First Watch Restaurant Group: Rapid Growth On Cards As Sales Momentum Persists

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Avocado toast with eggs and roasted tomatoes

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Investment Conclusion

Based on recent quarterly results, First Watch Restaurant Group (NASDAQ:FWRG) is clearly on a roll. We were encouraged to note that, not only did FWRG, expand system sales and same-store sales on a year-over-year basis and compared to three years ago, the firm recorded substantial traffic growth, which considering the deteriorating macroeconomic environment has been a challenge, for the competition. In addition, although, relative to the prior year’s same quarter, gross profits, operating income, net income, and earnings per share all declined, the outcomes were a function of inflationary headwinds related to commodities and labor, rather than based on the fundamentals of the business, in our opinion. Further, a key indicator of the health of the business, average unit volumes per restaurant were considerably higher over the prior twelve months, as were dine-in transactions, weekday breakfast and lunch orders, and per person average checks. Moreover, we were relieved to note that new unit development for the year remained on track with nine new stores launched over the second quarter.

Over upcoming quarters, given that based on July trends, it is likely that the sales momentum FWRG has been witnessing over the past eighteen months will persist, we anticipate strong: system sales, same-store sales and traffic growth. Our expectation for significant sales upside is driven by: the planned increase in the number of FWRG cafés serving alcohol; the introduction of the fall menu which includes new selections; our conviction that dine-in sales will recover to pre-pandemic levels (were at 93% in the second quarter) while off-premise sales are sustained, and that weekday lunch and breakfast transactions will continue to expand; and the sales growth associated with the substantial increase in footprint size over the past twelve months.

We anticipate improvement in gross margins on a sequential basis, given our expectations for some easing in costs of chicken, bacon, eggs, bread, avocado, and coffee beans which form FWRG’s key supplies basket, 50% of which is cost insensitive due to hedging with future contracts, and stability in hourly wage levels. However, despite revenue leverage from sharply higher sales, easing inflationary headwinds, as well as operating and labor efficiencies, we expect margins to contract on a year-over-year basis. Based on dramatic sales growth but weaker margins, earnings and free cash flows for FY2022, are likely to decline compared to FY2021, in our assessment.

Over the long term, FWRG is well-positioned to evolve into a significantly larger organization through major footprint expansion and same-store sales growth. In regard to new unit development, management has guided to an ultimate restaurant base of ~2,200 stores, from ~450 that were operating at the end of the second quarter. With respect to same-store sales growth, in addition to the usual seasonal menu turnover and off-premise transactions, we expect a loyalty program to support ancillary sales expansion. Further, restaurant operating margins are likely to expand considerably due to lower commodity costs, labor and operating efficiencies, and price increases beyond inflationary trends. Leverage at the corporate level will be derived from economies of scale related to corporate overheads, technology, the e-commerce platform, and advertising. As a flow-through of dramatic increases in sales and margin expansion, earnings and free cash flows will surge, on a secular basis, in our judgment.

Given the second quarter outperformance, our Buy Thesis on the stock, which we had outlined in our initiation report, remains intact. Therefore, we are confident that FWRG will meet and exceed our conservative 10-year normalized revenue growth rate of ~15% and 10-year straight-lined operating cash flows margin of ~11%. Accordingly, we are reiterating our 1-year Price Target of $30/share and Buy Rating on the stock. (Please refer to our initiation report “First Watch Restaurant Group: Undervalued Rare Asset With Significant Growth Potential” for our detailed opinion on the company).

Key Takeaways From The Second Quarter

F2Q2022 Results Summary. For the quarter, FWRG generated: ~$231 million in retail sales (+20% compared to F2Q2021), ~$185 million in revenues (+19.8% on a year-over-year basis), beating analyst estimates of $175 million, and $0.05 in earnings per share (negative 37.5% compared to a year ago period), ahead of consensus projections of $0.04. In addition, relative to F2Q2021, restaurant operating margins were 18.2%, representing a decline of 430 bps, same-store sales expanded by 13.4%, and customer traffic advanced by 8.1%. Net income for the period was ~$2.7 million, reflecting a decrease of 28.5% over the previous year’s same quarter. Cash flows from operations at the end of the quarter were ~$31.8 million.

Geographic Diversification Remains On Track. Despite regulatory delays, supply-chain bottlenecks, and labor shortages, FWRG managed to launch nine new restaurants across seven states during the second quarter, including one in the new market of Asheville, North Carolina, and a third in the Chicago metropolitan area. Considering that over FY2020 and FY2021, the company debuted 42 and 31 new restaurants, plans to introduce between 41 and 48 restaurants this year, represent a reversion to the ~10% long-term target growth rate management has guided to.

In addition, we are encouraged to note that FWRG’s focus on site selection is paying dividends, as new restaurants are outperforming across regions, in core emerging markets and in new markets. Specifically, given their substantially larger footprints, new stores, are typically accounting for higher average unit volumes than those associated with mature units. Further, the significant experience FWRG has gained in turning new units profitable is reflecting in recent new development achieving mature margins in relatively shorter time frames, resulting in increased cash-on-cash returns, over smaller time horizons.

