Wingstop: Framing an investment in Oct. 2020
Diligence Report | 25 min read | How I framed this opportunity as a buy-and-hold investor
Originally published on midstoryventures.com in October 2020.
Before you read this segment in the Diligence Report series — please read the “Introduction: Diligence Report Series” post here.
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Narrowing the Focus
There’s only a few things you need to know about Wingstop.
First, it sells really good wings. Second, it focuses on takeout. Third, it appeals to Hispanic and low-income households. Fourth, it franchises these concepts.
That’s it. That’s why restaurants are such a good business. If you can make one store work, all you have to do is wash, rinse, and repeat.
Because it’s so simple, you should spend 80% of your time on three areas:
Because restaurants trends can impact the moat and quality of any concept, you should spend the majority of time evaluating if the concept is capable of adapting over the long-term.
Because the model is so reliant on the franchisee’s success, you should spend the majority of your time evaluating if you trust management to pick the right franchisees.
Because the business does not offer a high free-cash flow yield, you should spend the majority of your time assessing if management has the right framework for growth.
The other drivers of the business are useless if you do not have high conviction in these three areas.
How long can Wingstop last?
The best way to think about durability for a restaurant is longevity and adaptability.
Does the concept have longevity?
Food can sometimes be trendy. It comes and goes, even if it lasts for long periods. Jamba Juice is one of those concepts that has been around for almost two decades; however, it is extremely niche. It only sells smoothies. Smoothies are things that people can easily make at home. There are also countless alternatives for beverages. Jamba Juice has continued to decline in same store sales as consumer behavior has shifted to other beverages.
However, there are some things that have just proved to be popular time and time again for the past few decades. Pizza and burgers are definitely one of those essentials in American culture. You’ll find these essentials on every college campus that you visit today. You’ll even find these essentials on every college campus when your parents attended college. Over 40 years, these items have not changed.
I’d like to say chicken wings have durability as a food concept, albeit not as durable as pizza and burgers. Pizza and burgers are just so ingrained in American culture. When a generation gets into the habit of eating a certain type of food, there is a trend for that generation to pass those foods that they love to their kids. Think about your favorite foods. Whether your 20 years old or 40 years old, your favorite food probably stems from a childhood experience. It gives you those memories.
I would put chicken wings in a similar category as burritos, tacos, and sushi. It hasn’t been around as long as pizza and burgers, but it is definitely at the top of every person’s mind when thinking about fast casual restaurants. It sits in a niche market with very little variation — people who eat chicken wings don’t look for something new.
Chicken wings might be less widespread than those three, but it also has a predictable market. At every bar and every sports event, you’ll find someone eating chicken wings. Wings has been on the Top 10 order list by GrubHub a number of times.
Like all things, chicken wings has the potential to be a “thing of the past” 5 to 10 years from now. There are current trends towards healthier food. Over time, healthier food has slowly moved culture, but not to the extent that some might expect. McDonald’s is still growing same store sales every year and it has been attacked at every angle since the 2000’s. So chicken wings face the same uncertain, but likely-to-exist fate as other fast casual foods.
Is the concept socially adaptable?
Geoff Gannon wrote a fantastic write-up on The Restaurant Group. In his analysis, he pointed out that the longevity of a restaurant really depends on the company’s ability to maintain and/or shift its social position. While most restaurants have a core part of their menu that never changes, over the long-term, they won’t look exactly like how they are today.
Wingstop’s longevity is directly linked to its lack of adaptability. What does this mean?
When it opened in 1993, it only had 8 flavors. Over the course of 30 years, it has only permanently added 3 flavors. Of the original 8, only one flavor has dropped off. Teriyaki, an original flavor, has changed to Spicy Korean Q. I would dare to say that only the absolute great fast casual/fast food chains have been able to do this: Chipotle, Chick-fil-a, In-N-Out, and Five Guys are the ones that come top of mind. The common denominator behind all these companies is they focus on simplicity.
While I expect their menu to change over the long-term, I doubt any of these companies, Wingstop included, would need to change their menu drastically to keep up with future trends. This is the definition of durable.
Is the restaurant concept physically adaptable?
