Bojangles - The Story behind Southern Chicken

Bojangles’ (BOJA)

Behind our favorite Chicken n Biscuits chain

·         A Southern fried chicken franchise with a loyal cult following

·         A look at its company-operated restaurants and its franchise counterparts

o   Its company-operated restaurants are more profitable, but they want to slow down store openings

o   Franchises are poorly managed and less profitable, but they want to speed up store openings

·         Real Estate (Built to suit) model is not as profitable as it could be

·         High FCF of about 7%, enough capital to expand operations

·         Good leverage position

·         Undervalued compared to its peers, a simplistic valuation model may be warranted to determine true value of the business

·         I would only purchase the stock in the hopes of seeing an acquisition, or if management takes note of its business model and implements more profitable strategies.

What's in your chicken?

I personally learned about BOJA through listening to MarketFoolery. The hosts mentioned it as a compelling business and its most recent expansion into Washington, D.C., and that they would visit a chain every time they were in the South for a business trip. I had not heard of the restaurant (or tried the food) yet, so I briefly looked at its metrics and found it not only to potentially be a great business, but currently at an attractive valuation (based on a quick skim of its metrics) as well! These were compelling reasons for me to look into the stock. With that, the agenda on today’s analysis is a brief look at the industry, an in-depth view of the business (model), and finally, valuation.

Bojangles’ is based primarily in the Southern United States. In the industry, there are two types of restaurants – FSR and LSR, for Full-Service Restaurants and Limited Service Restaurants, respectively. It identifies itself as an LSR, and believes it has qualities of both the LSR subsets: QSR (drive-thru and low prices) and a fast casual restaurant (high quality food and good service). For the purposes of our analysis, we will identify Bojangles’ as a QSR.

QSRs generally operate in a highly competitive landscape and have little pricing power. They tend to have small economic moats, low switching costs, and little product differentiation. However, Bojangles’ boasts of a “cult-like” following, and a specialization in their favorite daypart - breakfast. These two qualities make for an interesting case in differentiation in this industry. However, I think the industry is becoming saturated with competitive substitutes for breakfast choices. Many other competitors (McDonald’s, Wendy’s, etc.) in the QSR space are trying this strategy and making breakfast their core product offering. This is not really an effective differentiation strategy. Bojangles’ cult-like following seems to be catching on though. They have a loyal customer base, and receive free advertising through (I would imagine) word-of-mouth and more importantly, in the media space. The Motley Fool’s MarketFoolery podcast, Rhett and Link’s Ear Biscuits mention Bojangles’ too. These media outlets allow listeners who do not even live in the Southern U.S., to learn about their product offerings and the brand, free of charge on BOJA’s part! They can exploit this competitive strategy to their advantage. Though I have not tried their products, the media outlets seem to talk about BOJA like everybody (signifying a target market with a varying demographic base) would enjoy the brand and their offerings.

The food also does not seem difficult to make. In other words, BOJA should have no difficult time looking for chefs to work for them. There are no qualifications to apply other than being older than 18 years old. This signals that BOJA has a large labor supply and does not need to offer a competitive pay structure (which may eat into their costs) to attract “top talent”. They can attract and retain good talent by incentivizing them through intangible benefits.

The Business Model

I will be looking at BOJA’s three (potential) streams of revenue. (1) The main business, company-operated restaurants, (2) franchised outlets, and (3) the (potential) construction-related revenue stream. The first two points will be outlines of their revenues, costs, and projected models. The third pertains to their built-to-suit business model, and suggestions for an improvement based on a short study of McDonald’s hyper-profitable business model.

The first thing to note is that BOJA uses a particular unit of measurement called the Average Unit Volume (AUV) a lot in its 10-K report. They compute the AUV by dividing revenues for a certain zone by the number of domestic freestanding restaurants with drive-thrus and interior seating that has been opened for twelve months. In fiscal 2017, BOJA generated $1.8 million in AUV, which is one of the highest in the QSR industry, according to their 10-K.

Company-operated restaurants and franchises

BOJA’s projected AUV for a company-operated restaurant in $1.5 million. At a restaurant level, cash flow is projected to be $110,000, and an average upfront of $85,000 under a commercial built-to-suit and equipment-financing model. Thus, it has an approximate one-year payback non-discounted payback period. This is a good conservative estimate of AUV, with decent returns.

Company-operated sales include the sale of food and beverages in company-operated restaurants. This amounts to approximately $518 million (37% of this figure are breakfast sales – about $155 million) in fiscal 2017. According to Technomic, total LSR sales amounted to $268 billion in 2016 (This figure is found in the 10-K, which means it is the figure that is relevant to BOJA). This means BOJA’s company-operated sales capture about 26% of the relevant market. This segment of the business is quite profitable.

