This column was originally published on RealMoney on April 25 at 12:51 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
I've always been impressed with Nolan Bushnell.
First he started Atari, which became the addiction of my childhood.
Then he started Chuck E. Cheese, which is my kids' addiction. If they had a choice, we'd be eating there for breakfast, lunch and dinner.
More recently he started uWink, but that's a topic for another article. For now, let's look at
The company operates Chuck E. Cheese, the family-themed restaurant, and it is the subject of the most recent potential activist battle for Pirate Capital. I've written about Pirate in several instances over the past few years,
The fund's more recent disclosure came on April 20 when it filed a 13D saying it owns 6.1% of the shares outstanding at an average price of around $32 and change. There were no demands in this initial filing, but I am going to take you through my thinking of what may be at hand.
There are two main reasons why an activist might go after a restaurant:
Asset play: Perhaps the real estate the restaurants are sitting on is worth more than the restaurants, and the market is undervaluing the real estate.
Operations: Perhaps the restaurant has declined recently, and since everyone is an expert on food, the activist could have ideas on how to improve efficiency and market share.
A look at the one-year chart is a clue that things have not been going so well lately for CEC. Much of that downward spiral was due to a subpar fourth quarter that saw CEC earn $9.9 million compared with $15.6 million a year earlier.
This is a substantial drop, even considering that the same quarter a year earlier had one more week. As I have written before, restaurants are hard turnaround plays. The only way to make more money from an operational standpoint is to get more customers in the door. That requires marketing efforts, and just maybe the restaurant space is getting so competitive that spending to keep your margins and customers is a losing proposition.
CEC Entertainment's Rough Patch
Source: Yahoo! Finance
As for the real estate, unlike some other restaurant operators, CEC leases most of its properties, owning just 59 of the 475 properties it occupies. About 25% of these properties are in California and Texas. While most of these leases are long term or have long-term extensions tied to them, I cannot say they would allow subletting.
I bring up subletting because maybe the best use of the location is not for a Chuck E. Cheese -- maybe it's for a Kinkos or some other store. But without seeing the actual lease, that is too hard to guess. One thing that is likely is that the company's PPE account is worth more than is stated on the books ($592 million). So the question becomes, how can that be monetized?
The company is in a great financial position. In fact, it can be argued that the company is in too good of a financial position and should perhaps leverage up more and return cash to shareholders. The company has a $1.26 billion enterprise value and $150 million in debt. With $183 million in EBITDA, the company has no problems paying down its debt. Trading at an enterprise value/EBITDA multiple of 6.6 times puts it well below the comparable multiples of its peers:
trades at 9 times,
at 11.7 times,
at 9.3 times,
at 7.5 times and
at 8.7 times.
And judging by this quote from the company's March 2006 10-K, it looks like it's not done expanding.
In 2006, the Company plans to add 26 to 30 restaurants, which includes opening new restaurants, acquiring existing restaurants from franchisees and relocating certain restaurants. The Company currently anticipates its cost of opening such new restaurants will vary depending upon many factors including the size of the restaurants and whether the Company acquires land or the restaurant is an in-line or freestanding building. The Company intends on opening or acquiring from franchisees a total of 80 to 90 company restaurants over the next three years, including approximately two to four relocated restaurants per year. The average capital cost of all new restaurants expected to open in 2006 is approximately $2.0 million per restaurant.
Although Pirate has not stated its intentions, my guess as to its planned request is threefold:
- Leverage up to buy back more shares.
- Stop expansion efforts until existing operations are on an uptick.
- Sell the company at a multiple similar to that of its peers, implying a quick 20-40% return.
Consequently, I'm long CEC and looking for $40 before peeling out.
Personally, I love the fast-food business and I have to admit that when its time to take the kids to Chuck E. Cheese, I'm quick to volunteer. I love the games there, both for kids and adults, although I think it would be neat (and cheaper) if they get some of the classic Atari games from my youth. I also like the pizza.
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At the time of publication, Altucher and/or his fund was long CEC, MCD and CKR, although positions may change at any time.
James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of
Trade Like a Hedge Fund
Trade Like Warren Buffett
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