Chuy’s: A Stock To Watch (NASDAQ:CHUY)

Editor’s note: Seeking Alpha is proud to welcome Yash Agrawal as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

Chuy’s Holdings (NASDAQ:CHUY) has exhibited improved performance since the pandemic. Furthermore, it is part of a sector that is expected to grow in the double digits. CHUY is on the right track, as the bottom-line figures are all near or at all-time highs. The business is expanding rapidly, thanks in part to new restaurant openings. However, CHUY’s increasing cost of sales is an area of concern. Its high P/E (price to equity) valuation compared to its peers lead me to believe the stock is at least modestly overpriced. Thus, my initial rating on CHUY is hold.

About the company

Incorporated in 1982, Chuy’s is a growing full-service restaurant offering Mexican and Tex-Mex food. Started in Austin, the company now owns 97 restaurants across 17 U.S. states. Chuy’s restaurants have an upbeat, funky, eclectic, and somewhat irreverent atmosphere while maintaining a family-friendly environment. Apart from its food, CHUY also offers merchandise such as t-shirts, sweatshirts, and hats to its customers.

Recent performance

According to Fortune Business Insight, the restaurant industry is expected to grow at a CAGR of close to 11% by 2029. This includes both quick-service restaurants as well as full-service restaurants like CHUY.

CHUY’s business recovered quickly after the pandemic struck in 2020. Sales grew rapidly, as CHUY observed an increase of more than 25% in 2021. This was followed by subsequent wins in the company’s quarterly results of 2022, giving long-term investors some relief. CHUY’s first three quarters of 2021 saw it grow sales by an impressive 80% vs. year-earlier results. The fact that this included the industry’s peak season certainly contributed to this growth.

As CHUY has continued to grow, investors expected higher earnings at the end of the third quarter. The company delivered, with an upside surprise of 8% EPS growth driven by a $2 million beat on sales. As a result, the stock price quickly went up and returned 20% in just 15 days after the Q3 earnings.

Strengths

CHUY caught up quickly following the setback that it faced due to the COVID-19 pandemic. Full-year 2021 was a strong period for the company as they generated revenue of $396 million, and both gross profit and net income hit all-time high levels as a proportion of revenues. I believe this performance could remain steady in the coming quarters, as most of their recently opened restaurants will soon become comparable to their old and mature restaurants and begin to generate steady income with lower operating expenses. This is part of the mission of an expanding restaurant chain, and CHUY appears to be on track to check that box as part of its long-term growth path.

Another point that draws my attention is the company’s share repurchase program. Rather than paying out dividends (which would be heavily taxed, and only a small benefit would actually be received by its shareholders), the company has repeatedly taken the initiative to buy back stock. After successfully completing its first program in 2021, the company executed another in October 2022. I see this as a strong move by CHUY, as it clearly shows how confident they are about the future of the business and that they feel the share price is still undervalued. Shares repurchases not only help the business with a lot of tax expense but likely contribute to increasing earnings per share (eventually).

The interest coverage ratio of CHUY is 70x, which is exceptionally strong vs. most companies in this sector. This indicates that the company has a significant degree of stability against its long-term obligations. It also ensures its shareholders that a minimal chunk of total earnings will be used to pay off the debts, and the majority of it will be passed on to the investors.

Digging deeper into the company’s financial health, I find that CHUY benefits from being in a sector where sales are instantly converted into cash. CHUY’s high revenues translate into a solid current ratio and quick ratio, recently sitting around 2.15x and 1.99x, respectively. This shows robust daily liquidity in the company’s operations and makes it nearly impossible to fail in its short-term obligations. That, in turn, serves to keep the company far away from serious potential default risk.

When compared to the S&P 500 Restaurants Index, CHUY has outperformed by producing 14% higher returns than the benchmark.

Weaknesses

When compared to its own past performance, CHUY is doing well in terms of revenues and net income. But from a broader perspective, CHUY lies far away from its peers. The company’s top line seems at par with the direct competition, but when we move toward the net income, the profits shrink faster than that of its competitors because of the greater operating expenses that CHUY incurs. The net income margin of CHUY is about 6%, while the same number for competitors Ruth’s Hospitality Group (RUTH) and Denny’s (DENN) is about 8% and 24%, respectively.

A major and unavoidable factor working against CHUY is ever-increasing labor and operating expenses. In the restaurant industry, a minimum cost of sales is vital for long-term sustainability. While the cost of sales as a percentage of revenue for the sector median is around 65% for the last 12 months, it was as high as 80% for CHUY. So this looks like an area of concern. This leaves CHUY with as little as 20% of its revenue remaining, from which further expenses will be deducted. As a result, that leaves a narrower amount of top-line sales that can be realized as profits.

CHUY’s stock price is up nearly 50% over the six months ended Feb. 8, 2023. That has made the stock pricey on a P/E basis. It now trades at around 27x 2023 full-year forward earnings, vs. a sector median P/E of around 15x.

CHUY is struggling to curb its increasing costs, and food price inflation means the situation has only worsened. Growing expenses, rising inflation, increasing interest rates, and reduced profitability have caused year-on-year EBITDA growth to fall to -18%.

As a member of the consumer discretionary sector, interest rates are more closely correlated to CHUY’s stock performance and pose an underlying risk to investors. Currently, CHUY has low interest and a good coverage ratio, and few major short-term fundamental concerns. However, from a long-term perspective, this advantage will only persist if their expansion plans, which involve company-owned and operated stores, are not backed by heavy debt.

In spite of the strong recovery and decent profitability, CHUY might have dented shareholder confidence a bit when they opened just one new restaurant in 2022, vs. expectations of five to eight new stores. The goodwill of a company highly depends on the trust of stakeholders, and when CHUY’s announcements weren’t acted upon, they opened the door for negative sentiment.

Looking forward

I determined an average stock price of approximately $25 through the use of intrinsic valuation methods, such as the DCF (discounted cash flows), EV/EBITDA (enterprise value to EBITDA), and P/E (price to equity) multiples. This is in contrast to the current stock price of $33. My estimations based on the valuation techniques applied are as follows:

DCF

• Cost of equity: 12.1%

• Cost of debt: 0.1%

• Tax rate: 12.2%

• WACC (weighted average cost of capital): 9.3%

EV/EBITDA

• The sector median multiple of 10.52x compared to 15.21x of CHUY

P/E

• The sector median of 15.56x compared to 27.1x of CHUY

Conclusion

CHUY’s increasing revenues, strong short-term liquidity, and share repurchase program all impress me. I believe that FCFFs will increase in the coming years, and I would like to see how this projection materializes in reality. So that’s why I would include CHUY on my watchlist.

However, the intrinsic value derived from the three valuation techniques I used here suggests that the stock is currently overpriced. That along with the high P/E and management not keeping up with the targets combine to produce an initial hold rating from me.