	2017	2016	2015	2014	2013
Consolidated Statement of Operations
Revenues:
Company-operated restaurant revenues	$518,380	$504,664	$462,138	$406,788	$353,592
Franchise royalty revenues	28,113	26,364	25,104	22,746	20,572
Other franchise revenues	945	853	960	938	998
Total revenues	547,438	531,881	488,202	430,472	375,162

Typical franchise terms grant the franchisee to operate for 20 years, with an option to renew. Franchise revenues include an initial franchise fee ($25,000 for normal restaurants and $15,000 for Express chains). They also include a 4% franchising royalty fee, the percentage is taken from the franchisees’ unit sales. “Grandfathered” units pay a lower royalty, and international (at the moment, just Honduras) units pay 5%. They also pay 1% to the corporate marketing fund and 2% of their unit sales to their local advertising co-operative fund. BOJA also has agreements with various franchisees to expand into assigned areas (“unit development”) and open a new restaurant every year over a five-year term. The fee to open up a new restaurant is $5,000 per assigned unit. This fee is deductible against the franchise fee for each unit developed under the agreement. Despite all of this, BOJA still provides consultation and advising services and allowing franchisees the option to train their own staff after they open their first franchise (i.e. not requiring the training payment – missing out on potential revenue and lowering the quality of restaurant-level management). They also spend a great deal on marketing and advertising, which seems to benefit the franchisees a lot more than BOJA’s income statement.

Are we profitable?

With all of that, the franchising revenues look very meagre compared to the whopping $518 million that company-operated restaurants generate. There is a case to be made for favoring franchises over company-operated restaurants: lower capital commitment for a stable cash flow. This however ignores the fact that they freely allow their franchisees to take all the profits, by allowing deductible fees, and relatively low royalty fees. Other fast food chains are not this liberal in their royalty fee policy. Subway has a $15,000 fee and charges 8%. Pinkberry asks for $35,000 and 5% royalty, plus a 2% marketing fee. Wendy’s charges $40,000, 4%, and 4% for its initial, royalty, and marketing fee, respectively. McDonald’s charges rent on top of its franchising fees. Most of its revenues actually come from rent lease payments, rather than burger sales. Thus, I think BOJA could increase its rates, tighten quality control in restaurant-level management, and spend less aggressively on marketing and advertising. These will all cut costs, and boost profitability. 

The CAGR (8.8%) company-operated restaurants expansion (new openings) rate used in the report for 10-K is not truly reflective of its actual growth rate. Since the number of restaurants are still relatively small, I do not think the CAGR, or any rate, for that matter will tell the whole story. Thus, only real numbers will be reflective of their growth story at this moment. In fiscal 2017, BOJA only opened 16 new company-operated stores last year, which is comparable to 29 in the previous two fiscal years (16 = 325-309, according to their financial statements – their report grossly overstates the number of stores they opened – 26, instead of the true 16). They are significantly accelerating in opening new franchise stores (32 new franchisee units). This aligns with their plans to open less company-operated restaurants and more franchises. I believe this is a mistake for two reasons. (1) Franchisees generate significantly lower revenues, and franchisees (like Tri-Arc) (2) give Bojangles’ a poor reputation due to its poorly managed locations. A quick research on social media sites Glassdoor and Reddit found that upper management needs to improve, and franchisees like Tri-Arc “are poorly run and don’t have the usual offerings and promotions”. BOJA should improve these issues to avoid the risk of offending customers and employees alike. Either they control the quality of restaurant-level management, or they open less of these stores. Surprisingly, I prefer the former, if they can execute it well.

Later in Valuation, we will look at the reason why they might not be opening new stores as quickly as (we think) they should. For now, here are its restaurant counts in fiscal 2017 and 2016, respectively.

