Wingstop (WING) has grown sales and earnings at a phenomenal clip since going public in 2015. The chicken wing restaurant chain’s revenue and earnings have grown by an annual average of 21% and 23%, respectively over the last five years. The share price responded even more impressively, going up 150% over this period. The share price rose by 67% in the last 12 months alone. While the company’s fundamentals are undoubtedly impressive, the current irrational valuation comes as a result of an exuberant market hungry for anything showing growth. Anyone shorting this company recently has likely been forced to close out the position for a loss as the shares surged higher on the stellar growth figures and speculation of a sale. Despite all of the enthusiasm from retail investors as well as some analysts, we think it is an opportune time for current shareholders to take their money off the table and lock in profits. Additionally, the extreme overvaluation combined with the other factors discussed below offer an attractive opportunity to initiate a short position.
High End Price to Sales Ratios
Wingstop currently has a price to sales ratio of 14.55. Sorting the entire universe of stocks listed on the major exchanges by price to sales ratio allows for some interesting observations. When you enter the world of price to sales ratios exceeding 14, an investor will find an array of biotechnology companies and high-flying software companies. Price to sales ratios this high are usually reserved for companies engaged in real innovation like drug development or developing software to make businesses more efficient. Yes, there are a few industrials, gold miners, and others but in Wingstop, we are talking about a chicken wing chain. It’s not even the only chain with ‘wings’ in its name. There is not much innovation here, the fast food market is saturated, and the barriers to entry are not low. We do not need to limit it to the price to sales ratio. The company’s other valuation metrics are just as extreme. Wingstop currently carries a P/E of 104, a forward P/E of 79.71, a price to cash ratio of 180, and the PEG ratio is 11.08.
The fast food and restaurant industry in general suffer from saturation. U.S. restaurants faced stagnant sales in and weak customer traffic in 2018 as cited in a recent LA Times article which also discusses headwinds expected for 2019. This was also in a year of record low unemployment numbers and low food costs. Some of the headwinds cited in addition to the crowded landscape include food and labor cost inflation. 2018 saw many chains close locations. Ruby Tuesday closed 51 locations last year and even Starbucks is shutting well over 100 stores thanks to softening sales growth as a result of increased competition.
Despite the strong economy, sales growth has been muted resulting in meager restaurant count growth. Unit count growth was only 1.2% in 2017 which marked a continuation of consistent decline in annual unit count growth since 2013. Restaurant Business Online predicted restaurant growth of 3.5%, 2.7%, and 1.8% for quick-service concepts, casual-dining, and fine-dining, respectively in 2018. A positive for Wingstop is that the majority of growth is seen in off-premise options or quick-service restaurants. However, increasing numbers of new restaurants account for some of the fast food industry’s weak traffic numbers. Additionally, another aspect will start to have more of an impact in 2019. Last year restaurants benefited from deflation in many ingredients including chicken wings. Wingstop noted a 20% deflation for wings in 2018 compared to the prior year which gave earnings a boost. This year labor costs are rising along with food inflation. Increasing menu prices to make up for the difference will make preparing food at home even more attractive alternative from a cost perspective.
Lack of Differentiation
Even just considering restaurants that sell wings highlights how saturated the market is. Yes, growth has been great for Wingstop up to now, but investors need to consider how the company differentiates itself from the competition. The list of chains selling chicken is ridiculously long and many of these sell wings. Some of the more popular chains for wings specifically include Domino’s, Buffalo Wild Wings, Applebee’s, WingStreet/Pizza Hut, and Popeye’s to name just a few.
A big part of the Wingstop story that has helped grow investor enthusiasm is the asset-light operating model. Being highly franchised, in addition to small restaurant size, results in low capital expenditures and attractive free cash flow. Carry-out orders account for about 75% of sales meaning more customers can be served. This is not a place you go to sit down and watch a football game like Buffalo Wild Wings. The average Wingstop is only 1,700 square feet. The small size and high carry-out mix likely results in higher sales per square foot than most competitors.
The company estimates an average initial investment of $380,000 for real estate purchase or lease costs and preopening expenses. Their second year target is for the franchisee to realize an unlevered cash-on-cash return of about 35% to 40%. As attractive as this business model may sound, investors also need to consider the negative side of the model. Low capital requirements mean lower barriers to entry. As mentioned above, the list of competitors is already extremely long and industry sales growth is stalling as a result. There is little preventing other chains or new entrants from trying out a similar model for some or all of their locations. Investors holding on now have to believe that Wingstop is going to be able to differentiate itself from the crowd long term while growing earnings at a rate far exceeding industry averages.
