Chuck E. Cheese evolution on Main Street gets an A-plus Wall Street rating

Nation's Restaurant News, April 3, 2000 by C. Dickinson Waters

IRVING, TEXAS -- Chuck E. Cheese, the bucktoothed, frenetically upbeat icon for CEC Entertainment Inc., makes a lot of noise about having fun at the company's chain of pizza and entertainment emporiums. But for Wall Street investors and American families, Chuck E. Cheese screams value.

The fun and value combination, along with growth-stock performance, has revved up a revenue engine driving the company to record profits of $44.37 million in fiscal 1999, up 32 percent, from $33.73 million a year ago.

In a world of harried dads, on-the-go soccer moms and busy kids -- where everything from digital video to cream-filled doughnuts competes for the discretionary dollar -- the brand has more than held its own.

Families spend an average $9 per person, for what the company describes as a full night out at a place "where a kid can be a kid."

Same-store sales continue to trend up, 5.7 percent higher in 1999, propelled by continuous concept enhancement, expansion of successful locations and marketing programs that reward frequency primarily with kids game tokens, not more food.

Since 1996 CEC revenue grew 51 percent, to $440.9 million, from $294 million. Earnings during that period rose an aggregate 236 percent as the CEC system grew to 357 company and franchised restaurants. Several Wall Street analysts view the company as a simple but compelling stock story.

"The company dominates its market segment like no other," said Robert M. Derrington, SunTrust Equities analyst in Nashville, Tenn. That CEC advantage is not enjoyed by other fast feeders, Derrington observed, explaining that CEC "has no direct competition, and it is in a position to grow its earnings 20 to 25 percent this year."

The brand has built a following among families with young children with its sky tubes, arcade games and seemingly bottomless ball pits that helped turn countless birthday parties -- which account for 12 to 15 percent of Chuck E. Cheese's business -- "from Mommy's nightmare into Mommy's dream," according to one former longtime analyst.

After opening 24 new sites in 1999 and with a plan to add from 27 to 32 company stores in 2000, CEC continues to attract growth-minded investors. Last year the stock climbed 53 percent, while most restaurant stocks lapsed into a negative performance.

The company purchased and absorbed its main competitor, the Discovery Zone, for $19.6 million during fiscal 1999. It cherry-picked the prime 10 Discovery Zone locations for conversion to Chuck E. Cheese's restaurants and sold the remaining DZ properties.

"CEC is a cash-flow machine," said Greg Schroeder, vice president of research for New York-based Josephthal & Co." Within the restaurant industry CEC probably has the highest cash-flow margins, at around 35 percent, due to the income stream from the vending. Every incremental quarter someone drops in a Pac-Man [game] raises the margins. Over the next three years earnings growth should average 25 percent. A 10-percent growth in new units and middigit comps should get them there."

But observers caution that growth for CEC will top out at some point as the brand reaches a level near 550 units.

For investors, said SunTrust analyst Derrington, "the number one risk is slowing same-store sales growth."

Schroeder, from Josephthal, observed: "This is a fairly built-out chain; this is not an emerging concept. Eventually, the unit growth slow."

In fiscal 1999, ended Jan. 2, profit margins increased to 16.4 points, from 14.5 points in 1998. Earnings per share rose to $1.58, from $1.20 per share a year ago.

"We think there is a lot of forward momentum," said Richard M. Frank, chairman and chief executive of CEC Entertainment Inc. "In my 15 years with the company, I don't think we have ever been in a better financial position."

To maintain momentum, said Frank, CEC has evolved a growth strategy that puts a strong emphasis on pushing profits through increasing same-store sales.

CEC completed its Phase II remodeling program, which upgraded the kiddie rides, games and prize packages in 250 stores, in 1999. Now it is focusing on rolling out a new interactive stage show called Studio C, featuring blue screen processes and Kids' Karaoke. Since the inception of the Phase II program, visitor frequency has increased from four to six times a year to five to seven times. The new initiative is slated to be in 66 units by year-end. All new Chuck E. Cheese's restaurants will feature the Studio C package.

CEC is in the testing phases of other enhancements of the core concept and other programs aimed at boosting customer frequency. In the works is a magnetic-card system to allow children to store tickets and save them for redemption at a later date. It also will reward frequency by adding free tickets for each visit.

CEC also has not forgotten its littlest customers in the push to drive sales.

"We are testing a new kiddie area targeted at 2- to 5-year-olds in Irving, Texas," Frank explained. "We are taking out some of the sky tubes and replacing them with interactive rides -- NASCAR or a Police car, for example. And we are eliminating the ball pits and bringing in seating for the parents."