First Watch Restaurant Group Stock: Undervalued Rare Asset (NASDAQ:FWRG)

Investment Conclusion

First Watch Restaurant Group (NASDAQ:FWRG) operates full-service day-time only cafes offering breakfast, brunch, and lunch. However, its breakfast segment is its most popular among customers. The food is artisanal, made from best quality ingredients, such as seasonal produce and farm-fed eggs, and prepared from scratch in FWRG’s restaurants. The breakfast chain’s staff begins working in its kitchens at the crack of dawn, to slice vegetables, juice fruits, whip up French toast batter, bake muffins, and brew hot coffee.

Their food includes items such as Avocado Toast, Smoked Salmon Eggs Benedict, Farm Stand Breakfast Tacos, and Lemon Ricotta Pancakes, in addition to revolving seasonal items like The Trailblazer Bowl, Carnitas Breakfast Tacos, Superseed Protein Pancakes, and a rotating fresh, seasonal juice. Moreover, despite the superior quality of their cuisine, prices are reasonable, reflecting a strong value proposition for customers. Accordingly, the brand has achieved significant success, and has expanded to 441 stores in 28 states.

Additional growth is expected to be derived from footprint expansion, plans to further develop the lunch segment, gain additional traction with the alcoholic beverage category, bump up restaurant prototypes in order to accommodate unmet customer demand, continuous menu innovation, and incremental growth of the delivery and take-out segments. Moreover, given the success the business is enjoying, we expect international expansion, in the future.

We are initiating on FWRG with a Buy Rating and 1-year Price Target of $30/share based on our 10-year Discounted Cash Flow model. Although, shares of the company have pulled back considerably since its initial public offering, we believe the decline is related to market weakness, rather than fundamental factors associated with the business. Therefore, we suggest investors partake of FWRG’s stock on days of market volatility, to participate in an opportunity to generate significant gains on investment.

Investment Thesis

FWRG’s first restaurant was opened during 1983 in the beach town of Pacific Grove, California. At the end of F1Q2022, the firm had a restaurant footprint of 441, comprising 346 company operated stores and 85 franchisee driven stores. A large fraction of FWRG’s restaurant base is located in three states, with Florida accounting for ~24%, Texas ~12%, and Ohio ~7%. The company does not have an international presence.

In FY2021, FWRG generated: ~$751 million in retail sales reflecting a growth rate of ~34.4% compared to FY2019, ~$601 million in revenues representing an expansion of ~37.8% on a 2-year basis, negative ~$2.1 million in net income versus negative ~$45.4 million over FY2019, and ~$63 million in operating cash flows. Same-store sales advanced by 63% over FY2020. At the end of F1Q2022, FWRG had cash and cash equivalents of ~$46.5 million and long-term debt of ~$98.5 million on its balance sheet.

The primary investor concern surrounding the FWRG story is that given its almost quaint profile (with most of its stores located on the Eastern Seaboard and service limited to day-time only), are plans to develop the footprint to 2,200 restaurants too ambitious? The secondary issue is related to the time-line for sustained material profitability, as the company has been largely unprofitable for most of its lifecycle.

Strong Customer Demand Signifies National Opportunity

We believe that the significant new unit development plans management has indicated are entirely achievable. Our conviction is based predominantly on the solid customer demand FWRG’s cafes appear to enjoy as reflected through the expanding same-store sales and the higher than the median, average unit volumes generated by recently launched stores. In that regard, it is noteworthy that FWRG’s most recently launched cafes are generating ~$2 million in average unit volumes/year, reflecting a ~10% growth over that associated with its legacy stores on average.

In addition, that the firm remains unrepresented in the highly populated States of New York and California presents a significant opportunity for opening a large number of new stores. In that context, it is notable that these States comprise a substantial population of FWRG’s target group of affluent, highly educated patrons, that typically skew female.

Moreover, the company represents the only restaurant chain operating cafes of its type on a large scale. In that respect, FWRG is differentiated from the other breakfast focused restaurant companies such as Denny’s (DENN), IHOP, and Waffle House, due to its focus on healthy food prepared from scratch with high quality ingredients.

Overall, FWRG’s cafes embody the culture and integrity of small independent cafes that dot the higher-end coastal towns of America, with their food with integrity and personal service attributes. Considering their welcoming ambience, differentiated menu, and excellent service, the company’s restaurants embody the spirit of premium cafes but at Main Street prices. Customers typically leave raving reviews of their experiences at First Watch restaurants.