Considering that the addition of restaurants is highly favorable to FWRG’s bottom line (given the strong unit economics), we are pleased that geographic expansion remains on track, despite the challenging environment.

Value Proposition Likely To Insulate Sales During Recession. An economic downturn is unlikely to severely impact FWRG’s sales, in our opinion. Our conviction is based on several factors, including strong customer loyalty established during the pandemic, when the brand retained the entire menu, and the more recent conservative attitude towards menu price increases, despite significant cost inflation. In addition, driven by chef-created cuisine prepared fresh daily, quality ingredients, and table service, and supported by a reasonable average check of $15/person, FWRG’s solid value proposition is a clear competitive edge, that will sustain customer demand, during a financial crisis, in our judgment.

Based on traffic trends evident during the Great Recession at FWRG, customers likely switched to weekend brunch in lieu of Friday night dinner, to limit expenses, as dinner is typically priced at a premium at restaurants. In addition, guests would forgo shareables and beverages to manage check values. In addition, prior management comments indicate that the company’s establishments outperformed the competition between 2007 and 2010. Further, given that FWRG’s restaurants are typically capacity restrained and have to turn customers away, the unmet customer demand will counter some fraction of decline in sales, if discretionary spending were to decrease.

Overall, considering, the elements described above, combined with the strong: guest satisfaction scores, NPS ratings, and customer traffic growth, the brand is currently enjoying, and that its customers skew towards the higher income bracket, gives us comfort that sales will continue to expand if an economic recession were to unfold.

Menu Mix An Under-Appreciated Growth Driver. Although menu innovation, through the change of culinary offerings every season, has long been a growth driver for FWRG, there is an increased focus to derive incremental sales from the element. In that regard, the group has been rolling out alcoholic beverages across the platform and upgrading its juice-based beverage line-up. In addition, FWRG has been prolific in launching new premium-priced limited time only menu items that despite being premium priced have garnered significant customer interest and reflected in sales growth.

Considering, that chef-inspired cuisine is a key strength of the brand’s business model, with the introduction of new menu items as well as the change in seasonal menu, reflecting in significant growth in customer traffic, we are glad that FWRG continues to focus on this vital growth driver of sales.

Adult Beverage Segment Roll-Out Almost Complete. 75% of FWRG’s restaurant footprint is now offering alcoholic drinks, with plans to complete the roll-out across the system by year-end 2023. Although the category represents just 6.5% of total sales, on an average, it has grown from the 4% level it accounted at the time of launch, sixteen months ago. As per management, the firm expects to innovate around the alcohol segment to drive incremental sales, similar to the initiative that drove sales associated with the juice-based beverage line-up from 3% to 15% of the sales mix. In addition, as alcohol licenses are certified in FWRG’s cafés, the company plans to initiate in-store promotion efforts to build awareness around the category.

Considering that alcoholic beverages generate the highest margins among menu items, we view management’s strategy to build awareness and menu innovate around the category as prudent. Adult beverages could easily turn into a significant growth driver for FWRG.

Guidance Upgraded To Adjust For Sales Momentum. Based on substantial growth in customer traffic over recent quarters, FWRG believes that its business is well positioned to outperform previous projections.

For FY2022, management now expects same-store sales growth of 13% to 15% versus the prior high-single-digit estimate. In addition, they model revenue growth in excess of 20% compared to the earlier guidance of over 15%. Finally, adjusted EBITDA is now anticipated to come in at a range of $70 million to $72 million, versus the previous projection of between $67 million to $71 million.

Considering, the strong momentum in sales, FWRG has been experiencing over the last eighteen months, and business dynamics which demonstrate that the growth is sustainable, the guidance appears reasonable, in our opinion.

Balance Sheet Appears Strong. At the end of F2Q2022, FWRG had cash and cash equivalents of ~$53.6 million and long-term debt of ~$97.2 million on its balance sheet. In regard to additional funding, the company has $75 million remaining on a revolving credit facility it had previously secured. Given these factors, we believe that FWRG is adequately funded to operate effectively and execute on its significant footprint growth targets. The firm does not pay dividends on outstanding shares.

Bottom Line

The combination of FWRG’s low brand awareness and outstanding guest satisfaction scores is the unlock to dramatic growth in the company’s fortunes. Even in the States, it has a presence in, FWRG is barely known, and remains almost undiscovered in regions where it is unrepresented. As the brand fortresses current markets and penetrates new markets, driven by outstanding guest reviews, awareness will grow, developing the customer base. In addition, that breakfast customers are typically habitual, will benefit FWRG substantially, as the footprint expands. Overall, the company’s cafes are the only ones in the industry that provide the culinary experience it offers, at scale. Therefore, with time, we expect the breakfast chain to become ubiquitous over the country. Given the growth potential FWRG underpins, its stock is a multi-bagger in the making. Buy, Buy, Buy.

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