Investment Thesis: Country Style Cooking (CCSC)

Posted on 19. Jul, 2011 by TheFreeInvestor in Stock Analysis

Last week, I started building my position in Country Style Cooking (CCSC) by buying an initial position. I think, it is a great business that taps into the immense potential of the Chinese market without the concerns that are raised for Chinese Internet stocks – threat of shutdown by government etc. Unlike US restaurants, I am handicapped to the extent that I can’t check out the restaurant operation first hand. But, I am comfortable allocating a small part of my portfolio to this Chinese concept that, if management executes well, might turn out to be a big winner.

Here is my investment thesis for CCSC.

The Business: What do they do?

Country Style Cooking Restaurants is a quick service restaurant chain in China with focus on delicious, everyday Chinese food. Its standard menu features its main dishes prepared in the Sichuan style, as well as a selection of other dishes, appetizers, desserts and beverages. The restaurant chain operates in the Chongqing municipality and Sichuan province that covers a region of 110 million people in Southwest China. In that region, the number of restaurants grew from 9 in 2008 beginning to 140 restaurants as of March 31, 2011. All stores are operated directly by CCSC as franchising is difficult under Chinese law. If management executes the expansion well then CCSC has the potential to be Chipotle (CMG) of China.

Here are some of the reasons I like CCSC –

• Large market: As mentioned above, the Southwest region of China has 110 million people — that’s equivalent of one third of US. It is unclear if Sichuan style spicy food would suit the taste preference of other Chinese regions. But, even with only the Southwest region, the company has a lot of room to grow from current 140 restaurants.
• High table turns: Though the ticket revenue per customer is low, average traffic per restaurant per day is approximately 1,600 and average table turnover is approximately 16 times per day.
• Local taste: There are already many multinational restaurant chains, e.g., McDonald (MCD) and KFC (YUM) that are aggressively building out their franchise in China. However, the knowledge of local taste and being a homegrown restaurant chain may prove to be a competitive advantage.
• Low cost of building new restaurants: The initial of cost of building a restaurant is only $200k-$300k. Though the margins are low in restaurant business, the low set up cost ensures that each restaurant pays for its set up cost in a year or so. So, the capital need for growing the business is not too high.
• Clean balance sheet: CCSC has $92 million in cash and no debt on balance sheet. So far, the company has been building new restaurants out of operating cashflow.
• Founder driven culture and realistic founders/managers: One of the founders, who started the initial 9 restaurants over a decade, is still running the firm. The overall culture of the firm seems to be frugal and grounded in reality.

Financials: How is the financial health?

CCSC’s balance sheet looks healthy with $92 million in cash and no debt. Revenue in 2010 was $113 million, up 50% from previous year, with $9.5 million in net income. As mentioned above, it is a low margin and high volume business. In the recent quarter, the increase in costs far exceeded that of revenue. Over long term, we have to keep a close eye on how management is controlling costs from spiraling.

As the firm continues to expand and open new restaurants, most of the operating cashflow is getting used up in growing the business. In 2010, capital expenditure was $17.7 million and operating cashflow was $13.6 million.

Valuation: What’s it worth?

CCSC is in very early stages of a potential large restaurant chain in future. If the concept is successful, it can easily expand to more than 1000 restaurants within its current region. However, at present, most of the cashflow gets invested in growth of the business. So, traditional valuation of CCSC is a tough exercise. Any kind of valuation will have to rely significantly on the terminal value of the business. Similar to what happened to Chipotle (CMG) in US, if the firm continues to execute its expansion plan effectively, it will be a multi-bagger in few years from now. As the market is spooked with the recent operational hiccups at CCSC, it seems to be a good time to buy into this potential large concept in China.

Risks: What can go wrong and when to sell?

The biggest wildcard seems to be about the capability of the management to scale up from a 9 restaurants operation to 100s of restaurants. It is unclear whether the current founder management is capable of operating at such scale. The recent spike in costs across the board is a concern. Recently they hired a senior manager from McDonald. I will be watching management effectiveness in coming few quarters. Typically operational issues are not as difficult to overcome as industry or business model headwind. So, I am hoping that the management will mitigate the recent operational issues.

Rising food costs has been a concern for all restaurants worldwide. With low margins, we have to see how well CCSC is able to pass on the cost increases to customers without impacting traffic significantly.

As the company continues to expand its reach and network around the world, I will be looking to efficiency gains and margin improvements in coming years. Any further consistent deterioration in margin will make me concerned.

Conclusion: What’s the bottom line?

Country Side Cooking is a play on the growing Chinese economy and improving standard of living. It is still early stage of this growing concept. If the management executes well, it will be a great investment in longterm. As the company works through the operational issues in near term, I am hoping to build this position to a full position and hold it for a long time.

(Disclosure: As of the publication of this post, I hold long position in CCSC and CMG. Please read the full disclaimer below.)

Tags: CCSC, CMG, MCD, YUM