This week, Buffalo Wild Wings' (NASDAQ:BWLD) stock skyrocketed after a report surfaced alleging that Roark Capital had offered to buy the company for $150 a share -- a hefty premium compared to the $117 a share price the stock was trading at before the story broke.
In this week's episode of Industry Focus: Consumer Goods, analysts Vincent Shen and Asit Sharma go over the deal, why BWLD's growth has been trailing for the past few years, and how Roark might turn the restaurant chain's performance around. Also, the hosts look at the potential merger between Mattel (NASDAQ:MAT) and Hasbro (NASDAQ:HAS); why Canada Goose Holdings has been one of the best-performing IPOs of the year; and more.
A full transcript follows the video.
This video was recorded on Nov. 14, 2017.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Another Tuesday, and another episode of the Consumer and Retail edition of Industry Focus. I'm your host, Vincent Shen, and the date is Nov. 14. Joining me via Skype from Raleigh, North Carolina, is senior Fool.com contributor Asit Sharma. Thanks for joining us, Asit!
Asit Sharma: Thank you, Vince! As always, what better place to spend my Tuesday afternoon than with you and our fellow investors?
Shen: Well, you mentioned you were a little bit under the weather, so I'm really glad you're braving through that and will be able to join us on the show today, because we have some pretty interesting news and a great company to cover that IPOed in the past year. First things first, I hope you don't mind if we start this episode by returning to a discussion that Danny Vena and I had two weeks ago. On Halloween, we talked about the toy industry, how Toys R Us is thinking about its business with the bankruptcy generally in its rearview mirror, and also how Mattel and Hasbro are dealing with changing consumer trends and some of the successes and challenges that they're facing themselves.
We've seen previously in many industries that are struggling with lots of change or upheaval, consolidation becomes a pretty popular way of surviving or enjoying a little bit more growth and success. So, as of late last week, investors are reacting to the news that Hasbro has actually approached Mattel with a buyout offer. These are the No. 1 and No. 2 toy companies. Combined, they would have about one-third of the industry market share in the United States, with over $10 billion of revenue, and their portfolio would include very famous toy names like Barbie, American Girl, Fisher Price, Nerf, Monopoly, Transformers and dozens of other brands. We have a few minutes to talk about this news. Asit, what do you think?
Sharma: I like this idea. If you were to go back to 2014, you would see the path of these two stocks cross. Since then, Mattel has lost 61% of its value, and Hasbro has gained 75%. Hasbro is obviously the much stronger player. It has operating margins of 15%-plus every year. Mattel's operating margins have dropped under 4%. Why is that? I think Hasbro has embraced more of an omnichannel strategy than Mattel has over the years. It's been quicker to embrace online sales. Mattel still has a heavy foot in the point-of-sale world. So, when we saw Toys R Us have this bankruptcy filing, Mattel was hit a lot harder than Hasbro, because Mattel can't manage its inventory quite as adeptly as Hasbro, and it relies more on the traditional retail channels. Having said that, it has awesome brands, Barbie, Fisher-Price, Hot Wheels. So, there's a lot of synergy between these two companies. And I think the stronger player, Hasbro, can really optimize operations for Mattel. And together, not to sound cliché, but we're just getting warmed up here, they will be stronger together. What do you think, Vince?
Shen: I think, despite the fact that some of the brands we mentioned on Mattel side, like Barbie, for example, have been seen declines for several years in terms of their sales, not seeing the growth that they want at all in some of those core names. At the same time, Hasbro has shown the adaptability that you mentioned, in terms of branching out a little bit, in terms of their strategy, and also some of these licensing deals that they've been involved with, with Disney and other popular titles in media, for example, have proven very lucrative for them. Also, for example, the maker of Star Wars toys, Hasbro. So, I think the combination definitely seems like a very appealing idea, especially for Mattel investors, to create an entity that can better compete in an otherwise pretty fragmented industry.
Combined, again, they would have about 30%, about a third, of market share in the U.S. Otherwise, in terms of this deal, the specific details that we have are pretty sparse. We know the deal discussions are in process, but there are still a lot of obstacles to something like this coming together. For example, the two companies would have to agree on a valuation and a buyout premium. And that's not necessarily going to be easy, since Mattel's stock was down 50% year-to-date before the news of these deal negotiations broke. Management will be trying to get the bid up from the multiyear lows where the stock is currently trading. And even then, if they do manage to come to an agreement, I think the regulatory picture is also not clear. The toy industry might be pretty fragmented, but I think it's always tough to sell the idea of combining the top two players, in any industry. Maybe the combination, the market share they would be able to claim, would be too much. There might be concessions in terms of spinning off certain businesses. We'll see. We'll check in on this deal as more details emerge.
