CCSC is inefficiently priced and has LT 100% upside.

Thesis

Trading at replacement cost, 4x EV / EBITDA, 10x P/(OCF – maint. CapEx), and w/ 50% mkt cap in cash, CCSC is at the turning point to its SSS and margin with 20%+ visible sales growth ahead at 13%+ EBITDA margin. I see 25% upside without rerating, 50%+ upside with rerating to 6x EV/EBITDA (still 2 turns below peer average), and 100%+ upside 2 years out if management can prudently execute store growth plans.

Company Background

CCSC is quick service restaurant chain in the south-western area of China. Think of it as the Chipotle / KFC hybrid that provides economic, hygienic, fast, and pretty good (I can personally attest to) Chinese food. It grew from 9 stores in Jan 2008 to ~270 stores today, and targets 500-1000 stores within the next 5-10 years. Note that when CCSC IPOed in 4Q10, it hit all the right concepts (China + consumer + significant CAGR @ 20%+ + operational leverage) and printed at astronomical multiples. Since then, operational efficiency and employee development had lagged the company’s aggressive expansion circa 2011-2012. Add such mis-execution to food + labor cost inflation and slightly slowing growth, the Co comped negative SSS for 4 quarters straight since 2012, suffered negative earnings, and had fallen out of market’s favor despite of the operation’s continuous improvement.

This opportunity / inefficiency exist due to several inconvenient factors:

• -          The market cap is < $200 mm and the average daily $ volume is < $ 0.5 mm, making it difficult for any credible institutions to take sizable positions and/or move the needle.
• -          This is a (1) Chinese ADR that (2) buried people when it IPOed at ~40x EV/EBITDA. A bad taste in previous believers’ mouth + little credible visibility for US investors who are guy-shy of Chinese scam.
• -          The founders Hong Li and Xingqiang Zhang jointly own 49.38% of the company. All directors and executive collectively own 72.92% of the company.
• -          The company’s name “Country Style Cooking” (乡村基) is (1) not the most flattering and (2) smells like a knock-off to KFC in Chinese, potentially alienating prospects.
• -          Negative earnings in 2011 and weak earnings in 2012, only covered by 1 non-bulge analyst w/ HOLD, so this is likely ignored by retail and institutional investors as a whole.

CCSC is trading at replacement cost / distressed levels.

Opening 1 CCSC store costs ~$ 300k CapEx (even less for its new Mr. Rice concept @ ~200k). At the current market price ~$180 mm – cash of ~$95 mm, each of the CCSC’s 270 stores has an implied value of ~$ 310 k despite company delivering a store-based break-even at 9-12 months out. So buying CCSC = buying matured, cash-flow rich stores at what it costs to build and ripen (note that Sequoia China paid ~2 mm per store in 2007). To put it in other ways, (1) the implied EV / Store for CCSC is materially below all public comps (figure 1), (2) for the 1^st time ever, CCSC ‘s EV is below its invested capital base (figure 2), (3) it’s trading at ~4x trailing 12 month EBITDA (vs. 7-8x peers) and ~10x P / (OpCF – Maintainence CapEx). The point is, no matter how you slice and dice it, CCSC screams cheap at least in the rear-view mirror and having 50% of market cap in cash gives me a lot of downside comfort.

Looking forward, such discount is unwarranted given growth & operational improvement

Let’s take a look at my favorite chart, figure 3:

CCSC has the cheapest EV/EBITDA multiple but the highest sales growth rate, perhaps indicating (1) it cannot make a dime off of its meals and/or (2) it is a scam. I believe neither is true and the company is at a turning point to ramp SSS, continue sales growth, and expand margins.

On trust: Trusting anything so distant requires a leap of faith after all, but I can at least take some comfort with the following reasons:

• -          I have personally eaten there and know friends/colleagues who swear by it in Sichuan.
• -          I can find plenty of reviews on http://www.dianping.com/ confirming my view.
• -          The CFO is very open to discussion on a prominent Chinese investment forum (xueqiu.com). The company also has both Chinese and English quarterly reports w/ online Q&A sessions. How many sub-$500 mm oversea companies you know do that?
• -          The firm is earning audited real interest on the cash.
• -          Given that Hong Li built CCSC in 1997 from nothing and still owns the majority of it, I find it hard to believe that she would jeopardize her future fortune.

On Growth & margins:

As mentioned above, CCSC had a few mis-steps post-IPO:

-          Aggressive store growth for the sake of growth in 2011 leaves its employee training playing catch-up, stretches its nascent logistics chain, and burdens the company w/ underperforming stores.

-          Expanding into 1^st tier cities (Beijing, Shanghai) in 2012 proves to be a mistake given the low-cost strategy conflicts against the high-rent + high labor cost against an inflationary back-drop.