State (FISCAL 2017)	Company-	Franchised	Total
	Operated
North Carolina	156	157	313
South Carolina	66	68	134
Georgia	32	70	102
Tennessee	43	30	73
Virginia	3	64	67
Alabama	16	20	36
Kentucky	9	5	14
West Virginia	?	8	8
Florida	?	7	7
Maryland	?	5	5
Pennsylvania	?	1	1
Washington DC	?	1	1
Domestic Total:	325	436	761
Honduras	?	3	3
International Total:	?	3	3
Total:	325	439	764

State (FISCAL 2016)	Company-	Franchised	Total
	Operated
North Carolina	150	153	303
South Carolina	67	68	135
Georgia	29	62	91
Tennessee	37	30	67
Virginia	?	61	61
Alabama	17	16	33
Kentucky	4	4	8
West Virginia	5	?	5
Florida	?	4	4
Maryland	?	4	4
Pennsylvania	?	1	1
Washington DC	?	1	1
Domestic Total:	309	404	713
Honduras	?	3	3
International Total:	?	3	3
Total:	309	407	716

The third portion of Business Model Analysis relates to Real Estate and is a critique of their strategy pursuing built-to-suit and equipment financing lease. I do not believe there is an issue with the second. However, something should be said about the first.

Not that there is an issue with the first, but I believe they can pursue a different sort of strategy in terms of acquiring new restaurants. Now, they conduct due diligence on an identified piece of real estate and work with the developer to build a property for Bojangles’ to operate in. Including the construction, the process takes a year. The average investment (for BOJA corporate in building company-operated restaurants and for the franchisee in building new locations) is averagely $2.7 million.

BOJA thus, pays the developer rent every month to conduct its operations. If we look at the case of McDonald’s, they could buy the land, build the necessary property to operate a Bojangles’, and act as the property owner, charging tenants the rent instead. Right now, operating costs include occupancy costs, which are (as they themselves declare) very expensive. I think they can change their business model in how they pursue growth by buying land, charging rent to their franchisees, and acquiring gains in property value. Of course, this has to be a change in the overall strategy of Bojangles’, and is something to look out for in the future.

Company-operated restaurant operating
expenses:
Food and supplies costs	164,666	158,644	150,563	133,191	118,563
Restaurant labor costs	151,212	138,839	126,380	112,506	99,378
Operating costs	121,935	112,256	100,916	88,476	75,160
Depreciation and amortization	13,632	12,709	11,456	9,713	9,011
Total company-operated restaurant operating	451,445	422,448	389,315	343,886	302,112
expenses

Valuation

We have determined that company-operated restaurants are much more profitable than franchises, unless a change in the quality control policy of restaurant-level management or a change in overall construction strategy is implemented. We have also analyzed the industry to see that really, the only true moat that they have is customer cult-like loyalty. They also have a strong brand presence in places outside of the U.S., their DMAs (which they are spending unnecessarily and aggressively on), and their target market. In this portion of the report, we will look at FCF and its debt.

Free Cash flow is approximately $40,129, which is about 7% of total revenue. Morningstar’s Pat Dorsey wrote in his book Five Rules to Stock Investing that a free cash flow of about 5% of total sales can be considered a “cash cow”. This is very good news for a company in its expansion phase. BOJA should use this excess resource to fund its growth, particularly in opening up more company-operated restaurants, since they have a large capital to do so.

They seem to be in a good leverage position. Financial leverage is 1.95, particularly high and conservative for a restaurant in this phase as well. Its debt to equity ratio is about 0.4327 – signaling to investors that BOJA is careful in financing a large portion of its growth with equity. Its interest expense of $ 6.447 million in fiscal 2017 was due to BOJA’s debt outstanding and its capital lease obligations. One thing to note is a decreasing interest expense ($8.307 to $7.485 million, in 2015 and 2016, respectively). This signals an efficient use of its debt, and predictable overpayments to its creditors, which is good for BOJA’s sheet.

The market cap of BOJA is $590.04 million and a P/E of 27.24. Notable peers are Chipotle (12.06B, 71.85 P/E), BJ’s (1.39B, 34.87 P/E), Red Robin (493.77M, 28.01 P/E), and Dave and Buster’s (2.35B, 21.72 P/E). Based on these elementary metrics, BOJA looks like a decent restaurant behind an undervalued stock. However, the market overall is overpriced in its valuation, so we must tread carefully, and not just look at peer metrics. A simplistic valuation model may be warranted to acquire a true value of the company.

Final Comments

Restaurants have had a rough time in recent years. There have been numerous brands that have not done well the past year, whether due to industry or unsystematic risk. Some examples include Chipotle, McDonald’s, and CAKE etc. We are also seeing many acquisitions in the sector. Inspire Brands acquired Sonic for $2.3B recently, along with many others. BOJA is even rumored to be in talks with BAC to put itself up for sale – an attractive candidate for a restaurant brands manager to acquire at such a cheap valuation.

With all that said, BOJA does not seem to be an attractive business. I like the brand and the restaurant – but after thorough analysis, I do not feel compelled to buy the stock for any other reason than to hope for an acquisition.