A Trend toward Healthier Eating
Two issues that have been written about for years are the obesity epidemic in the U.S. and soaring health care costs. Per the Centers for Disease Control and Prevention, 39.8%, or 93.3 million U.S. adults were obese in 2015 through 2016. Obesity related conditions include heart disease, stroke, type 2 diabetes and certain types of cancer accounting for some of the leading causes of preventable premature death. The annual medical costs of obesity in the United States were estimated to be $147 billion in 2008. This price tag has likely only gone up since then.
The Food and Drug Administration finally took a small step to combat obesity last year by requiring that major restaurants show calories on their menus. While past studies have shown that this kind of requirement increases awareness, it appears that it does not necessarily change purchase decisions. In any case, the nutritional information provided by Wingstop highlights that there are no low calorie options or even anything that does not come with copious amounts of fat and sodium. The average Wingstop customer may be either amused or appalled when they notice the serving size is two. As it turns out, you cannot actually order the serving size of two wings.
With increased education and awareness, one can only hope that the trend toward healthier eating finally gains meaningful traction. In such a scenario, Wingstop would suffer as much or more than any fast food chain given its extremely limited menu which can be boiled down to two items, wings and fries. Wingstop lists the following risk in its 10-K : “If our customers perceive our menu items to contain unhealthy caloric, sugar, sodium, or fat content, our results of operations could be adversely affected.” The word ‘perceive’ is not really appropriate here. The issue is not if consumers ‘perceive’ the food to have a lot of fat. It does have a lot of fat – it’s a fact, not a perception. It’s more a matter of if consumers are going to make more health conscious decisions or not.
A Valuation the Company Is Unlikely Ever to Justify
The current valuation is already pricing in absolutely tremendous growth for the years ahead. If the company fails to continue to deliver the dramatic growth of the last few years, the shares have a long way to drop to get to anywhere near a reasonable multiple. This is especially the case for a company operating in a saturated highly competitive industry susceptible to changing consumer tastes. Keep in mind that the company currently carries a PE ratio of 105 and a price to sales ratio of 14.69. Mc Donald’s (MCD) numbers are less than half these values for both ratios. Shake Shack (SHAK) is another company that has been growing sales rapidly and also sports a high PE ratio of 114 but comes with a more reasonable price to sales ratio of 4.77. Domino’s Pizza (DPZ) has shown impressive earnings and sales growth over the last five years but the shares are not cheap. However, the pizza chain definitely seems to be trading at a discount in comparison to Wingstop with its PE of 31 and price to sales ratio of 3.05.
Using a discounted cash flow model is another way to see how the chicken wing chain is currently priced in a manner that takes record breaking growth as a given. Our model starts with the current price of $77.36 per share, considers a five year time period, and uses a discount rate of 10%. Even if we assume a still lofty PE of 30 in year five, the model requires an average annual growth rate of 33% to justify the current price. The model also had the dividend growing at the same astonishing rate as earnings over the period which is highly improbable.
The estimates required to justify the current valuation are so farfetched, they do not even align with management’s own guidance. Investors that believe the growth required to justify the current price is rational must truly believe the company can grow earnings by over 200% in the next five years. Wingstop grew net income from $9 million in 2014 to $21.7 million in 2018 representing growth of 141%. No one is arguing about the fact that this was phenomenal growth. However, this was from a lower base making that kind of earnings growth likely to prove unsustainable going forward and the probability that the company would exceed this growth rate is even lower.
The current market valuation for Wingstop is a clear example of irrational exuberance. The stock has been surging higher on Wall Street’s hunger for growth. The chicken wing chain has shot way over its fair valuation. Current shareholders should lock in their profits. Holding on now is being greedy. As Warren Buffett once said, an investor is wise to be fearful when others are greedy and greedy when others are fearful. Holding a fast food chain with limited menu options, carrying a multiple exceeding 100 is a risky proposition to put it mildly. For investors interested in taking on a short position, we think Wingstop offers an enticing opportunity. Put options are another alternative to shorting this momentum driven stock. One possible put option to consider is the one expiring on January 17th with a $75 strike which would cost an investor about $795 based on the bid-ask spread’s midpoint. It requires a drop of 13.4% to break even with slightly over nine months until expiration.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in WING over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.