But while we're on the topic of M&A, another deal made headlines yesterday that I wanted to discuss as well, Asit, and that's with private equity firm Roark Capital, which has made a bid for Buffalo Wild Wings. Let's get some background for where Buffalo Wild Wings' business currently stands before we look at Roark and their buyout offer.
B-Dubs stock was down close to 25% year-to-date prior to the buyout news. Looking back two years to when the stock traded briefly above $200 per share, [it's] actually down over 40% in that time. The company has already had to navigate crossroads before this acquisition news came to light, because over the summer, the longtime CEO, Sally Smith, announced her retirement after activist investor Marcato Capital managed to wrangle more control of the company, winning a proxy battle, and they put three of their people on the board of directors. Asit, we know that the restaurant sector has been dealing with some pretty weak traffic and business conditions over the past two years. Buffalo Wild Wings, their comparable sales at restaurants have been in decline for six of the past seven quarters. Profit margins are hurting. What do you think was Marcato Capital's biggest criticism of the company before they won the board seats, and how do you think they're trying to turn the company around?
Sharma: Marcato's biggest beef with Buffalo Wild Wings was probably the fact that BWLD wasn't using its capital appropriately. The company, in trying to boost earnings per share, was buying back restaurants. Now, traditionally, if you are a quick-service or fast-casual chain, you're moving in the opposite direction. Some listeners may remember, we actually talked about this a year ago. Most companies will start to franchise restaurants and go capital light as they become more successful. Think Wendy's and Dunkin Donuts, which have both gone to near-100% franchise models, where the corporation doesn't own its own stores so much as collect those lucrative royalty fees.
Well, Buffalo Wild Wings was actually trying to boost its core earnings by going to franchisees and buying back restaurants at a high cost. And Marcato stepped in and took issue with this, and I sort of agreed with them. I thought, this isn't the way to boost earnings long-term. I think they suffered from that. At the same time, as you mentioned, Vince, concurrent to this, the trends inverted for the fast-casual industry. Whereas dining out had been increasing for the past few years, suddenly concessions by grocery stores, the availability of ordering out and UberEats, which has sprung up -- so many factors combined to take traffic away from fast-casual restaurants. One of those being, McDonald's is back, believe it or not, and it's getting a little bit of market share from traditional players. So, really bad point for Buffalo Wild Wings to be at. And one more thing is its costs are increasing due to rising chicken wings prices. So it's sort of a perfect storm of factors that made them vulnerable for this new capital group, Roark Capital Group, to come in with an offer of $150 per share.
Shen: Yeah. The traffic trends have been weak in fast-casual, casual dining, a lot of different sub-sectors within the restaurant industry. With Marcato Capital, now that they're in control, they're going to be pushing for the refranchising that a lot of the restaurant industry has been pushing toward. They've also made changes to the promotional strategy. You mentioned the rising cost of the chicken. For example, my brother and I used to be big fans of their Tuesday promotion, in terms of half off their traditional wings every week. They've swapped traditional wings for boneless ones since the traditional wings have steadily increased in cost over the years. They couldn't afford those prices, having those promotions, and the traffic just wasn't making up for the lost in profitability there. And the refranchising effort has really begun in earnest too. I think it was over 80 locations in Canada, Texas, Pennsylvania, nearby Washington D.C., restaurants there being selected as part of that process. Marcato wants to take the current 50% franchise portion for Buffalo Wild Wings, 1,200 locations total, push it closer to 90% to be in line with some of the competitors and other restaurant chains that you mentioned, Asit, also, Burger King and Domino's are at similar levels.
So, Roark Capital throwing its hat in the ring -- this is a private equity firm that has a lot of experience in the restaurant industry. They've had previous or current investments in Arby's, Jimmy John's, Auntie Anne's, among many other dining chains. In the past month, the bid it's made is supposedly at over $150 per share. So, though the two companies, I don't believe they've come to the negotiating table yet. Even at $150 even for the offer, that would be a 28% premium for yesterday's closing price for Buffalo Wild Wings' stock. Marcato Capital spent months trying to get their directors on the board. Now, they're finally beginning to execute on their turnaround plan, and they get this buyout offer. Asit, do you think this is a deal that management is or should be seriously considering at that approximately $150, if the reports are accurate?
Sharma: I think they should. That much of a premium implies that Roark Capital Group sees that it can do a lot on the execution front to improve margins and keep increasing price per share. Otherwise, why would they go in with such a hefty offer, only to see share price continue to be stagnant or fall further? So, management understands that this is a well-disciplined company which will come in. In in my opinion, I think Roark Capital Group will attack restaurant margin. Restaurant margin is when you take your total revenue and all of your stores. On the cost side, you take your occupancy, your labor cost, your food cost, and a few other operating expenses, then get that bottom figure. It's relative to the restaurant industry.