Given the highly favorable business dynamics linked with FWRG, we believe that its cafes have a place across the country. In addition, the confidence management has in the concept is encouraging. Further, we appreciate the urgency the company has demonstrated in efforts to rapidly monetize the substantial customer demand for its product. FWRG plans to debut 130 new restaurants from 2022 through 2024. For FY2022, the objective is to launch 30 to 35 company operated and 8 to 13 franchisee operated cafes.

Significant Profitability Closer Than It Appears

When emerging restaurant companies believe that their respective concepts represent a national opportunity, they develop the business with the growth factor in mind. The approach reflects in significant spending in developing the logistical infrastructure and corporate teams to support future demand. Therefore, even though the restaurants associated with these firms are profitable, the corporations themselves remain unprofitable. We noticed this in regard to Sweetgreen (SG), and presently in connection with FWRG.

We view revenue leverage as the key factor that will fuel profitability. Beyond organic revenue growth related to the existing restaurants, there appear numerous opportunities for sales growth over the next few years. With respect to same-store sales, revenue growth in the adult beverage category, which has been rolled out in ~70% of the footprint, new introductions within the ‘follow the sun’ menu which changes five times/year, wherein freshly harvested fruits and vegetables are incorporated in the menu when they are most flavorful, improvement in menu offerings and customer awareness related to the lunch segment which currently accounts for ~24% of total sales, incremental seating capacity in existing and potential restaurants to accommodate the unmet customer demand associated with the breakfast and weekend brunch categories, and uptrend in takeout and delivery sales, will propel growth.

Geographic expansion, which we have already discussed above, will further ignite revenue growth. In that regard, it is important to note that corporate stores will be the predominant driver of new unit development, with franchisee propelled stores declining as a fraction of the restaurant base, as the footprint evolves. In addition, we believe, that considering the affluent customer base and the value proposition offered by FWRG cafes, the average check of ~$14/person, appears underdone. We believe the firm’s customers could handily absorb a price hike beyond inflationary trends.

Besides the decrease in cost/dollar of sales at the restaurant level, economies of scale related to procurement of supplies, the digital platform, marketing spending, and corporate fixed costs, will provide additional leverage, boosting earnings and free cash flows. Overall, we are unconcerned about the time-line associated with the breakfast chain’s profitability, given the continued significant growth in sales. As revenues keep growing, margins will expand accordingly, and lead to outsized gains on the bottom-line, in our judgment.

Risks

The Group’s Success Might Be Upended During An Economic Downturn. Based on FWRG’s financial performance during and following the Great Recession of 2007-2008, the company’s performance is unlikely to be significantly impacted, if a financial crisis were to unfold. During the previous economic downturn, customers began to manage checks, dropping a beverage or a shareable item, from the order. However, the frequency of visits remained steady. As per management, presently customers are not demonstrating economizing behavior in their selection of menu items.

Further, the firm in addition to offering an excellent value proposition, is highly conservative in raising prices, having resisted increasing prices last year, and hiking rates below inflationary trends this year. Moreover, FWRG has a relatively affluent clientele. On the whole, we believe the company is in a sweet spot in regards to customer demand, and expect sales volumes to be largely sustained during a recession.

One-Year Price Target

We utilized Discounted Cash Flow analysis including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $30/share for FWRG. We assume a normalized 10-year revenue growth rate of 15%, (vs. FY2021 revenue growth rate of ~37.8%). In addition, based on our analysis of FWRG’s historic financial reports, we model normalized 10-year operating cash flows as ~11% of revenues/year and straight line 10-year capital expenditure as ~7% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 48.21 million to arrive at our 1-year Price Target.

Bottom Line

If we come off as fan boys of FWRG, that’s because we are. In our opinion, investing in FWRG is a no brainer. The company has literally no problems. It is already growing sales nicely. It has several drivers of same-store sales growth. Management is onboard to rapidly expand the footprint. And, as sales held up during the last recession, FWRG will likely continue to thrive if an economic decline unfolds.

Some investors might signal unprofitability as a red flag, but we are not part of that camp. As the imminent major revenue growth unfolds, profits are bound to flow to the bottom-line, reflecting in outsized returns on capital, for long-term investors. We’re siding on this one with Advent International, the private equity majority owners of FWRG, that currently hold ~80% of the company’s stock.

We suggest that investors take advantage of the pullback in FWRG’s shares due to market volatility, and initiate sizable positions in the firm’s stock.