Contributor: Joshua Thomas.

Firm: Midsummer Small Cap, LP.

Firm Type: Hedge Fund.

Location: New York, NY. Call: Short on Buffalo Wild Wings Inc (BWLD:US)

Timeframe: 1 year to 2 years.

Recent Price: $141.77.

Target Price: $90.0.

Strategy: Value.

Rating: 94.1% Disclosure: The author of this report held an active position in this security at the time of posting. Disclaimer: This is a reduced version of a full SumZero report republished with the author's consent. The opinions expressed reflect those of the contributor and not SumZero, Inc.

Trading at nearly 40X EPS, the Market is extrapolating BWLD's historical growth rates far into the future. We believe the company's growth algorithm is fundamentally broken and the stock is poised for multiple compression as EPS growth decelerates.

Growth model is broken: inflection point in concept's lifecycle DUE TO MARKET Saturation. Store base is set to transition from consistent double-digit unit growth to decelerating, single-digit unit growth (i.e., "Middle Age"). As the concept reaches Middle Age, it will be unable to support historical rates of company EPS growth of +20%. The Street believes, even if the core concept decelerates, lost growth can be replaced through the incubation of new concepts. Due to aggressive and impetuous capital allocation decisions, we believe prior rates of EPS growth cannot be replicated going forward.

The Price of past Growth: mortgaging the future. BWLD stores generate mediocre returns on capital; in order to manufacture high rates of EPS growth, management consistently reinvested >200% of earnings into growth CapEx. Accelerated reinvestment was made possible by maintenance CapEx levels (per store) that were considerably below depreciation, given the youth of the store base. In essence, the company mortgaged its existing asset/store base to fund elevated levels of growth CapEx, creating an off-balance sheet liability. The last meaningful re-model cycle was in 2008 and we believe older stores will require fresh capital injections, lest traffic and same-store-sales suffer at the expense of new concept/unit growth (i.e. "The CapEx Wall"; see Brinker Int'l). We believe the company will inevitably be faced with choosing one of two options, neither of which is attractive for the stock.

Alternative #1:

Transition to cash flow; protect the BRAND, accept more modest earnings growth, and likely a lower multiple. Buffalo Wild Wings represents a valuable brand and asset base; the responsible course of action would be to transition the company from growth mode to cash flow mode; decelerate unit growth, abandon efforts to incubate/invest in new concept(s), accumulate cash to prepare for remodel campaigns to protect the brand, with the result being a reduction in earnings growth to the low teens. Under this scenario (base case), we believe the intrinsic value of the business is approximately $80 to $100/share.

Alternative #2:

The Mid-life crisis; continue the pursuit of growth at any cost, risk permanent damage to the core concept. Given management's obsession with (maintaining) the company's growth image, we believe management is suffering from a mid-life crisis as the core concept approaches saturation; continued investment in new company stores leads to weaker incremental returns and slower EPS growth. If, in the pursuit of new avenues for growth (i.e. new concepts), the store base is neglected, same-store-sales could suffer; Restaurants represent a high operating leverage (incremental margins) business; loss of sales could force earnings to de-lever over a high fixed-cost base

Under such a scenario, intrinsic value could be materially impaired from our base case, leading to further declines in the stock. We are already observing signs that this is the path that management has chosen.

Valuation:

At nearly 40X EPS, the stock is priced for perfection; Despite decelerating growth at the core concept and efforts to incubate new concepts, stock is trading at the highest P/E multiple in 5 years. Applying comp multiples to franchise and company-owned businesses suggest at least -30% downside. Restaurant industry trading at historically peak cyclical levels; Industry multiple compression offers further downside (up to -45%).

Why Does this Opportunity Exist?

BWLD represents the "goldilocks" choice for growth and GARP investors; company is exhibiting attractive revenue, SSS, EPS and unit growth but does not trade at "nosebleed" multiples of other high-growth consumer names (e.g., CMG @ P/E >50X; WFM @ P/E ~45X). One time benefits in input costs/pricing have buoyed earnings: Collapse in chicken wing prices provided margin reprieve and easy comparisons BWLD is (currently) benefitting from what is effectively a large price increase by eliminating wing orders by the count. The Street supports the stock/story; emphasizes the income statement and focuses on EPS growth, believing the model is self funding and +20% EPS growth can be maintained. Looks at flawed "cash-on-cash" (EBITDA/Build-Out) metric. Believes 1,700 store count is achievable and excited by the prospect of emerging brands. Growth multiple is justified.

Variant Perception:

Management has painted itself into a corner in the uncompromising effort/fixation to manufacture consistent +20% EPS growth; refresh the existing asset base and slow growth or gamble on unproven concepts at the expense of neglecting older stores. Prior years of robust EPS growth were achieved by >200% reinvestment of earnings, which is unsustainable. Management has grown reactive and short-term oriented, placing the concept and company at risk; The Street support is based on faulty premises; As system approaches maturity, BWLD will face a maintenance CapEx wall (e.g., Brinker/Chili's); marked deceleration in franchisee growth is a leading indicator and telling of saturation (True market TAM is below 1,700 stores); Correct unit analysis methodology demonstrates stores generate returns below the cost of capital and inferior to fast casual alternatives; growth multiple is not justified.