Building position in WING

I’m long Wingstop (WING) as a buy and hold forever stock as long as the following points remain true:

• company has a long runway to reinvest cash flows into supporting franchisees and opening up company owned restaurants
• franchisees continue to earn strong cash on cash returns that pay them back from their original investment faster than comparable brands
  • currently 35-40% unlevered cash return over two years on 390-400K original investment
• existing and new franchisees in both domestic and international markets continue to open new restaurants, allowing the company to reach its goal of 6K stores and beyond, with that distribution eventually becoming 50% US based and 50% international
  • currently 1.6K, mostly US based
• digital sales, ghost kitchens and delivery continue to given the company the same amount of sales for a smaller physical footprint, leading to higher AUV per location

I’m going to experiment with a new pitch format in this post that is broken into the following sections:

• The Business and Why I Like It – overview of Wingstop’s business and why I want to own it for years into the future
• Management – some thoughts on Wingstop CEO Charlie Morrison and why I think he’s a good allocator of capital
• The Valuation – why I think I’m buying below intrinsic value

The Business and Why I Like It

WING makes money by 1) franchising Wingstop restaurants and taking a 10% fee off revenue and 2) opening company owned restaurants. I think both (1) and (2) can be repeated across the United States and world with minimal margin impact – in fact, I think margins can improve as the company gets more aggressive on cloud kitchens and delivery.

Franchising

Why would you franchise a Wingstop? I think the answer boils down to two facts – WING is an established brand and the unit economics of each location are excellent.

The company has been around for 27 years. Wingstop opened its first location in 1994 and has been franchising locations since 1997. The menu offering at its core is simple – boneless or bone-in wings with 11 different flavors across the spiciness spectrum and three dipping sauces. The wings are great in my opinion (see The Wingstop Experience for some on the ground due diligence – I’ll take any excuse to eat fast food and call it research). This franchise has a strong track record and I think it will still be around decades from now.

Next, the unit economics of opening a Wingstop are excellent and existing and future owners will be motived to open them as long as this stays true. If you read WING’s filings, you’re going to see a variation of these two paragraphs everywhere:

A huge competitive advantage the company has is that its unit economics keep franchisees coming back for more. More incentivized franchisees mean faster growth for WING, as each additional Wingstop location generates a royalty fee for WING equal to 10% of revenue.

Before getting into the royalty fee, I want to reiterate how good these returns are for franchisees. I’ve commented in previous posts that my hurdle rate for any investment is 10% per year. If I were passionate about managing restaurants, I 100% would be opening a Wingstop as it beats my hurdle rate to a pulp. Check out this comparison with investing 400K in stocks at a 10% return versus 400K in a new Wingstop:

Importantly, these returns are being commented outside the industry as real – on Patrick O’Shaughnessy’s podcast Invest Like the Best, restaurant expert and invstor Zach Fuss says WING’s franchisee returns are best in the industry.

This investment makes a ton of sense for anyone with capital and restaurants as a core competency. It should outperform the market pretty much every year and has little correlation to stocks. Furthermore, that return is unlevered. If I can put 50% debt on this investment at 10% financing, I get a 60% IRR:

If these returns continue, the line of people who want to franchise is going to be out the door. To WING’s credit, they’re very aware that a mismanaged Wingstop could put the kibosh on these returns, and has all prospective owners go through a four week training program and pass a test. I’m speculating, but I think the slow(ish) growth in franchises (10-20% per year for last three years) is to keep up quality and not flood the market.

I want to call out a quote from WING’s 2020 10K that shows just how committed existing franchisees are:

We have a broad and diversified domestic franchisee base. Since 2014, the number of franchisees who own ten or more restaurants has more than doubled. This increase is consistent with our strategy to grow with our existing franchisees. As of December 26, 2020, our domestic franchise base had an average restaurant ownership of approximately six restaurants per franchisee and an average tenure of seven years.

WING 2020 10K

WING wants franchisees with experience and skin in the game. The average of six restaurants and seven years makes me think they’re well on their way to Malcom Gladwell 10K hour experts for franchisees.

Finally, to put a name on the franchisees, Rick Ross is probably Wingstop’s most well known franchisee. As much as he loves the wings, I bet you he probably likes the returns on equity even more.

