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Investment Conclusion
BJ’s Restaurants (NASDAQ:BJRI) is recovering from a downturn it suffered during the pandemic. System sales, comparable sales, and gross profits have surpassed pre-COVID-19 levels. However, margins, which have always been a problem for this firm (except for short bouts when they trended uncharacteristically higher), typically coming in below industry averages, remain depressed.
In order to expand margins, management has implemented strategies to improve productivity and minimize spending. Additional leverage will be derived from lower fixed costs/dollar of sales, as ongoing efforts to further escalate customer demand deliver on a substantial basis. Moreover, with a current footprint of 214 restaurants, 70% of which are located in four states, BJRI has significant white space to develop a presence in under penetrated territories and expand into new regions.
Overall, given opportunities for revenue growth, margin expansion, and geographic diversification, combined with a solid management team (with decades of experience running BJRI), we believe the firm’s turnaround is assured within a couple of years. Therefore, we view BJRI’s current stock price as an opportunity to accumulate shares, in order to secure significant returns on capital.
We are initiating on the Brew House chain with a Buy Rating and a 1-year Price Target of $45/share, derived utilizing our 10-year Discounted Cash Flow model, that includes a perpetual growth driven terminal value.
Investment Thesis
The first BJRI restaurant was launched in 1978 in Orange County, California, as a pizzeria. In 1996, adding proprietary beer and expanding the menu substantially, BJRI regrouped as a full-service casual dining restaurant chain. The concept has 214 restaurants across 29 states, with heavy concentration in California (61), Florida (22), Texas (34), and Ohio (14).
During nine-months ended September 2022, BJRI generated: ~$940 million in revenues, reflecting a growth rate of 18.1% compared to the same period in FY2021, same store sales growth of 16.9% on a year-over-year basis, ~$115K in net income reflecting a decline of 89.1% over nine-months ended September 2021, and break-even earnings per share versus $0.04 realized during the same time frame in FY2021. At nine-months ended September 2022, operating cash flows were $33.8 million. The company had a cash and cash equivalents balance of $19.2 million, and long-term debt of $50 million on its balance sheet.
The primary issue drawing investor interest in BJRI is whether a turnaround of the business is possible? The secondary concern surrounding the story is related to footprint expansion, if significant new unit development is realistic for the group?
Potential Turnaround A When Not If Event
Following the lifting of pandemic-era restrictions, BJRI’s customer demand has been on an upswing and revenues have overtaken pre-COVID-19 levels. In that regard, it is noteworthy that during F3Q2022, revenues expanded by 8.2% over F3Q2019 levels, and by 10.3% on a year-over-year basis. Over nine-months ended September 2022, sales have advanced by 18.1% over the same period in FY2021. Clearly, generating significant sales is not an issue for BJRI.
Nevertheless, the firm has implemented initiatives to enhance sales growth, including remodeling its stores to increase seating capacity, is working on a project to prepare patios for service during additional seasons, and modernizing the bar statement to include an ultra large flat screen television and moving beer taps to the back wall. In addition, with a view to improve customer service, BJRI has introduced technology at key customer touch-points, such as providing servers with tablets to take orders, call-ahead service, digital wait-lists, and order tracking for take-out and delivery transactions. Further, the restaurant chain increased its employee base by 6,000 over F2Q2022, with a view to improve quality of service. Moreover, BJRI is testing a downsized menu in its stores, focused on core Brew House favorites and fare unavailable at alternate restaurant concepts. We are encouraged by the company’s efforts to expand revenues, as sales leverage as a function of lower fixed costs/dollar of sales, can contribute considerably to margin growth.
Given that BJRI’s margins remain below industry averages, reflecting in disappointing earnings and free cash flows, margin improvement is critical for a successful recovery of the business. The firm has enforced several policies at the restaurant level to reduce spending, such as: procuring cheaper sizes and cuts of chicken breasts, salmon, and avocados, slow cooking chicken wings rather than deep frying them, and switching suppliers of chemicals, linen, glassware, and take-out packaging. In addition, BJRI is testing a smaller menu and deploying technology at the table-side, to derive operating efficiencies.
As restaurant level operating margins expanded by 200 bps to 10.3% from the second quarter to the third quarter, it appears that the margin improvement policies are having a favorable impact on the business. In that context, it is noteworthy that management expects restaurant level margins to escalate to ~15% during FY2023, and has guided to long-term restaurant level margins in the high-teens.
