs and others are attracted to the better opportunities the from having a big name restaurant on their resume, besides being a famous chef, the second best way of opening a new restaurant is to have worked for one. The people who are known to be capable of working in a high-end restaurant are limited, and it’s probably difficult to attract them without an established reputation.  This is not a perfect thesis since data on high-end restaurants is limited. Additionally, some upstarts have succeeded in the high-end restaurant space, though they appear to have started with lower-end concepts.

Fogo’s superior culture:

So we can see from our explanation above why a churrascaria is a more efficient model than a traditional steakhouse. So why isn’t Fogo’s model more duplicatable? Well, there are other Brazilian steakhouses in the U.S. In fact Texas De Brazil is another chain that is roughly the same size as Fogo. However, we do not believe that any Brazilian steakhouse has come close to replicating the returns of Fogo with anywhere near the # of units. So why is this? We think the key differentiator is culture. For starters Fogo is originally from Brazil and still has nine units there. Brazil has more of a service-focused culture, where being a waiter/server can be seen as more of a career than a short-term job. Not only does Fogo’s Brazilian roots lead to greater authenticity, but the restaurant uses Brazil to staff its locations in the U.S. and abroad. Roughly 20% of staff at a new Fogo come from Brazil. The company is able to do this though the H-1B visa program. This a factor that constrains the unit growth rate (long-term we believe a little over 10%) of the company.

Fogo’s long-term mentality is an important aspect that is difficult to replicate. Fogo has considerably less turnover than competitors. We believe lower turnover is part of what leads to superior service and overall better quality. Fogo was the #1 rated chain steakhouse by consumer reports. In cities where it faces competition from Texas De Brazil, FOGO has higher scores on Yelp. Texas De Brazil isn’t public, though, so we don’t know its exact financials.  We have consulted industry experts who believe its unit economics are vastly inferior to Fogo. We believe Fogo’s lower turnover is from three factors.  First the Gauchos (servers/chefs) are largely paid through tips, thus FOGO’s success becomes their own.  They earn much higher wages than industry averages.  A typical gaucho can earn six figures. Managers also earn much higher wages than the industry. This makes the desire to leave to competitors very low. Secondly, Fogo trains for the long haul.  A gaucho will master a meat for a year before moving on to another one. Other companies have tasks learned much quicker thus leaving less potential for time spent on development. Fogo also largely promotes from within. Other companies would like to promote from within, but their employees leave too quickly. A lot of this is a network effect.  Other restaurants would like to retain staff and promote from within but, they can’t because their wages are not superior enough to make employees stay, which is in part due to lower quality created from lower-turnover. It is a virtuous cycle for Fogo.  Additionally we have found that Fogo’s management is very giving nature.  Its management genuinely treats employees as the most important asset from multiple conversations to actual actions.  For example meals are free for Fogo employees when working and half off for their party when they are off. This is far superior to subsidized meals at other restaurants. That attitude of management appears to have penetrated down.

Durability:

We have found that steakhouses are extraordinarily durable businesses.  Using copies of Zagat dating back to 1990, we found that over 86% of steakhouses in San Francisco were still around in late 2016 (when we conducted this research).  For Los Angles it was 83%.  For Chicago it was over 53%.  New York was the toughest market with 44%. Boston was somewhat of an outlier with only a third but that was due to a lot of lower priced steak restaurants with higher fail rates if true comp of high end steakhouses are counted that would be 2/3.  A comparison to other types of high-end restaurants is very favorable as only 22.2% of high end restaurants in Chicago from 1990 are still in business today and 25% from NYC today.  Our study which shows a roughly 2% mortality rate for steakhouses is still overstated because we only counted chains as one and only saw one location fail.  Dissecting results further, we noticed that high end steakhouses had an even lower failure rate. Survival of steakhouses goes up with age, slightly with rating and presumably with initial profitability.  The main reason for failure, may actually be a change in ownership as one generation retires the next may not want or be capable of running the business, chains avoid this problem.  Taking in all these factors the adjusted failure rate is likely under 1%.

It is unclear why steakhouses have been so durable. The only thing that we know for sure is that they have been. We have two theses on why this is.  One is that steak has less change than other restaurant styles; a steak cooked today is largely the same as it was 50 years ago. The other thesis is that high-end steakhouses are more like luxury brands which tend to have a lot of staying power. There is also the possibility that America is a meat eating country as a part of its culture or that steak has more craveability. Unfortunately, we have not found a way to test any of these theses.

We take further solace in the fact that Fogo has only closed one restaurant in its history.  That one unit was open for 20 years in Brazil and was likely pressured more by the changes sweeping within Brazil than issues within the restaurant.  We are further comforted by the fact that with the exception of one location, margins (according to management) are all within 600 basis points of each other.  All locations are currently profitable, with the exception of one location in Las Vegas that isn’t near the strip.  This location was built in a new shopping center which was still building out other locations when Fogo opened, so the initial sales were slow, but sales have been accelerating. Puerto Rico was profitable before the storm hit the island, but its future is up in the air now.

We have also noticed that some restaurants fail when they attempt to enter a new region.  However, despite Fogo’s limited store base, the company has succeeded in every region in the U.S. and is also successful in Brazil and Mexico.

Valuation:

Fogo’s depreciation is well above maintenance capex. We have spoken to management about this and looked at other steakhouses and believe this is sustainable. FOGO should do $1.12 per share in free cash flow per share in 2017 pre new restaurant capex.  We are more than happy to buy FOGO at 12x FCF, with all the maturation, store improvement, two non-earning JV units, and future store growth as further upside. We think 2018 FCF per share of close to $1.50. We believe that FOGO could eventually grow to 130 units in the U.S. and as many as 200 units overseas (likely to be JVs). EBIT margins from scaling G&A and a return to 30% restaurant margins could roughly double from today.  Assuming a 15X prenew store capex FCF exit multiple, we believe that FOGO shares should compound at over 25% per anum through 2028.  This does not include accretive share buybacks.  We believe that the company will start buying back shares in 2018.

Further Upside:

The four wall economics while exceptionally good have not been maximized. The founding family had an aversion to alcohol and did not push liquor. Their attitude was that if customers wanted a drink, they could, but they wouldn’t let a customer order a drink at the bar without food. Fogo will probably never have the same kind of alcohol purchases as other steakhouses due to the shorter stay and higher upfront price, but there is definitely room for improvement with a more prominently displayed bar, which the company is rolling out as it remodels. The company is also focusing on adding higher end add-ons such as a seafood tower.  Dessert is under penetrated, and a desert ordered in advance is an easy way for Fogo to increase their check size. Advertising and marketing is running only 2% of sales.   From our talks with management, they seem to produce excellent returns. Fogo is nowhere near as well known as the other major steakhouse chains.  Increasing advertising could be a good way to drive sales.

Business:

Fogo De Chao is a Brazilian style churrascaria with 48 restaurants in the U.S. & Brazil and one JV in Mexico and JV unit in Saudi Arabia.  The company believes that they can have 100 restaurants in the U.S. and potentially more than that overseas.  The company’s restaurants serve an all you can eat lunch meal for roughly $40 and dinner for $60.

Catalyst

With a reversal of most or all of the short-term issues dogging FOGO, the company should show improved unit economics a return to growth and easily beat consensus estimates of $0.83 in 2018. We believe FOGO will have EPS over $1.00 in 2018.

Fogo should be able to begin repurchasing shares in 2018.

The company will likely find another JV partner.