Tuesday, 3 November 2015

Cara Operations and Risk

I'm trying to get my head around Cara's valuation, as it makes no sense at all, and yet, there is no shortage of institutional support.  Maybe the explanation is that there's a buyout premium reflected in the shares?  Maybe there's a Prem Watsa put?

For anyone not familiar, Cara is a Canadian restaurant franchisor.  Prior to 2004, it was public, and was taken private.  More recently, it IPO'd in early 2015.

I read a recently published Globe and Mail article from August 2015, debating the valuation, which I agreed with (for the most part).  Here's a link.

The author's argument is that while other Canadian iconic consumer discretionary companies such as Dollarama, Alimentation, and Saputo, deserve premium multiples due to reliable histories of growth, Cara doesn't.

First, a quick digression, here's a quote from the same article citing a couple of analyst comments on peer multiples (which I find absolutely ridiculous):

"It’s not just the cult stocks that are expensive, however. According to Capital IQ, there are 75 public restaurant companies on the U.S. and Canadian exchanges. The median EV/EBITDA is nearly 12, and the median forward P/E is almost 30. In this context, Cara’s multiples of 19.5 EV/EBITDA and a 29.6 P/E at Friday’s closing price of $33.29, look … well, “reasonable” may not be the right word, but perhaps “understandable.

Mr. Bowes and other analysts willing to put “buy” ratings on Cara at this point say the company deserves a premium multiple because of its expected EBITDA growth, driven by improved restaurant performance, increasing royalty rates, and cost reductions that will improve profit margins. Mr. Bowes noted that Cara’s first-quarter “operating EBITDA” of $24.9-million was nearly 35 per cent higher than his expectations.

If Cara can provide similarly thrilling numbers Tuesday, it will likely provide support for the shares’ rich valuation. But Mr. Sklar of BMO prefers to compare Cara not to hot U.S. restaurant names, but to the Canadian consumer stalwarts outlined in this story’s first paragraph. When Mr. Sklar initiated coverage of Cara in May with a “market perform” rating and $34 target price, he estimated Cara’s EV/EBITDA multiple at 16.5, versus 11 for Couche-Tard and 12 for Saputo and Jean Coutu. Dollarama, which he called “the blue chip Canadian consumer growth stock,” was at 18.5, he estimated. Now, according to Capital IQ, Cara and Dollarama have pulled even: They both have a multiple of about 19 now.

While Cara represents an “interesting” consolidation story, Mr. Sklar said, “we note that Saputo and Couche-Tard are also considered to have strong management teams, and we note that they both also represent consolidation opportunities, but on a global scale. While Saputo and Couche-Tard have been successfully consolidating their respective sectors for many years, Cara’s roll-up strategy is just in its infancy and largely remains to be proven out.”

So here are my takeways from the above:

  1. The market in its infinite wisdom has awarded Dollarama a premium mutliple (which itself is ridiculous), therefore, if investors are ok paying close to 40x ttm eps, 19x EV/EBITDA and 4x sales for Dollarama, well geez, Cara should be valued similarly.  Investors after all, are exceptionally consistent and bang on in terms of valuing all companies at all times.  Dollarama is no exception.
  2. I wonder why Q1 EBITDA grew 35%. vs. expectations  Maybe the previous year's quarter had IPO related expenses buried in SG&A and the analyst forgot to normalize these? 
  3. Is it just me or does the above not reek of greater fool theory in action?  i.e., buy X because it's peers are similarly over-valued.  This will work as long as greater fool theory works.
I have nothing against Cara.  I love Harveys, Beir Market is fantastic, Swiss Chalet is a Canadian Icon.  Milestones, Kelseys, and Caseys are great.   It all boils down to one question in my mind, and that is, what are you actually paying for the right to own a slice of the above.

From the 2Q MD&A:

"Operating" EBITDA was $53.3M for the 26 weeks ended June 28.  Ok, I'll accept the normalized adjustments except for stock based comp.  It's not every day that a business incurs losses on equipment rental contracts or restructures.  For the most part, these adjustments aren't really all that material.  I don't accept the stock based comp add back.  This is just my own idiosyncracy in normalizing.  I know it's widely accepted to add back stock based comp, but this will be a real expense in the future so to not count it is a bit aggressive in my opinion.  I'm going to deduct SBC of $3.2 which basically gets me back to $50M.

If I annualize this, I get expected EBITDA of $100M for 2015. In management's IPO roadshow presentation, link here, management set the bar for Operating EBITDA of between $175M to $240M within 7 years, Working backwards, at the high end, this works out to compound growth in EBITDA of 15.7% and at the low end, 9.8%.

And for this, investors are paying almost 18x forward EBITDA today.

I don't think that it would be incorrect of me to state that investors are paying almost 2x current EV/EBITDA in the hope that EBITDA grows at 9.8% over the next 7 years.

What about free cash flow?  In the IPO presentation, management emphasized low CAPX requirements going forward.  Here's the slide:

I can't actually find much in the way of supporting free cash flows from the Q2 report, there's no annual report yet due to the shortness of time since the IPO, so I'll have to settle for audited operating cash flows from the prospectus and make some assumptions:

From the above, I can see that pre IPO operating  cash flows were $88.5M at the end of 2014.   Through Q2 2015, operating cash flows were only $12.5M, due mostly to a non-cash working capital adjustment for gift card liabilties of $25M.  Let's assume that operating cash flows make their way up to $88.5M at the end of 2015.  Management is emphasizng a reduced capx intensive business.  Thus far through Q2 2015, the company spent $6.5M on PPE.  Let's annualize this and assume that 2015 FCF's are $88.5M - $13M, or $75.5M.

At the company's current valuation, I get $1.8B / $75.5M, or 24x estimated FCF.

Here are the comparable metrics for consumer discretionary food/restaurant companies currently in the market:

McDonalds:  EV/EBITDA = 13X
Red Robin: EV/EBITDA = 8.67X
Restaurant Brands: EV/EBITDA = 14.86X (likely lower as EBITDA probably reflects acquisition costs on a TTM basis)
Wendy's: EV/EBITDA = 10.3X
DinEequity: EV/EBITDA = 11.37X
Brinker's: EV/EBITDA = 8.14X
Darden: EV/EBITDA = 10.54X
Buffalo Wild: EV/EBITDA = 11.67X

Concluding Thoughts

In order for valuation to make any sense in the context of the above restaurant concept companies, one of two things must happen.  Either 1) Price has to drop by 1/2 from here, or 2) EBITDA must double within the next few years.  To me, Cara is the epitomy of risk in real time.  The shares present the illusion of safety due to positive stigma surrounding the concept of a collection of recession proof Canadian brands, but they are anything but safe at the current valuation.  Caveat emptor.

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