To cope w/ margin pressure, CCSC decided in 2011-2012 to drop food portions & quality. So what happens when you have (1) new sites out of core market, (2) new spending for marketing and employee training, (3) new cost for logistics build-up, (4) worse reviews, and (5) rampant inflationary pressure? The SSS and margin suffered materially in late 2011 and 2012 as new stores enter into the “same store” count, and the market sold off CCSC aggressively into the depressed territory described above.

These problems, however, are being addressed, fixed, and improvement ignored by the market.

-          Closing underperforming stores in 1^st tier cities and focus on stably expanding into peripheral provinces around its core market. This should lift SSS visibly in the future.

-          Additionally, as new stores mature and old stores stabilize in core markets, cannibalization should stop.

-          Introduced the “Mr. Rice” concept similar to a Chipotle-style assembly-line QSR. This new brand has 20% lower CapEx, faster SSS ramp, a better concept/name, and noticeably higher ROIC w/ similar margins. It has proven its success in new markets and has a much better chance to become the go-to for middle-class workers in non-core markets. The mix is currently ~10% of the total store base and management looks to grow this portion quickly. Should also deliver SSS upside.

-          At this point, CCSC’s morning + afternoon traffic is quite low and its menu pricing is non-staggered, meaning that the stores are not selling enough high margin products to those willing to pay. This trend has changed in 1H13 and management is slowly rolling out (1) high margin breakfast + afternoon dessert and (2) high-price, high-margin mixes to lunch and dinner. The research + deployment window is typically 6 months, so we should see more of such measures into 2014. Reviews had been very positive, and if such momentum continues, we could see some meaningful EBITDA margin expansion into 2H13 and 2014.

-          Naturally, the mix-improvement taxes CCSC’s logistics; but they just started ramping its central kitchen for central procurement, processing, and delivery. The base is currently only ~30% utilized and should improve margins by 1%+ as operating leverage kicks in.

Restaurants are ultimately about details day in and day out. CCSC is taking all the right steps to grow its store-base, traffic, ticket size, and margins. SSS has already turned positive for them (+3%) in 2Q13 against YUM’s -20% and China’s weak economic back-drop, and I see 20%+ Top-line growth at 13%+ stabilized EBITDA margin very achievable into 2014/15. The best part is, just the south-west China market itself has the capacity to hold at least 250 more CCSC stores and can do much more as more cities urbanize.

In other words, by my numbers in YE14, CCSC will be a business w/ ~350 stores, ~$270 mm top-line, ~$35 mm EBITDA at 13% EBITDA margin, and generates ~$25 mm in LFCF (assume no further expansion).  And it can continue to grow 15%+ top-line, 30%+ EBITDA for quite some time, but only trades at ~7.7x forward P/lFCF.

CCSC may be garnering institutional interest.

As per the CFO’s tweet on Xueqiu.com, a non-deal roadshow occurred between July 24-26, 2013 in New York. Since then, along with CCSC’s improving 2Q13 results, the trading volume had materially gone up.

While the absolute trade sizes are still small and it may still be too early to tell, I can at least hypothesize that I am no longer the only one investigating this opportunity, and whatever inefficiency may sooner or later vanish, especially when many high quality Chinese names had significantly rallied within the past 3-6 months.

My price target is $10 in next 3-6 months, and $15-20 within 2 years.

Once I convinced myself that CCSC trades at least 20-30% cheaper than every comp, has 50% of market cap in cash, and is in the early inning of margin expansion and continues sales growth, I do not see much downside within the $ 6-7 range.

With no multiples expansion, CCSC can trade at YE14 EBITDA @ $35 mm at 4x multiple, or about $ 9 / share (~25% upside). The same PT can be also be replicated withYE14 /s no-growth FCF discounted at 10% perpetually.

With very likely value discovery and multiples expansion, I see CCSC trading at 6x EV/EBITDA by YE14, which is around $13.50 / share (~80% upside). Why not a higher multiple? Because (1) they still have to work to get there and the environment for a low-cost QSR is always difficult, (2) the management, while honest and open, err on the side of conservatism and does not put most of the cash to work, and (3) there is still significant room to improve the restaurants’ operations.

If the management executes and delivers 500 stores within 5 years with reasonable profitability, the number gets to ~$20 / share or ~$ 0.6 mm EV / store, more fitful for CCSC’s growth and profitability profile, and the stock can continue to work as the company has a long growth trajectory ahead of it.

Risk

The risk is our usual China risk, fraud risk, food inflation risk, etc; but these risks apply to any company in China listed in the U.S.. Competition is a real risk, but I think the market is large enough to contain multiple big players and CCSC has proven itself in its core markets; none of the local competitors so far has the capital access and stream-lined logistics as CCSC does. The relationship between the founding husband and wife is also a real risk, but their son Kunwei Zhang appears quite happy, independent, and competent (Source: http://www.bobaow.com/u/75/article/45769.html), and such a personality most likely comes from a good family.

Sources: Bloomberg, Company SEC filings, Company IR website, Xueqiu.com