Why I bought The Stock of Diversified Restaurant Holdings

A Senseless Market Capitalization

Published on:
July 13, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Animal Spirits may explain why an investor would prefer to franchise a Buffalo Wild Wings restaurant as opposed to simply purchasing the stock Diversified Restaurant Holdings. Below is an argument for the latter option using a simple, cost-benefit analysis between the two alternatives. 

Building 65 Franchises Versus Purchasing The Stock

The expected cost to open a Buffalo Wild Wings restaurant ranges from $2.6 to $3.7 million. Let's multiply the expected cost by 65 (the number of restaurants SAUC franchises.) Let's further assume that we require a minimal 5% return on our capital of $201 million, which would bring us to an expected profit of $10 million.

Management of SAUC noted that the costs to open a restaurant are
somewhat lower. On page 7 of the 2017 annual report, management wrote that
"the average cash investment per restaurant ranges from approximately $1.7
million to $2.6 million."

So let's use their lower estimated cost of $2.1 million to open a store and calculate the expected profit as we did in the first paragraph. We conclude on a total cost of $136 million, on a profit of $7 million and on an annual revenue of $137 million, in line with what SAUC earned last year. 

While the cost to open 65 franchises is between $136 million to $201 million, SAUC’s current market capitalization is $34 million, about 3/4 lower. In 2017, sales were $165 million and profit generated was $8 million (the profit excludes an $18 million tax provision, which I will further discuss, below.) In short, to build 65 franchises, the expected cost is about $6 per share, while the price of SAUC, representing a similar economic outcome, trades at about 1/5 of that. 

diversified restaurant holdings financials
Source: Public filings and my calculations

Why The Decline in SAUC's Stock Price?

Since May of 2017, shareholders watched the price of SAUC decline each month. At fault, I believe, are three events. The first event is higher costs for chicken wings. Traditionally, the price of chicken wings was around $1.25 per pound.  But last year, it reached over $2 per pound. And since chicken wings are 25% of the total cost of sales for Buffalo Wild Wings, it impacts earnings. Last year Tim Carmen of the Washington Post wrote

The second event was that SAUC sold restaurants operating under the name
While this was an underperforming segment, its absence going forward lowered future revenue guidance. In numbers: the 2015 revenue, which included income from Bagger Dave’s, was $172 million compared to the 2016 revenue of $166 million, a decline of 3.5%.

The third event at fault for the lower stock price is an obscure change in accounting rules. Because of changes related to, management reported on a $19 million loss in their income statement.Without the reported tax provision loss, I estimated earnings would have been $8 million, or $0.30 per share.

diversified restaurant holdings
Source: Public filings and my calculations

My Appetite for Wings

 My interest and fascination in the restaurant business is limited. I never visited a Buffalo Wild Wings restaurant and frankly wouldn't know the difference between a chicken wing and thigh - I hardly ever eat meat.  

But the rationale to purchase SAUC as strong as DAVE because there were additional forces at work. Besides the low current valuation of the stock relative to its past valuation, the acquisition of Buffalo Wild Wings, may bring good news. This entity is 82% owned by Roark Capital Group, named after infamous character of Ayn Rand's novel,

The key force behind Inspire Brands is its boss, Paul Brown, who has with a proven track record in the restaurant business (he revamped Arby's).

Inspire purchased Buffalo Wild Wings for $2.9 billion, and that at the time of purchase, there were 1250 restaurants (about half were owned by the company). This equates to an average purchase cost of $2.3 million per restaurant or franchise. Keep this number in mind as you read the concluding section below.

The Math

To me, a reasonable price for the stock of SAUC is $2 per share. Another way to look at the valuation is to assume $2 per share. From there, you can say that the market value of the equity would be $56 million, and if we add back the liabilities of $131 million, we get a value of $187 million for assets that compose of 65 franchise stores, or $2.8 million per restaurant. This price aligns with what I believe is the replacement cost of the portfolio.

Ask Me Anything