Overall, we believe the strategies enacted to advance margins, combined with an expected decline in commodity prices, is bound to reflect in some improvement in overall leverage. Nonetheless, if the firm is unsatisfied with the level of potential margin expansion, raising menu prices beyond inflationary trends is reasonable, in our opinion. Given the popularity of BJRI’s restaurants among customers, a successful turnaround of its business is imminent, one way or the other.
Geographic Diversification Opportunity Represents Low Hanging Fruit
Given business dynamics, we believe BJRI can handily expand to 425 restaurants that management has cited as a long-term objective (will take a while as footprint growth is ~4%/year). The major factor driving our conviction on the matter is that the concept with a current base of 214 stores appears highly under penetrated, compared to key competitors, Olive Garden with 887 restaurants, and Texas Roadhouse (TXRH) with 607 restaurants. In addition, that 70% of BJRI’s stores are located in four states out of the 29 it has a presence in, indicates that the brand has significant white space to develop within its existing markets. In that regard, based on management commentary, it appears likely that with a view to leverage: supply-chains, supervisory talent, and brand awareness, near-term new unit development will be focused on regions that the Brew House has a presence in.
Further, that BJRI’s restaurants are well differentiated from other restaurant groups, is an additional element that provides us comfort that there is room for substantial footprint growth. In that regard, the brand’s stores are arguably more polished, with large dining rooms (~7,500 square feet with ~250 seats), high ceilings, distinctive glassware, and linen napkins (compared to plastic cups and paper napkins dispensed at mass market casual dining restaurants). BJRI’s outlets are also distinct in that they fall within the sports-bar category, and the menu that includes slow cooked entrees, deep dish pizzas, signature desserts, and thirty proprietary beers on tap, is consistent with that popular at such venues. Entrees are priced between $7.25 and $29.95, and the average check/person in FY2021 was $19, versus $21 at Olive Garden, and $19.68 at Texas Roadhouse.
Over recent months, the company has increased focus on marketing to 10 million potential customers that reside within 10 miles of a BJRI restaurant, have similar profiles as the brand’s most prolific customers, yet have never dined at the business. We view this addressable population as low hanging fruit and an excellent opportunity for BJRI to capture market share. In addition, we consider medium sized cities along the Eastern Seaboard and the Mid-Western states, where the firm already has a presence, as appropriate white space to expand into, over the near-term, given their population density, and the popularity of the sports/pizza/and beer culture in the areas.
Overall, given BJRI’s profile as the only sports-bar concept at scale, provides it with the brand recognition and pricing efficiency that favor its success over that of the independent neighborhood sports-bar.
Risks
BJRI Is Unable To Resolve Its Margin Challenges. The company generated its peak operating margins during FY2016 and peak profit margins over FY2018. Since then, BJRI has been unable to sustainably recover to those levels, although margins were improving prior to the pandemic. In our judgment, the group’s current strategy to leverage operations through detail oriented approaches to spending is appropriate, and likely to deliver favorable outcomes.
Nevertheless, we believe that considering the $50 million investment in BJRI by Act III, an investment firm owned by Ron Shaich, the founder of Panera Bread, indicates that the firm is on the radar of the private equity industry, and that there is sufficient likelihood that the restaurant chain might be acquired for a premium, if business profitability fails to improve.
One-Year Price Target
We utilized Discounted Cash Flow analysis including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $45/share for BJRI. We assume a normalized 10-year revenue growth rate of 8%, (vs. nine-months ended September 2022, revenue growth rate of ~18.1%). Based on our analysis of BJRI’s historic financial reports, we model normalized 10-year operating cash flows as 9% of revenues/year and straight line 10-year capital expenditure as ~4.25% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 23.4 million to arrive at our 1-year Price Target.
Bottom Line
BJRI restaurants are great. They are modern and energetic, with excellent food paired with an award winning beer line-up. The concept appears popular with customers with average weekly sales of BJRI restaurants beating those of Olive Garden restaurants.
We believe the margin challenge could be fixed if BJRI were to raise prices to levels consistent with its polished casual profile, and leave its value orientation to mass market casual dining concepts. In our opinion, customers comprehend the distinctive quality that BJRI’s restaurants provide. Therefore, demand is unlikely to suffer, if the firm were to price the menu appropriately, for the experience it offers.
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