Beyond social brand position, a restaurant must also have an adaptable physical position. I searched Google Maps to understand the restaurant’s real estate location. I focused on areas that I was familiar with: Folsom, Sacramento, San Diego, and Los Angeles. From my observation, I noticed two trends:
Wingstop tended to AVOID most expensive shopping centers. In San Diego, In-N-Out and Chick-Fil-A are in the heart of the shopping center district. Wingstop is positioned right outside that high-expensive radius.
Wingstop likes to position themselves in neighborhoods, especially low-income ones. For example, Inglewood has a higher concentration of Wingstops in a two-mile radius than Santa Monica has in a five-mile radius.
There are four implications with these trends:
It attracts less competition because these neighborhoods have less discretionary consumer dollars floating around.
Franchisees have lower rent because these neighborhoods are less attractive for most concepts.
It is less impacted by healthy trends, since individuals with lower income are more focused on food quantity for survival than food and health quality.
It matches up with Wingstop’s 2020 Investor Day deck, where their best customers are Asian Americans, Hispanic, Family, and Lower-Income Households.
What does this have to do with physical position? Takeout as a percentage of all orders across the Wingstop system is 75%. The company is pushing that number through its digital channels in order to make the restaurant become like a cooked-to-order kitchen, ready to go for pick up to delivery at a moment’s notice. Because takeout is such a big part of their business, physical position of locations actually matters less than other restaurants. Restaurants with more square feet or most expensive locations will face pressure as they try to become more like a kitchen themselves too. However, you don’t know where the future of the chain will take you, which is why you need optionality. Luckily, Wingstop locations are already well-positioned near the target demographic. So if for some reason their take out value proposition was dwindling, they could always use their strong physical locations to capture their audience in a different way.
What makes this system special?
For a company with a franchise model, the competitive advantage is really in the franchise system that the company has built.
THE FIRST TEST
The first test to see if the franchise system works is asking yourself if you would become a franchisee over the length of the contract (in this case ~10-years).
Wingstop is 98% franchise-owned and has been running this high since its inception. Like most franchise systems, the typical franchise profile has a suitable net worth available to invest in multiple properties. In fact, existing franchisees have so much buy-in with the system that existing franchisees accounted for 69% of restaurants opened in 2013/2014. This number has grown to 80% in 2017/2018. The proof is in the pudding. Franchises want more of it.
Here are the reasons why they want to be part of the system.
First: Simple Menu
If I quit my job and started a restaurant, I would want a simple menu that never changes. Wingstop serves only chicken wings as their main entree. Focusing on essentially one food product makes it easy to operate. You don’t have to worry about complex distributors or have a world-class supply chain like McDonald’s in order to function. For the side dishes, they only offer fries, bread rolls, corn, and veggie sticks. That’s it. Even more impressive is the fact that Wingstop has never had to lower their prices to compete. Instead, they introduce limited-time flavors on occasion to generate new interest and demand. The only company that comes to mind with enormous pricing power on an unchanging menu is In-N-Out.
Second: Predictability
Next, I would want to know that my inflow of customers in predictable. Predictability is king in the food business. When my brother worked at McDonald’s as his first job, he called customers who would frequent the restaurant – the “regulars.” He knew the exact time of day they were going to come in, their exact order, and their exact seat .
Fast casual restaurants are inherently more predictable than high-end, expensive restaurants. While a high-end restaurant does have a certain predictability to it, it does not have frequency. And when a customer is less frequent, they do more thinking. And when they do more thinking, you are giving them the chance to pick something other than your restaurant. Think about it this way: when you are going out to a fancy dinner, are you more likely to try something new or pick the exact same place again?
Fast casual restaurants are inherently more habitual because they are more frequent. These are routine meals. They want reliability for routine meals. Wingstop capitalizes on this. You know exactly what you’re going to get: wings! More importantly, they capitalize on takeout. In fact, 75% of their orders are takeout. Takeout is inherently more habitual than dining-in because you are just looking to get food, rather than getting the overall experience. This is why Domino’s is also extremely predictable.
Third: Efficient System
If I were running a restaurant, I would want it to be as efficient as possible. In fact, if I were running a takeout-focused restaurant, I wouldn’t want any customers to actually eat in my restaurant. That is how efficient I would want to be. It would be so efficient that I would only focus on one thing: cooking.