How Franchisees Pay WING

WING collects a franchise fee of up to $30K when a new franchised restaurant opens and a 10% royalty fee off revenue. The 10% is broken down into 6% that goes directly to WING and 4% into the “Ad Fund”, which is used for “digital and television advertising on a national level”. I expect this will be important for 2021 when live sports are more prominent than last year and events like tailgates and group viewings of NFL games become a thing again. If you can show hungry people an easy and delicious food option before half time that’s available on DoorDash (more on this later), the odds feel good you’ll convert a few of them.

Owned Restaurants

Although 98% of WING locations are franchised, the 2% that are owned for FY2020 generated 26% of revenue:

Notably, the company increased same-store sales by 14.2% over FY2019 due to both increases in order sizes and more stores opening. WING will both acquire franchises from franchisees (more speculation, but to me this is a guard against franchisee mismanagement – WING can step in and turn the ship around if necessary) and open stores on its own. I mention the increase in same store sales over 2019 in part to show the company survived and thrived during the pandemic.

Some Notes on Digital Sales and Deliveries

Digital sales are 62.5% of WING’s total sales and they have a good partnership with DoorDash. You can order through Wingstop’s mobile app (which functionally is the same as what SBUX does – you can order, see when it will be ready, choose locations, etc. – no discount or rewards program yet though) or order through DoorDash.

COVID as expected had a massive impact on digital sales, which were just 38.2% in 2019.

I can’t say what margin impact if any digital sales will have on WING, but it does seem fair to assume they can take far more orders and even start opening ghost kitchens if digital keeps growing. The company describes how physically small WING locations are as an advantage, which is what makes it possible to acquire one for 390K. Less foot traffic and the same or more orders means better throughput (no waiting in line, no talking to customers in person so employees can focus on making and packaging food). I think AUV could easily keep growing given more digital sales.

WING mentions ghost kitchens on their Q4 call:

And then lastly, as it relates to new formats, we are up to 13 ghost kitchens across the planet for Wingstop. We’re expanding them in the U.S. in key markets, very early stages, but we like what they provide for us. Right now, it comes down to the same comment I made in prior quarters. We really want to understand the unit economic model. We want to understand whether it’s a partner or build strategy. And we’re taking our careful and thoughtful consideration into each of those decisions as we move forward, but expect us to continue to expand that footprint as well.

WING Q4 2020 call

Management clearly is open to new and better ways to produce the same amount of sales given less and less physical space. This is a small part of the WING story now but is a free call option you’re getting when you buy the company.

Finally, the DoorDash partnership which started in 2017 I think is worth something and could be expanded to Uber Eats and other partners in the future. Delivery partners – especially those that went public recently – are likely to be highly motivated for their shareholders, flush with capital and feeling pressure to compete, so WING should be able to benefit from the arms race in delivery playing out before our eyes.

The Wingstop Experience

This Saturday I went to the Wingstop in Malden and came away pretty impressed. The experience verified what I read in earnings calls:

• This Wingstop was located in a small strip mall (other places there – Planet Fitness, Bank of America, Sherwin Williams) that Google Maps struggled to find. For those familiar with the Somerville / Malden area, this was much less high end than Assembly Row and in line with what WING management describes as their strategy of pursuing Class B real estate instead of Class A
• The actual size of Wingstop relative to a McDonald’s, Burger King or other fast food concept is small. There were 5 employees, a closed off dining area and a rectangular kitchen area that was maybe 2x the size of a normal household kitchen (small enough that you could see to the back wall from the register)
• The place was busy as heck despite there being minimal foot traffic. Most of the orders being processed were for delivery or pick up. While we were there, a number of people picked up orders that clearly were for large groups. The shelves that had ready to pick up orders were close to full at all times
• I’m a sucker for fast food, but bias aside I thought it was delicious and the chicken quality was head and shoulders above what you would get from MCD, BK, Cook Out and even Wendy’s. I got Hawaiian and Hickory BBQ on the flavors – Hawaiian is the least spicy and I wouldn’t do it again, tasted like General Gau’s, but BBQ was excellent. The seasoned fries that came with the meal were notably on par with anything I’ve had from fast food joints

Some pictures to commemorate the experience:

But Do They Have a Moat?

