First, let’s take a look at the company’s share count.
[ Enlarge Image ]CEC Entertainment Inc. - Shares Outstanding, 1994 - 2Q 2011
This is a pretty impressive decline, with the company repurchasing $837 million worth of shares since 2003. Unfortunately, not all of this went to reducing the share count, as the company was also aggressively issuing stock to insiders. While the company’s treasury shares (shares that it has repurchased) ballooned from 16 million in 2003 to 42 million at the end of the recent quarter, it shares outstanding (gross of treasury shares) grew from 54.5 million to 61.6 million. So while the company repurchased 26 million shares (nearly half of the total outstanding in 2003), the net decline was just 18.9 million (less than 1/3 of the total outstanding today). This amounts to a sizable transfer of shareholder wealth to insiders, and immediately raised a red flag for me.
[ Enlarge Image ]CEC Entertainment Inc. - Historical Returns, 1994 - 2Q 2011
From this chart, I note that the company’s returns have been steadily declining for most of the decade. Furthermore, return on equity spikes in 2008 while the other metrics continue trending downward. This indicates that equity has declined fairly significantly which is usually the result of increased leverage. Let’s take a look.
[ Enlarge Image ]CEC Entertainment Inc. - Capital Structure, 1994 - 2Q 2011
Here we see that the company has dramatically increased its leverage over the last four years. In 2007, the company drew down a little over $300 million on its line of credit in order to fund capital expenditures and its share repurchase program. I prefer when companies match their capital budgets with their cash flows from operations. Using debt adds a level of riskiness which I view as unnecessary unless the company is in dire need of change in order to remain competitive.
Let’s take a look at the company’s cash flows.
[ Enlarge Image ]CEC Entertainment Inc. - Cash Flows, 1994 - 2Q 2011
Note the large and persistent difference between the company’s free cash flows (green bars) and cash flows from operations (red bars). This suggests that the company has significant ongoing capital demands, which I find out of the ordinary as compared to many of the other restaurant chains I have looked at. At first I thought that perhaps this was due to a significant expansion in the store count, but over the last six years, the company has only increased its store count by 32. The company’s 10-Ks helpfully break out different capital demands. From the most recent 10-K (emphasis added):
This seemed like a significant number of projects on the go. I went back through the company’s past 10-Ks to get an idea of the turnover in projects. Over the last five years (since the company began providing these details), the company has completed game enhancements at 606 restaurants, which is greater than the number of restaurants it owns and operates. This suggests that game enhancements need to occur a little more than twice per decade, at a cost of $0.1 – $0.2 million per store. The company has also completed 146 major remodels, so this occurs about once a decade, at a cost of $0.6 million per store. Store expansions seem like they would be completed opportunistically as leases come due or as space comes available for expansion. This should only affect a subset of stores, so I’ll focus on the other two categories only. If each store requires a game enhancement twice a decade and a remodel once a decade, for a total cost per decade of $800,000 – $1,000,000, this works out to $80,000 – $100,000 per year, per store. The company 507 stores currently, which works out to capital demands of about $40.5 – $50.7 million per year. The high end of this figure only accounts for about half of the company’s actual capital expenditures each year. A little over half of the remainder is accounted for by the store expansions, and I think we can safely assume almost all of the rest is due to expanding the number of stores.
Game enhancements include replacing a portion of the store’s games and rides with new and, to a lesser extent, refurbished equipment. We believe game enhancements are necessary to maintain the relevance and appeal of our games and rides. In addition, game enhancements enable us to introduce improvements in game and ride technology. We completed 180 game enhancements in 2010. We currently expect to enhance the games and rides at approximately 140 to 150 stores in fiscal 2011 at an average cost of approximately $0.1 million to $0.2 million per store.
We undertake periodic major remodels when there is a need to improve the overall appearance or layout of a store or when we introduce concept changes or enhancements to our stores. The major remodel initiative typically includes interior design modifications that allow us to more effectively utilize space allocated to the playroom area of the store, increasing the number of games and rides and developing a new interior identity. We completed 15 major remodel initiatives in 2010. We currently expect to complete approximately 15 to 20 major remodels in fiscal 2011 at an average cost of approximately $0.6 million per store.
