Lately, shares of fast casual wing franchiser Wingstop (WING) are the epitome of momentum-based, nosebleed valuations in a raging bull market. The management team at WING has built a great business, with more than 1,100 locations (mostly in the United States), of which 98% are franchised. The stock has been on fire, rising by 24% in January alone:
The good (and bad) news for investors in restaurant franchising businesses is that the business model is straightforward and future profits can be modeled more easily than with owned chains. This is simply because your financial results vary much less when you are simply taking a cut of top-line sales, versus relying on the bottom-line net profit after expenses are paid.
WING shares are currently valued at $1.4 billion, with the enterprise value (debt included) surpassing $1.6 billion. The company should generate about $105 million of revenue in 2017 (two-thirds from franchise fees and royalties), based on roughly $1.1 billion of end customer sales system-wide (based on company filings). The company expects to grow 10-15% annually for the foreseeable future, and eventually reach 2,500 locations in the U.S. International growth will also pace WINGs revenue trajectory, as the company grows from only 100 units today to likely at least several thousand over the long-term.
So just how expensive are WINGs shares currently? There are two ways we tend to think about valuing franchise businesses. First, in a vacuum based on what we think the growth path will look like and what kind of valuation we expect investors to assign the business given those assumptions. Second, looking at comparable companies that are further along in their growth can give investors a sense as to long-term profit margins and normalized valuations.
Lets start just by looking at WINGs business alone. It is reasonable to think that they can reach 2,500 U.S. units and another 2,500 international units over the long term. If we assume a 10% annual unit growth rate, the company would reach 5,000 global locations in 2033. Current EBITDA margins are in the high 30s percent level, but with more efficiencies as the business grows, it is not crazy to think they could get to 45% EBITDA margins, as many larger franchisers have done. Assuming the current 6% royalty rate and adjusting for ~2% inflation, total revenue in 2033 could be ~$700 million, with EBITDA of $315 million (45%).
Mature franchised businesses trade for EV/EBITDA multiples in the high teens on average (see chart further down below), so lets attach a 17x multiple to that 2033 EBITDA estimate. We come up with an enterprise value of $5.355 billion sixteen years from now. If we discount that value using a 10% discount rate, the present value would be $992 million. Lets call it $1 billion. That implies that WING stock is roughly 60% overvalued at todays prices, even after we assume they grow the chain 400% over the next 16 years (no easy task).
A second healthy exercise to test this type of valuation work is to look at comparable companies and see what kind of unit growth their businesses have attained and what kind of valuations Wall Street is assigning those companies. Faster, smaller growers like WING do typically trade at a premium, given the growth potential over the long term, but when the gap gets to be extremely high, that can certainly give support to the idea of short-term overvaluation.
Within our coverage universe, there are plenty of highly franchised chains which we can compare to WING. Below is a list we feel represents good comparables:
When we see this kind of valuation disconnect among a small subset of businesses, and bullish growth outlooks projected for more than a decade also yield a conclusion of materially overvalued, we cannot ignore it. Investors tread carefully.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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