Activist Investor Letter To Buffalo Wild Wings $BWLD
As you know, investment funds managed by Marcato Capital Management LP ("Marcato") currently own securities representing beneficial ownership of 5.2% of the shares outstanding of Buffalo Wild Wings Inc. (the "Company"). It has been two months since we first sat down with management to begin a private dialogue about opportunities to enhance shareholder value. Given the Company's lackluster analyst day presentation and observable discontent among shareholders and research analysts, we have determined that it is appropriate at this point to share our perspectives with the investment community. Along with this letter, we are filing the analysis that we shared with management at our first meeting in June and hope that research analysts as well as current and prospective shareholders will consider this information and express their views on the subject matter.
I should emphasize that we are exceedingly optimistic about the future of Buffalo Wild Wings. In the crowded and competitive restaurant universe, Buffalo Wild Wings offers an experience that is superior to and highly differentiated from those offered at any of the sports-themed competitors in its markets. The benefits of its national scale, from marketing to purchasing to best practices, will continue to position Buffalo Wild Wings as the preferred destination to experience televised sports outside of the home. In fact, we think the Company's estimated addressable market of 1,700 units (compared to 1,220 expected by year-end 2016) in the United States and Canada may be far too low and deserves to be revisited.
We also believe, however, that Buffalo Wild Wings must make substantial changes to its business practices if it hopes to reach its full potential both as a company and in terms of shareholder value. Our initial conversations with management focused on the Company's capital allocation decisions, which we discuss below and detail in our attached analysis. Following months of engagement with the Company, we have come to appreciate that suboptimal capital allocation behavior is symptomatic of a larger organizational deficiency: a tendency to favor gut feel and thematic proclamations without
tangible evidence or appropriate analytical support. The management team of Buffalo Wild Wings communicates its strategic and financial rationale to the investment community with inveterate avoidance of specificity. The chronic absence of detail around even the most basic of metrics causes us to question whether the right questions are being asked and answered.
We direct this concern not only toward management, but also toward the Board of Directors whose duty is to oversee, evaluate, and incentivize management in such a way as to ensure that the business is run in shareholders' best interests. We are committed to doing our part to help the business achieve its full potential. We expect that the necessary changes will include the following:
1) The introduction of fresh talent at both the Board and management levels. The Company must improve its experience and sophistication in areas of restaurant operations, franchise system development, corporate finance, and capital markets. We are confident that the Board would benefit from adding independent directors with operating experience in the restaurant industry, in particular with a franchised restaurant concept. We note that no current director has direct restaurant operating experience outside of the CEO. We would also stress that any changes to the Board should only be made after consultation with interested shareholders, and we would view any unilateral action to change the composition of the Board as a hostile act of entrenchment.
2) A greater focus on operational excellence within Buffalo Wild Wings' core business. The Company must improve in key operational areas such as food quality, price/value perception, speed of service, technology implementation, food cost optimization, and labor engineering – all areas where it is substantially underperforming its potential, and, that if improved, can drastically help restore the Company's customer value proposition. Efforts to drive "growth" primarily through new unit openings and franchisee acquisitions currently take unwarranted precedence over maximizing same-store sales and restaurant-level margin opportunities at core Buffalo Wild Wings. Over the long-term, neither system growth nor franchisee acquisitions will be able to compensate for a decline in the profitability of the core concept.
3) Cessation of "emerging brands" growth plans. Buffalo Wild Wings' continued success is not an inevitability; as such, we believe the Company should remain singularly focused on its largest earnings driver rather than placing wild bets, however small, on hit-or-miss "growth drivers"— particularly those in the highly competitive, non-core, fast casual space. Experiments with new restaurant concepts are distracting management from advancing Buffalo Wild Wings' core brand. At this point in time, any corporate resources, be they personnel, capital, or attention, would be better allocated to addressing the operational improvement opportunities at core Buffalo Wild Wings.
4) A profound increase in urgency, follow-through, and accountability. A review of past years' earnings reports reveals a number of Company "priorities" that have since dragged on without meaningful progress, the most obvious example being the bungled roll out of table-side order and pay functionality. The commentary in the current period regarding the near-term goals
for these programs is the same that it was two and three years ago despite the Company having missed its initial execution objectives. Even now, management is content to highlight the opportunity while very little tangible progress has been achieved. This issue is representative of a much larger issue of management's persistent failure to execute and the Board's failure to hold management accountable.
5) An audit of managerial decision tools and a reconciliation of business outcomes as compared to forecasts. Despite frequent assurance from management of the use of DCF- and IRR-based forecasts to approve investments such as remodel campaigns, new unit openings, or acquisitions, our experience with retail and restaurant businesses has taught us that those processes can be highly flawed. We take seriously the tendencies of development staff to reverse-engineer projections to achieve a stated hurdle rate or highlight data with a selection bias to support past decisions. The Board must review past capital investments to ensure that outcomes compare favorably with the underwriting process. We recommend starting with an assessment of the Company's large franchisee acquisition in 2015, which based on all available data, has been an unmitigated disaster. That such an obviously misguided decision could be made under the guise of rigorous analysis underscores the weaknesses in the Company's capital allocation processes and need to commit to a disciplined capital allocation program.