I’ve never worked in a restaurant, but I have played two restaurant-simulation games: Overcooked and Diner Dash. Overcooked tasks you with cooking each ticket order on time. Diner Dash tasks you with waiting tables. When my siblings and I play these games together, we can’t even finish one round without screaming!
Luckily, companies like Domino’s and Wingstop have broken the game. It’s best to think of Domino’s and Wingstop as extremely efficient kitchens. Wingstop’s average store is 1,700 square feet. While I don’t have square footage information for Domino’s, I would imagine it’s around the same. Starbucks is the only foodservice company that has able to pull off anything smaller, which is a 450 square foot drive-thru center. Other restaurants are killing to have this type of system, which is why companies like Mealpal are offering their technology to restaurants to become more kitchen-like. A lower square footage means a lower-break even point. 1,700 square feet is strides better than Chipotle’s 2,500, In-N-Out’s 3,800, and McDonald’s 4,000,
Fourth: Effective System (Delivery and Digital)
Delivery
Domino’s and Wingstop have very similar models, but they differ one important aspect. Domino’s has spent, and continues to spend, a significant amount of money to build its delivery infrastructure. While it undeniably has the best in-house delivery system in the world. it’s losing its value. Postmates, DoorDash, GrubHub, and UberEats have opened up the floodgates for other restaurants to compete with Domino’s by creating seamless delivery systems. That means their precious capital investment might generate lower returns than expected.
While Domino’s cares more about controlling the delivery system and customer experience, Wingstop cares more about the efficiency of the system. Wingstop doesn’t have as much investment risk in delivery as Domino’s. However, it faces customer risk. I spoke with Delfino, a District Manager of Wingstop for more than 20 years, and he alluded to the fact that customers can sometimes be frustrated because DoorDash drivers. Once or twice a day, a DoorDash driver will pick up the food at the restaurant but fail to confirm the order or deliver it to the customer. The customer gets mad in the process and blames Wingstop, even though Wingstop did not do anything wrong. However, he said it does not greatly impact the restaurant because it is only one or two transactions amidst the dozens and dozens of transactions every day.
Another risk with outsourcing delivery is that it is expensive. DoorDash can eat up as much as 25% of gross ticket value.
While there isn’t an absolute one-size-fits-all answer for choosing between the two, it is important to know that each comes with a set of risks. I believe Domino’s delivery system, which is the main source of their competitive advantage, is vulnerable. I don’t see Domino’s going anytime soon, but I do forsee higher Domino’s investing higher amounts of capital expenditure to deliver the same amount of value to the customer. I believe Wingstop made the right move to outsource delivery since it is easier for a franchisee to rely on a well-built delivery model than it is for them to figure out how to make an internal delivery system work. In fact, after having the opportunity to invest in Postmates as a venture capitalist, I realized how hard it is to actually manage a last-mile delivery system. Though DoorDash or any of these carriers aren’t perfect, I believe they are economically the best solution for Wingstop.
Digital
Digital apps serve three purposes:
To streamline the order-to-ticket process
To increase the number of takeout orders and make ordering habitual
To develop loyalty customers through usage-based rewards
The companies with the best digital presence are McDonald’s, Chick-Fil-A, and Starbucks.
It’s unfortunate that Wingstop is currently not up to speed on the digital opportunity since Wingstop is the king of takeout in the fast food industry.
Wingstop faces backlash on basic IT problems. More importantly, Wingstop doesn’t tap into its more valuable idea: wings as a craving. When I click through McDonald’s, Chick-Fil-A, or Starbucks, I feel so excited about the possible things that I can get. Though this may be a personal perspective, navigating through Wingstop’s app doesn’t make me want to order wings any more than I did earlier. While this is discouraging, over the long-term, I expect Wingstop to make more significant moves into this area. Through their recent partnership with Olo, they have revamped their digital presence and increased digital sales from 7% to 35% with a ~30% conversion rate. They also noticed that digital orders were $5 higher in value than any other type of order.
