Retail and Restaurant Valuation Distortions
Analysis Of John A. Gordon
June 03, 2010
Premise
The Wall Street Journal on May 29th discussed the effect of depreciation expense capital spending decisions and how it will affect earnings and valuations, highlighting mature retailers. But, one must look closely at the whole picture. This viewpoint holds for both retailers and chain restaurants.
Discussion
On May 29th, in his well written Financial Analysis and Commentary column, John Janarone of the Wall Street Journal discussed the variability of depreciation expense and the outlook for earnings, for various retailers, such as PetSmart (PETM), Best Buy (BBY), Barnes and Noble (BKS), among others. It highlighted a mature retailer, PetSmart, and the premise of the article was that valuation measures may make stocks look artificially expensive, as companies cut back on expansion and eventually depreciation expense falls.
The article points out correctly that retail (including restaurants) are way overbuilt in the US and slow up is needed.
To us, the article once again highlights the faculty metric and displays the limitations upon focusing on short-term company GAAP earnings trends.
Depreciation is a non-cash expense (but still a charge to earnings) that is a proxy for capital assets charges. On the sources and uses of cash schedule, depreciation is an add to arrive at free cash flow, or roughly, cash flow from operations less capital spending.
The problem is that a decline in depreciation expense, while providing a momentary short-term boost to earnings, is a sign of lack of vitality and business expansion. In reviewing companies, I look for declining depreciation expense as a signal. Even if store openings slow, CAPEX should be spent on remodels and reimaging.
Buffalo Wild Wings (BWLD) faced questions last year as it missed its depreciation target as it was building a lot of new stores. With its comparable sales momentum problems the last two quarters duly noted, it was doing what an underpenetrated US national company should do: build new units.
Retail businesses and chain restaurants battle minute by minute for customer attention and to make a splash. Too old of a store base means something is wrong—the company is in cash cow mode, or it can’t find sites, or that its new stores are not economically viable.
In the chain restaurant arena, refranchising is underway in many companies, driven by the belief that franchising makes company cash flows more predictable, and the royalty stream is worth more than building and maintaining company operated restaurants. So when a chain sells its company units to franchisees, it takes a book gain or loss, and hopefully eliminates some G&A and depreciation expense.
With company operated restaurant margins optimally in the 20-25% range (McDonald’s (MCD) and Chipotle (CMG) are industry leaders), and franchising profit margin at around 70-80%, refranchising seems like an easy decision. But which throws off more free cash flow? It will be interesting to watch YUM and Jack in the Box (JACK) long term as their US refranchising ramps up. In the last year, both have mentioned the earnings shortfall after refranchising and noted plans to cut G&A.
Refranchising can drive percentage margins higher but once completed, the company must rely on franchisees making their growth unit goals. And with franchisees paying more in cost of money (since they are smaller) and have lower unit economics than company operations (franchisees pay a royalty); the growth pattern will be a bit cloudier. Most chain restaurants don’t even discuss franchisee sales, let alone profitability. Earnings disclosure needs to be revamped in the US.