The list above speaks to functional changes that will improve business performance. At a higher level, however, there is an intellectual divide that must also be addressed: there is a glaring deficiency of understanding at the Company in how capital deployment relates to shareholder value creation. Yesterday's announcement of a $300 million share repurchase authorization further highlights this point.
Management self-identifies its objectives to be those of a "growth company" but does not appear to have a clear sense of what that exactly means or how (and if) achieving this poorly defined "growth" objective is best for shareholders. Growth in revenue or earnings simply cannot be evaluated without consideration for the capital deployed in the achievement. This basic principle of corporate finance is tragically underappreciated by the current management team.
Instead, management celebrates consolidated revenue growth without discriminating between revenue derived from growth in royalties from franchisee unit development, same-store sales growth (itself a product of tension between higher price and declining traffic), new company-operated unit growth, and the purchase of units from franchisees. Each of these revenue streams has a radically different margin profile and comes at a radically different capital cost (franchise royalties in particular come at no cost whatsoever). Most importantly, the income derived from each of these different revenue streams receives a radically different value in the market due to its unique degree of capital intensity and predictability. Management and the Board should be solely focused on growing market value per share, determining which types of revenue growth will best deliver that outcome.
Additionally, management frequently highlights growth in average unit volumes, but fails to acknowledge that this growth has been accompanied by an increase in per unit construction and pre-opening costs from $840K in 2003 to $2.6M in 2015, leading to a significant decline in the returns on invested capital. We perceive that the pursuit of higher average unit volumes (management's barometer for "growth") has led the Company to deploy ever-greater amounts of capital into larger units tailored to more populous, but also more competitive, and more expensive markets. Similarly, remodel costs for the current Stadia program are increasing over prior remodel budgets, and the Company has not articulated the basic return on investment methodology that illustrates why the new remodels are attractive, why the current remodel cost is appropriate, or if similar outcomes could be achieved at a lower cost. Might shareholders and customers alike be better off if capital were instead invested into smaller-format units that, at the expense of lower AUV's, could profitably succeed in smaller, less competitive markets with lower construction and operating costs, producing higher returns on capital?
Management appears to believe that realizing its identity as a "growth" company means delivering EPS growth of 15% or greater. However, even this statement is made without any design as to how that will be achieved. Beneath the headline, there is no calculus as to how same-store sales, operating margin expansion, franchise vs. company unit growth, franchisee acquisitions, and share repurchases will combine to produce such a result. Just how this earnings goal is achieved, and in particular how much capital is required to achieve it, will dictate the multiple of EPS at which the shares will trade. This is the vital and missing link between earnings creation and shareholder value creation. The apparent lack of sensitivity to this connection is the primary impediment to shareholders earning an attractive return on their investment in the future.
Unfortunately for shareholders, the easiest growth to come by has been the kind that is BOUGHT, requiring the most capital and offering the lowest returns. As same-store sales have decelerated and the law of large numbers has made it difficult for new unit additions to sustain historical revenue growth rates, management has turned to buying in franchisees in its pursuit of "growth." The large franchisee acquisitions in 2015 were telegraphed to investors, under the pretense of being "opportunistic," as helping the Company achieve its goal of growing sales and net income. At the same time, the Company did not offer any concrete rationale for why this transaction would create more shareholder value than allowing the units instead to be sold to a third party buyer – an outcome that would have retained the existing high-value franchise royalty stream and avoided a major capital outlay at an excessive and unprecedented multiple, and moreover would have avoided the additional cost and distractions of transaction fees, remodel requirements, regional G&A investments, integration risks, and operational complexity.
Despite the Company's refusal to disclose key financial metrics of the transaction, it is clear to us that the acquisitions of 2015 were mistakes and would not be approved today if an appropriate methodology were employed. This acquisitive behavior is almost certainly reinforced by an incentive compensation system, designed by the Board, that rewards (if not preconditions) management for maximizing absolute growth in revenue dollars, net income dollars, and store openings – all metrics that fail to acknowledge the capital required to achieve these outcomes and whether the returns on that capital investment are appropriate. In contrast, most other high-performing restaurant companies emphasize metrics more explicitly tied to shareholder value, including operating income (not sales),
EPS (not net income), and ROIC and total shareholder return -- all of which are absent from management's incentive compensation design.
We are confident that Buffalo Wild Wings is in a strong position to compete and succeed in the future. However, we believe this opportunity will be squandered if our concerns highlighted here are not addressed with urgency. We look forward to a vigorous discussion of these factors with the Board and management going forward.