Chuy’s Holding: So Much Potential Turning To Dust

Investment Conclusion

We have mixed views on Chuy’s Holdings Inc. (NASDAQ:CHUY), a Tex-Mex restaurant group, founded in 1982. Prior to the pandemic, the company’s revenue growth was reasonable, and sales have rebounded strongly to almost pre-COVID levels in FY2021. Further, the business underpins several margin expansion opportunities, including cost savings on the SG&A line, as spending on infrastructure development to support growth in the restaurant footprint is now complete. Moreover, considering that CHUY’s restaurants are limited to Texas, and the South-East and Mid-West regions of the U.S., there appears a significant opportunity to expand into additional domestic territories. Furthermore, the firm has zero long-term debt on its balance sheet, and has not withdrawn any funds from the revolving credit facility, it has available. Ultimately, considering the substantial popularity of CHUY’s restaurants, that it is typically profitable, its current depressed valuation, and that it carries zero long-term debt, the company could likely become an acquisition target.

Despite the upbeat profile, we are not highly excited about CHUY because of its slow pace of growth with respect to earnings and geographic expansion, given that the company was founded in 1982.

Nevertheless, considering that the firm appears undervalued based on our 10-year Discounted Cash Flow model, we assign CHUY a Buy Rating with a Price Target of $40/share.

Investment Thesis

CHUY is a full-service sit-down restaurant chain headquartered in Austin, Texas. The company has 96 restaurants spread across 17 states, with 41% of the restaurants located in the home state of Texas. CHUY does not franchise, and all its restaurants are corporate owned and operated. The organization does not have an international presence.

In FY2021, CHUY generated: ~$397 million in revenues reflecting a growth rate of ~23.5% compared to FY2020, same store sales growth of 22.1% over the prior year, ~$30.2 million in net income relative to a net loss of $3.3 million during FY2020, $1.50 in Earnings Per Share versus a loss/share of $0.18 over the previous year, and ~$43.4 million in operating cash flows.

The predominant investor concern surrounding the CHUY story is whether the brand has the ability to achieve the significant potential its business clearly demonstrates? The secondary issue garnering Wall Street attention, is if CHUY’s focus on value pricing is the right strategy for the firm, considering that profit growth has lagged the growth of the organization?

Below Average Footprint Expansion Has Severely Limited Growth

Between 2007, which marked the year, the current CEO took charge, and YE2021, CHUY’s restaurant footprint has expanded by 88 restaurants. 88 restaurants over 14 years is limited by any standards, but more so, when compared to the number of outlets recent restaurant company additions to the public market, Dutch Bros. (BROS) and Sweetgreen (SG) have added over their relatively shorter histories. The element is puzzling as based on outstanding Yelp reviews and evidenced through the strong sales growth the company has achieved over the years, it appears that the brand enjoys substantial customer demand. In addition, considering that CHUY remains debt free and is profitable, the restaurant chain could likely secure enough investment capital, to rapidly penetrate regions where it remains under penetrated or unrepresented. Given that it takes ~$2.5 million to construct a CHUY restaurant, it is hardly a stretch to imagine that funding to build scores of new units every year, would be difficult to arrange.

Therefore, it appears entirely possible that the restaurant group prefers to remain regional rather than develop into a national player. Or management does not believe it can successfully execute on the launch of more than a handful of stores every year. In that case, a change in top leadership might drive a shift in CHUY’s new unit development strategy. Conversely, a private equity firm might purchase the Tex-Mex chain, take it private, and fund an accelerated development of CHUY’s restaurant footprint, with a view to optimize earnings potential. Nonetheless, the current restaurant footprint size, is severely limiting, not only in terms of considerably higher profits that could be derived from a larger restaurant base, but also in regard to the possibilities for margin expansion typically associated with economies of scale and scope enjoyed by a larger enterprise. We believe a switch in the patterns of annual net increase in the number of CHUY’s restaurants is inevitable.