Fifth: Economics
Based on square foot per store, average unit volume ($) per store, average profit margins, and average initial investment, it seems as if Wingstop is top in its class for franchisee economics.
THE SECOND TEST
The second test focuses on other opportunities that a franchisee could entertain. Notice that the focus here is on franchisee opportunities, not Wingstop’s restaurant competitors.
Restaurant competition has to do more with the concept’s innate durability and management’s ability to steer the ship, rather than the actual competitive position of the restaurant itself. Restaurant trends come and go, so it’s really pointless to think about existing competition or future competition. A restaurant with a socially and physically adaptable concept can alter its menu to fit the current appeal. A competent management team knows how to build franchises in areas where there is less competition.
Wingstop is in the business of selling a system, so you have to ask yourself: would you be able to build a franchise system that has Wingstop’s simplicity, predictability, efficiency, effectiveness, and economic potential? Even if you could, how long would it take you? It takes decades to build successful franchise systems. The death of a franchise system is growing too fast. It took at least 20 years for Chipotle to build its concept into a household name.
How much cash flow can this system generate?
Whereas the moat refers to the strength of the franchise system, quality refers to the financial performance from the system. More specifically, it refers to the quality of those financial levers.
Like most franchise restaurant systems, Wingstop has three levers:
Royalty Rate
Average Unit Volume (AUV)
Capital Investment
Royalty Rates
Royalty rates are by far the most important factor when assessing a system’s bargaining power. Because cash flows from royalties increase as the AUV increases, it can easily outpace any income from franchise fees. The average royalty rate across 13 of America’s most popular fast food franchises is 5.0%. Wingstop’s royalty rate is 6.0%. As a general rule of thumb, a higher royalty rate is an indicator of more bargaining power than the average restaurant. This is not always the case though. Pizza Hut, a franchise system owned by Yum Brands, is listed as charging a 6.0% royalty rate. However, it’s system-wide sales have remained nearly stagnant and have experienced SSS declines. In no way should is their 6.0% royalty rate an indicator of justifiable value creation. Instead, it seems like Yum Brands is milking Pizza Hut’s franchisees in their locked-in contracts for as long as they can since it may lose soon. On top of all the indicator’s I think Wingstop has great bargaining power because people want the own the franchise. They recently increased rate from 5.0% to 6.0%, which is a big deal. Of these four pillars, your royalty rate is definitely the hardest to increase. I don’t expect Wingstop to increase it very soon.
Average Unit Volume
AUV is the best indicator of the typical unit’s cash flows, whereas system-wide sales (same-store sales) is a better indicator of growth. The ideal way to think about AUV is by segmenting the franchises into young and mature stores. Typically, young stores will contribute more growth than their mature counterparts grow with inflation. While Wingstop doesn’t report this number anymore, their S-1 states that their young stores can scale up to $820,000 in their first year of operations. That’s very similar to a Cheescake Factory where their young store become mature really fast. This means that the payback for a store is faster than your average retail store.
Wingstop reports their AUV numbers but they don’t break out the AUV of young and mature stores, so I calculated AUV based on total franchises (a mix of young, mature, domestic, and international franchises). I believe this is a more appropriate way to think about the overall system, given that they did not publish enough segmented information to understand each store level.
Since 2012, Wingstop has increased their Franchise AUV from $824,000 to $993,000, which is roughly a 3.0% CAGR. For a growth-stage concept, this is very reasonable. In fact, more mature restaurant concepts actually experience much lower AUV growth than Wingstop. Chipotle with 2,500 stores (twice the size of Wingstop) experienced a -5.4% CAGR on their Corporate AUV since 2014. McDonald’s with 37,000 (the second largest restaurant chain in the world) experienced a 0.1% CAGR on their Franchise AUV since 2013. Unfortunately, Domino’s does not disclose their franchise system sales, so it is tough to calculate their Franchise AUV. But based on their fortressing strategy, I would imagine their AUV would be declining or stagnant. Going forward, I believe Wingstop still has some room to grow their AUV through digital orders with higher ticket values. However, Wingstop will eventually run into an AUV ceiling because they are also pursuing a fortressing strategy.