Wingstop in their earnings calls says they don’t have a direct competitor, and for the most part I agree. I can’t think of a pure boneless / bone-in wings fast food concept other than them. Buffalo Wild Wings is the one that inevitably comes up in discussions with friends, but the experience and economics of each are completely different. Interestingly, Roark Capital has invested in both WING (2011) and Buffalo Wild Wings (2017).

Management

CEO Charlie Morrison has been with the company since 2012 and prior to that was at Pizza Inn (he mentions the pizza delivery model a lot on calls) and Metromedia Restaurant Group.

He owns about 0.31% of the stock, which is frankly not great for insider ownership but I’m willing to look past that due to the business potential.

It is obvious to me reading some of WING’s earnings calls that Morrison is long-term focused:

Again, Morrison’s pizza experience and mention of pizza delivery on calls makes me think he sees a lot of potential in WING being more delivery and digital sales based. This has been the Dominoes story and a big driver of the massive return for that stock. I would be very happy to see WING using that playbook.

If I have any issues to speak of, it’s the special dividend the company paid this year that was backed by debt. I don’t understand why the company did this instead of investing it into more company owned restaurants, which seem like they also should produce 35-40% unlevered returns (arguably more since no one knows how to manage a Wingstop like Wingstop).

In Q3 2020, Wingstop announced this $5 special dividend backed by a $480 million securitization that gave it a lower cost of debt. The company also did a special dividend in 2018. I don’t understand the rationale here other than to return some capital to shareholders. If anyone has ideas / more information, please shoot me an email (you can press the I icon bottom left and add a note there and hit Submit).

Additionally, the fact that the company is ~6x levered doesn’t make sense to me considering capex is pretty small every year (as long as company owned restaurants stay low, this is not a very capital intensive business because it’s 98% franchised), unless the reason is to keep returning capital to shareholders through debt. I would like to understand more here and it’s possible there has been mention of it in previous earnings calls.

Additionally, the history of insider purchases for WING is admittedly bad (can’t find a single instance in last few years of someone purchasing on open market – let me know if I made a mistake). I attribute this to the current valuation being fairly optimistic, which brings me to the next section.

The Valuation

WING to most buyers probably looks prohibitively expensive at 100x+ TTM earnings, 15x sales and 43x EBITDA (using adjusted figure of $72mm for 2020).

Unlike most companies trading at this type of valuation though, WING has a pathway to growing cash flow by double digit percentages for years into the future. It has a backlog of 700 franchises franchisees are ready to open that will play out over the next 3-4 years. Many franchisees own 10 or more Wingstops and want to own more. The company’s growth has barely started beyond the United States. For these reasons, I have conviction in the company being able to achieve its goal of 6,000+ franchised restaurants. If the company hits this goal, I think the current valuation is a bargain.

I’m pulling numbers out of thin air, but I think a 5% FCF yield is reasonable for a growing business – if you repeat this for 20 years, you’ve paid off the business in cash. To get to a 5% yield, WING needs to produce $191mm in cash at a $3.8bn valuation (valuation as of Friday, 3/12 close).

How realistic is getting to that 191? The company is at a meager $57.5mm right now ($65.5mm operating CF – $8mm capex), but keep in mind there are only 1,583 locations. I calculate FCF margins right now at 23% (57.5 / 249mm revenue). If the company can raise margins to 30% based on more digital sales and cloud kitchens, I can see a way to over $300mm in FCF. I count $270mm in just franchised FCF alone:

Assuming company owned restaurants contribute just $30mm, we’ve hit the $300 target and are now at an ~8% yield. I see no reason the company couldn’t get to 10K stores and beyond.

The caveat here is that growing from 1.5K to 6K takes time – at a 20% CAGR (well beyond how fast they’ve traditionally grown) this will take at least to mid 2027. Some things that could speed the process up to more FCF:

• WING opening more company owned stores
• WING bumping % of digital sales (if you order on app you just pick up – this would have same effect as SBUX seeing faster throughput rates once everyone started using app) and deliveries
• WING adding menu items with higher margins

Either way, even if the current valuation proves rich in the interim, I think long term the WING opportunity is excellent and I expect franchisees to continue franchising more stores. I don’t see any immediate threats to the 35-40% unlevered return on stores and really like the brand. Overall, this is a company I’m fine continuing to invest in at the current valuation and below until the facts change.