I did a quick thumbnail calculation this morning. Buffalo Wild Wings' restaurant margin is 20.5%. And that's sort of low. I think any good private equity group, like Roark Capital, could come in there, and we could see 3% to 5% improvement, which, those dollars add up given the company's top line. And I think management doesn't have a lot of other options. Sally Smith has mentioned, she's going to retire at year end. So, there's been a little bit of confusion, uneasy rudder at the top -- who's going to lead? Marcato has the board seats, but haven't necessarily provided more leadership alternatives. So, I think it's actually in Buffalo's interests to go ahead and take this offer and work with the incoming team to see if, No. 1, they can improve those restaurant margins, and No. 2, get back to basics. Yes, wing costs are rising, but you get people into wings restaurants with that primal promise of watching sports, eating wings and drinking beer. I know this sounds simplistic, but that's the way to increase those comparable sales, which are projected to be at -1.5% this year. So, to reverse those comps trends, you have to get back to making it fun for people like Vince and his brother to come in there on a Tuesday night, watch a basketball game, drink some beer, eat wings. I think Roark understands this, given the pedigree that you mentioned, the companies they've worked with. They know how to get to that core value proposition and emphasize that.
Shen: Yeah. The last thing I'll add to that is, the chains that Roark Capital has had in their portfolio, the franchising and that trend toward greater franchising, is something that could absolutely align with Marcato Capital's views and bring them together, assuming that the offer is enough for shareholders to agree and have the deal go through. Again, we'll provide updates on the show as more details emerge regarding the situation.
Next up, we're going to take a look at one of the best performing IPOs of 2017.
Our last topic for today is Canada Goose Holdings. The apparel company priced its IPO over the summer, and in the several months since then, shares have gained over 50%. This is a company that has grown and flourished thanks to the strength of its brand and the reputation it has for offering very high-quality outerwear made in Canada that can survive very harsh environments and conditions, but at the same time is very coveted in fashion circles and urban fashion centers. This allows Canada Goose to occupy the high-end luxury corner of the market. Its famous parkas can easily run over $1,000. The company released its fiscal second-quarter earnings last week. Asit, what has impressed you the most about this company?
Sharma: The thing that's really jumped out to me, Vince, is the strategy that Canada Goose has: That's clicks and bricks. The company reported 34% in fiscal second-quarter 2018 earnings. That came from a combination of physical stores, country-specific online stores, and traditional retail channels, which they call wholesale. They sell wholesale to high-end retailers. This seems to me the path forward. If you are an emerging retailer, and that shadow of Amazon is looming over you as it looms over every single retail business on the planet, this might be a way to succeed and flourish. Have a niche product -- as you mentioned, a parka that sells for $1,000 -- and other more affordable outerwear. They use handcrafted materials. They actually hire sewers. If your read through their annual reports, this is a company that backs up that price tag with that artisan component we've discussed many times, which I think is very attractive to both people who desire quality and the hipster contingent of retail.
Shen: [laughs] Absolutely.
Sharma: Then, have flagship stores. I want to read something from the company's most recent transcript which is interesting to me. This is from the CFO, John Black, and he's talking about the stores they've opened. Bear with me, listeners:
"We do have a few learnings, of course, from the new stores. And there's some minor changes in the economics of the stores, the new ones vs. the old ones, but they're not material. Just as a reminder, a few things to consider when you're looking at the stores. They're generally between 3,000 and 5,000 square feet. Our cost to enter them from a capex" -- that's capital expenditure -- "perspective is between $3 million and $5 million. And they're profitable in the first year, and paid back within two years. So, those are the hurdle rates we've put in place, and all the new stores should achieve this."
Right now, Canada Goose has flagship stores in Toronto, London, Tokyo, New York City, and Chicago, and they plan to have 20 stores in place by 2020. But, while these are modeled after the big innovators, Apple's retail store, of course, which started this trend, they're nothing like a traditional idea of a flagship store. They're actually quite tiny when you think about a high-end brand. Lower footprint, lower capital investment, much higher return on that investment, much quicker return on the investment. I was sort of amazed by this. My wife has family in Canada, so I was familiar with the brand. Actually, somehow, I confused this with a vodka brand out there, but it's not. It's a quite nice hybrid model that maybe companies can follow and be insulated from the trends that we talk about all the time on this show. What leapt out at you, Vince, when you looked over this company? I know you've been interested since their IPO.
Shen: Yeah, I've wanted to cover this company for some time now. Today, you mentioned it as one of our show ideas, and I was very excited to take that on and mention this company, for any Fools who hadn't heard of it or saw the performance and were kind of curious about what makes this company so special.