Capital Investment
The financial strength of the franchise system not only relies on the income it generates, but the capital it has to invest in the business. Wingstop is one of the only franchise concepts (between retail and restaurants) that has enough bargaining power to put the responsibility of real estate ownership on the franchisees. In most cases, this is a win-win.
Wingstop’s returns on invested capital upon opening one new store is extremely high since it’s basically all profit and no capital. Franchisees avoid paying the “large markups” on leases charged by other restaurants like McDonald’s. This allows Wingstop to maintain a healthy franchisee relationship. Instead of squeezing every nickel and dime from the franchise owner, Wingstop allows them to grow their return on equity from their own business – just as every entrepreneur should.
Between 2012 and 2018, Wingstop’s incremental investment to open a new franchise was approximately $25,000. As discussed later, Wingstop generates $25,000 in free cash for every restaurant. That means Wingstop gets its money back in one year.
How much value can I get for one franchise?
The beauty of a restaurant, especially a franchise, is that it is incredibly easy to value. The goal is to find the value for one franchise. And the best way to do this is to let the market do the work.
Let’s say Wingstop has 1,500 total franchises at the time of this analysis. For the sake of simplicity, let’s also assume that franchises make up the entire value of the company. Realistically, franchise-owned stores contribute 80% of total profit and corporate-owned stores contribute 20%. So this 80/20 ratio is a good way to think about a sum of the parts value allocation. But since majority of the value comes the franchise system, treating the company as if it is 100% franchised makes it easier to value.
Let’s say Wingstop’s market cap is $3 billion. That means the market is offering about $2 million for each existing franchise. But what does this mean?
McDonald’s has an implied value of approximately $4 million per franchise. Does Wingstop’s franchise is undervalued?
No, the only way to know if this value makes sense is by comparing the cash flows generated from each franchise to the value that implied market value for each franchise.
Let’s make a few assumptions:
Take Rate (Royalty-rate) of 6%
Long-term franchise AUV is about $950 thousand
Pre-tax profit on the royalties and franchise fees is 60%
The tax rate is 25%
The business requires no capital expenditure or working capital investment
You can play with the numbers of this calculation to determine the free cash flow generated from each franchisee. With these numbers, Wingstop generates $25 thousand free cash flow from each franchisee. That it means it generates a free cash flow margin of 44% on a $57 thousand of franchise revenues.
Since you know the implied value of each franchise and the free cash flow generated from each franchise, you can use simple algebra to calculate the free cash flow multiple for each franchise.
With these assumptions, you calculate a free cash flow multiple of 80x. I like to think in terms of yields, so this means the market is offering a 1.25% free cash flow yield. You can compare current free cash flow yield to the yields offered historically for the company or for future free cash flow yields on a normalized basis. You can also compare this yield to yields offered for other franchises from McDonald’s, Wendy’s, Papa John’s, Domino’s, etc.
How many times can I repeat this concept?
The beauty of a franchise system is that the success of one franchise store can most likely be replicated with another store in a different location.
For the past few years, Wingstop said it could do this across 2,500 stores. Last year, they hired some consultants and BCG and discovered that they could actually replicate this across 6,000 stores. Their target growth rate for number of net units is 10%.
The way I think about “target” numbers proposed by management is modeled after Geoff Gannon from Focused Compounding.
I am not the CEO, I am not as smart as him, And I certainly do not have same type of information as him.
So if you told me that to bet on whether I was right or he was right about the number of possible units, I would bet that he has the right number. However, that does not mean that I do my due diligence. It just means that when I think about growth, I should evaluate how the CEO thinks about growth — his framework for capital allocation to achieve that number.
Before I talk about capital allocation, I’ll acknowledge three things:
The growth rate of net stores is most likely the strongest predictor of intrinsic value growth
The max number of units that a company should open is 100, based on Peter Lynch’s Beating the Street
The 6,000 target store target means it will be bigger Chipotle, Chick-Fil-A, Panda Express, Jack in the Box and as big as Taco Bell, Wendy’s, and Papa John’s.
What’s the framework for capital allocation?
Wingstop is a growth stock. But Wingstop pays out 40% of their FCF as a dividend, so it can also be considered a dividend stock. This creates an interesting conundrum.