Bottom-Line Growth Hampered By Value Proposition And Menu Pricing Mismatch

We believe CHUY’s has outgrown its focus on value pricing, that might have been prudent, during the years of emerging development. Today, in regions that it has a presence, the restaurant chain has strong brand awareness and enjoys significant appeal among customers. Those factors are reflected in CHUY’s solid average unit volumes, which were $4.2 million at YE2021, with the firm’s best performing outlet generating $9.7 million in average unit volumes.

In regard to ambience, CHUY’s restaurants range in size from between 5,300 square feet to 12,200 square feet, and seat between 200 and 400 customers. Each outlet features a patio area and a full-service bar. Although, it is a restaurant chain, each restaurant is designed differently, consistent with the “if you’ve seen one Chuy’s, you’ve seen one Chuy’s”, motto, CHUY’s founders followed, while building the earlier restaurants. Further, the food served is made from scratch and freshly prepared, and the menu, although featuring only Mexican and Tex-Mex dishes, is sufficiently large. Moreover, it is a full-service sit down restaurant with table service. Overall, given the above described profile of CHUY’s restaurants, and that its target demographic is between the ages of 21 and 44, and earns an annual income in excess of $60,000, that value pricing (average check is $17.30/person) is a major factor driving customer demand appears stretched and outdated, in regard to the Tex-Mex chain.

This focus on value pricing is reflecting poorly on margins, not only because higher menu prices would result in higher sales, and as a flow-through, increased revenue leverage, but also in regard to staffing, as anecdotally it appears that front-line worker wages at CHUY are not highly competitive. As fully staffed restaurants offer brisker service and more accurate orders, reflecting in superior customer service, and consequently, better guest satisfaction scores, it is critical that CHUY raise menu prices to not only off-set current inflationary pressures, but significantly beyond that, to truly reflect in dollar terms, the value proposition it provides customers. Anything less than that would be leaving money on the table.

Risks

The Looming Recession Might Unfavorably Impact Sales Growth. Given, the value proposition CHUY offers for an average check/person of $17.30, that customer demand will suffer during a potential recession, is highly unlikely. Instead, we believe, the company is well positioned to benefit in case of an economic downturn, as the Tex-Mex chain’s menu prices are highly competitive. In that regard, it is noteworthy that the average check/person associated with similar full-service sit-down experiential dining restaurant chains is considerably higher than CHUY’s, with The Cheesecake Factory’s coming in at $29.30, Texas Roadhouse at $46.17, Outback Steak House at $24, and Carrabba’s Italian Grill at $23. As Americans beset by financial worries, seek to counter their anxieties, they are likely to dine-out, particularly at reasonably priced restaurants, with fun and exciting atmospheres, such as Chuy’s.

One-Year Price Target

We utilize Discounted Cash Flow analysis, including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $40/share for CHUY. We assume a normalized 10-year revenue growth rate of 10%, (vs. FY2019 revenue growth rate of ~7%). In addition, we derive our net income for 10-years using a net profit margin of 8% (compared to FY2019 net profit margin of ~1.46%). Based on our analysis of CHUY’s historic financial reports, we model normalized 10-year operating cash flows as ~13% of revenues/year, and straight line 10-year capital expenditure as ~8% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 7.5% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of ~19.9 million to arrive at our 1-year Price Target.

Bottom Line

All is not lost. CHUY’s revenues have expanded significantly over the years and the company is profitable. Customers, based on reviews they have shared on Yelp, appear to appreciate the value proposition CHUY offers.

Although, rapid footprint expansion and a substantial increase in menu prices would unlock the business’s true value and improve shareholder returns considerably, even if the firm ambles along at the weak pace of new unit development and earnings growth, it is still throwing out profits and free cash flows.

And the likelihood that someday CHUY might see the light and embark on a rapid growth strategy that would expand shareholder returns considerably, is a blank check awaiting redemption, that is always present in the horizon.