You mentioned some of the long-term management targets, in terms of their DTC footprint, their direct-to-consumer footprint. They want 15 to 20 e-commerce sites, 15 to 20 company-owned retail stores over the next few years. It's really interesting to see how important that direct-to-consumer component of their business has become in terms of profitability, but also their growth as well. In fiscal 2017, DTC revenue was about 28.5% of the total top line. The prior year, it was just 11.4%, and the year before that, it was just 3.7%. So, the growth they've seen in terms of expansion with these stores, with the sites, the volume that's moving through them is excellent. I remember management, in one of the calls, speaking to about how their Tokyo store, when that opened, there were apparently over 100 people in line waiting for the store to open. So, it's this kind of cachet that the brand has developed for itself.
On that side, in terms of the expansion, the growth they're seeing there, that's great, but it also has a huge impact on their profitability because the profitability of being in the DTC segment is so much higher. For example, gross margin of 73.7% in the most recently reported quarter, versus 47.4% for the wholesale segment, which is bigger in the more traditional route of working with your retail partners -- department stores, for example. And another comment from management that I thought was very powerful, they said a jacket sold via the DTC channel gives the company two to four times greater contribution to operating income than the sale of the same jacket through wholesale partners. So, you can understand why management is so focused on this part of their business.
I think there's also an opportunity for the company to expand into other product categories, too. For example, Canada Goose recently launched a knitwear collection that has been selling very well, meeting or possibly exceeding management expectations. Each new launch like this gives them insight for the next potential category release, and gives them more coverage beyond just the winter cold-weather outerwear to other seasons, so they can branch to other products and even out some of their revenue in terms of the seasonality.
Final points, then, in terms of this company. If you're considering this stock, I think we should spend a few minutes looking at the valuation. In the apparel industry, the double-digit annual growth that this brand has been able to deliver, I think their three-year CAGR for revenue growth is around 37% for the past three fiscal years. And the U.S. has actually shown the strongest growth for the company with the three-year compound annual growth rate of over 50%. You mentioned your family in Canada and their familiarity with this brand. Brand awareness in the U.S. market is still pretty low for Canada Goose, just 16% compared to 76% in their home country. So, a lot of room to run here. The stock is trading at over $31 per share. That puts the forward price-to-earnings above 70 times according to S&P Capital IQ estimates. So, you're paying a pretty penny for a piece of that growth. Are you sold, Asit, on this business, and paying that premium?
Sharma: I am, actually. If you look at their price-to-sales ratio, it's another way to gauge what a reasonable price for a company is when it's very young. And that's up, their [shares] are priced at 7 times the 12-month trailing sales. So, both of those numbers are a little bit high, but what you're paying for is that growth. Keep in mind, this is still a very tiny company. So it has the potential to earn into both of those metrics. One of the things that I like to look at when I see a company that's flying high that I'm interested in is, how well do they manage their inventory? And why I look at that is, at some point with these rapidly increasing sales, you're going to bump into problems, most likely, with the relationship between your sales and your inventory, have a bad quarter, and then the market will adjust that high-flying P/E ratio down. We've all had that experience.
What I really like about this company is that its manufacturing is quite flexible. They have factories in Canada, and they're not afraid to sell out of items. In fact, in one of the recent calls, the CEO was discussing that: "Look, we do sell out of items, but that's a good thing. We don't want to be overstocked in inventory." Which means they're a little bit more fleet of foot, can supply inventory a little bit more rapidly, and sell into demand. That's one of your protections if you're buying a high-flying retail company which has a high price-to-sales ratio. You don't want it to be the other way, where they've got a lot of inventory, but one slip-up is going to cost them. Nonetheless, there could be some rough quarters in any growth story. Long-term investors, Fools know that if the company has a competitive advantage, it's well-managed, and the demand is there, you can work through those quarters. So, given all of those, I would be an investor. It's not going to be a straight-up path, but I think this company has a lot of potential. I'm very interested in it, and I'm glad we had the opportunity to talk about it today.
Shen: Yeah. I think the value of that brand, the reputation that it developed, not easy to do, very valuable. The flexibility in terms of their manufacturing that they mentioned, and their flexibility and their willingness to maintain that cachet by having items sold out, for example, having lines at stores, that's very valuable. Their inventory levels will probably get a little choppy, maybe rise a little bit. I think they did in the previous quarter. As they expand, for example, with their DTC push, as they open these company-owned stores, they want to be able to make sure that they supply them properly. But the company, I think, has shown a great ability to manage that. Also, their retail partners are very happy, have shown great sell-through rates through the wholesale channels at full price. So, again, the brand being very coveted among fashion-conscious consumers. It's definitely a company that we'll have to speak about again in the coming months, provide an update and see where things stand as they push into this DTC strategy that a lot of other apparel companies, like Nike, for example, are focusing on.
Otherwise, Asit, thanks for joining us today! Fools, thanks for listening! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Again, thank you for listening and Fool on!
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Apple, Buffalo Wild Wings, Hasbro, and Nike. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Dunkin' Brands Group. The Motley Fool has a disclosure policy.