How do you manage a stock that is grows at a compounded rate of 40% per year while paying an annual dividend?
Wingstop manages this by converting 40% of the FCF into dividends and keeping the remaining FCF as excess cash. The 60% remaining FCF doesn’t need to be reinvested into the business to generate the 10% target store growth because Wingstop doesn’t need to invest into capital expenditures or working capital.
There’s another issue though: Wingstop runs a Total Debt/EBITDA of 6-7x.
So what are management’s options to deal with excess cash and intense leverage?
Increase executive compensation
Reinvest into the business
Pay a higher dividend
Accumulate cash
Pay back its debt
The first two options destroy shareholder value, the next two create financial risk, and the last option has its limits.
By increasing executive compensation, management steals the cash for themselves instead of returning the capital to shareholders or debtholders. Reinvesting into the business has a high chance of diluting returns since Wingstop’s current system does not need any capital to run, so any excess capital investments will probably not create the same value.
Paying a higher dividend is not a bad idea for shareholders, but it does strip Wingstop of its future ability to pay down debt in the future. Accumulating excess cash to offset the heavy debt load is not a bad idea because it hedges some of the risk, but an optimal cap structure with a nonoptimal level of excess cash basically negates the idea of shareholder maximization.
Paying back is the option that does the best job in decreasing the most financial risk. Levering a system that relies on franchises who have debt on their units is double leverage and it can get messy really quickly if one domino falls over. The downside of the decreasing financial risk is the fact that you are decreasing financial returns. Additionally, paying down debt has its limits. In the FY 2018 Q4 earnings call, Wingstop acknowledges that you can’t “prepay without incurring a penalty on any of the bonds that [they] have issued.”
Wingstop ultimately chooses the option to accumulate cash and maintain its debt levels.
In that same earnings call, Wingstop mentions that investors should expect to see “cash build over time” and should expect consistency with their return of capital policy.
But why does management have heavy debt loads in the first place?
It has to do with its history and its captain. Wingstop was founded by the brilliant restaurateur Antonio Swad but sold the concept to a private equity shop so he could work on his next idea. For the next 12 years, Wingstop carried heavy debt loads by its private equity owners.
In 2012, Charlie Morrison caught a lucky break and joined Wingstop after bouncing around from portfolio company to portfolio company. At the age of 50, Charlie is the the CEO, President, and Executive Chairman of Wingstop and is one of the youngest on his Executive Team and Board of Directors. He is towards the end of his career and he wants to make a splash. His heart is set on becoming the CEO of a “Top 10 Global Restaurant” and is not going to let anyone stop him.
The combination of Wingstop’s private equity history and Charlie’s ambitious personality explains why high debt balance.
So the only question boils down to whether or not you trust that Wingstop will act consistently and competently on your behalf?
Warren Buffett says that integrity is the most important aspect in trusting someone with your money and I believe the best measure of integrity is consistency — consistency in the way one thinks, talks, and walks.
Managers think based on the way they are incentivized and Charlie is incentivized to grow its net new units, adjusted EBITDA, and stock price across its short-term and long-term incentive plans. In fact, he is incentivized to grow new net units at an acceptable level of AUV in order to achieve optimal compensation, This lines up with the way he talks about the company.
Charlie clearly demonstrates that he knows the key drivers of the business and the keys to strengthening its competitive advantage. He talks about new stores and adjusted EBITDA all day long. And this lines up with the way he acts.
He attends investor conferences to sell his stock. He consistently delivers strong performance across financial measures like adjusted EBITDA and non-financial measures like new units and digital conversion. He has also kept his dividend commitment for the past 3 years and maintains a steady Total Debt/EBITDA ratio.
Key Considerations
Wingstop is one of those businesses that is really simple to understand, but not easy to analyze. Like any investing, it takes a great deal of faith. Some investments take more faith than others. Here are three pieces of advice as you dig more into Wingstop:
Think about owning the cash flows of one franchise — value always comes down to one or two drivers
Focus on the catastrophic risk — quality is useless if your concept is dead
Talk to franchise owners — they are the real customers
Thank you for reading. I hope to sharpen my skills every month and develop meaningful relationships along the way. What points do you agree with? What points would you like to share your own perspective?