We believe store expansions improve the quality of the guests’ experience because the additional square footage allows us to increase the number and variety of games, rides and other entertainment offerings in the expanded stores. In addition to expanding the square footage of a store, store expansions typically include all components of a major remodel and result in an increase in the store’s seat count. We completed 28 store expansions in 2010. We currently expect to complete approximately 30 to 35 store expansions in fiscal 2011 at an average cost of approximately $1.0 million per store.
Here’s the point: Only about half of the company’s capital expenditures are required to stay competitive (remodels, new games). The rest are related to growth, which makes them largely discretionary. In a pinch, the company can hold off on the growth capital expenditures, saving about $50 million per year in cash flow that could be used for more pressing needs, like paying down debt. This suggests greater financial flexibility, which decreases the riskiness of the operations.
[ Enlarge Image ]CEC Entertainment Inc. - Cash Conversion Cycle, 1994 - 2Q 2011
This chart shows another interesting aspect of CEC. The company operates at a working capital deficit, as it is able to delay paying its suppliers while simultaneously collecting payment from its customers and rapidly turning over inventory. Here’s what the company had to say in its 10-K:
As noted elsewhere, this is an attractive characteristics which can provide a competitive advantage where this trait is not enjoyed by the company’s competitors.
Our requirement for working capital is not significant since our store customers pay for their purchases in cash or credit cards at the time of the sale and the cash from these sales is typically received before related accounts payable to suppliers and our employee payroll become due. Frequent inventory turnover results in limited investment in inventories and our accounts payable are generally due in five to 30 days. As a result of these factors, we are able to operate with a net working capital deficit (current liabilities in excess of current assets), and we can do so without incurring significant short-term or long-term borrowings.
[ Enlarge Image ]CEC Entertainment Inc. - Revenues and Margins, 1994 - 2Q 2011
Here we see the company expanding its gross margins while experiencing shrinking operating margins. About half of the decline in operating margins is due to increasing non-cash depreciation charges, which I am not worried about. The other half is due to increases in the company’s “Other Store Operating Expenses” which doesn’t provide a lot of clarity. Normally, I don’t like to see soft accounts like this expanding, as it could be masking problems elsewhere as costs are inappropriately pushed into an opaque account (for more information about this, read Financial Shenanigans which I reviewed here).
As with other retailers, it is important to look beyond aggregate sales. Aggregate sales can continue to rise solely as a result of an increasing store count, masking declining store performance. Note that the following chart uses different scales for each metric.
[ Enlarge Image ]CEC Entertainment Inc. - Store Level Metrics, 1994 - 2Q 2011
Here we see that the company has experienced relatively stable sales per company-owned store for the last decade, while franchise royalties per store have increased nicely. I had expected sales per store to decline more dramatically given the recession, but things have held up quite well. In fact, both the 2001 recession and 2007 recession outperformed the boom years from 2003 – 2006.
Ok, now we move on to valuation. In valuing CEC, I made conservative estimates of the number of new stores the company would open and franchise in the near term, based in part on its recent growth. I also made assumptions regarding the sales per company-owned store and royalties per franchised store. This allowed me to arrive at an aggregate revenue figure. I then projected a normalized operating margin (taking into account recent declines. I used the company’s historical average tax rate to arrive at NOPAT. To move from NOPAT to free cash flow, one must make assumptions about capital expenditures and non-cash charges included in operating expenses. I looked at the company’s historical relationship between depreciation and store count (my proxy going forward for PP&E) to arrive at a figure for non-cash charges. I then assumed $100,000 per year per store for capital expenditures, plus $4 million for each new store added. From all of this, I calculated free cash flows and then discounted them to the present and derived the value of equity.
The result is that CEC appears to be undervalued by at around 20%. Unfortunately, with the company’s large debt load (and the transfer of wealth to insiders noted earlier), I would need a much more significant discount to get interested, so I’ll pass.
What do you think of CEC Entertainment?