DRVN - Driven Brands Holdings: Waiting For Margin To Improve As I Expect

2023-11-14 23:31:52 ET

Summary

• Driven Brands Holdings reported positive 3Q23 results with increased sales and revenue, but margin performance remains a concern.
• DRVN should be able to meet the implied 4Q23 guidance, but the consensus seems to be not pricing in this.
• It is positive to see the company taking steps to improve margins in the Car Wash and that integration headwinds in the Glass segments are expected to end in 1Q24.

Summary

Following my coverage of Driven Brands Holdings ( DRVN ), which I downgraded to a hold rating as I lacked the confidence that DRVN would be able to meet consensus expectations, This post is to provide an update on my thoughts on the business and stock. I reiterate my hold rating as I monitor DRVN margin performance over the next few quarters.

Investment thesis

In the recent 3Q23 quarter, system-wide sales increased 10% to $1.61 billion, revenue grew 12.5% to $581 million, and total same-store sales [SSS] increased 6.4%. Additionally, the company reported $127.2 million in adj EBITDA with a margin of 21.9%, down 310bps from the previous quarter. Looking ahead, management reiterated their FY23 guidance revenue of $2.3 billion and adj EBITDA of $535 million. A part of my worry previously was DRVN's inability to meet consensus expectations, but that has become slightly less of a worry after the 3Q23 results. The non-Glass parts of PC&G and Maintenance, two of DRVN's core legacy segments, both continued to grow strongly and profitably in 3Q23. Particularly impressive was maintenance's 9.1% SSS, which was driven by 14% Take 5 SSS, 26% EBITDA growth, and around 115 bps of EBITDA margin expansion. This largely reflects the Take 5 oil change banner. As this is DRVN's largest and fastest-growing segment, the strong performance in 3Q23 has certainly given me confidence that DRVN could meet its own 4Q23 revenue guidance. The issue here is that Car Wash and PC&G both remained weak in 3Q23, and margins in both segments declined both sequentially and y/y, which might continue to put pressure on the stock.

If we look at the guidance analysis I have done above, management implied 4Q adj EBITDA guide is ~$129 million, 3% above consensus estimates, which means the market is not pricing in management guidance effectively. I believe DRVN should be able to meet its implied 4Q EBITDA margin guide and continue to improve margin ahead, as the US Car Wash segment should see margin improvement. For context, management has decided to close 29 unprofitable locations during 4Q23. In addition, management has categorized $271 million in PP&E assets as held for sale, which reflects the expected sale of over 130 sites that are no longer central to the company's strategic plan moving forward. Accordingly, a large goodwill impairment of $851 million was also recorded by DRVN for its US car wash operations. Now, these figures and actions seem bad at a glance; however, I think what is done is done. The positive takeaway I have is that Car Wash margins might be nearing a bottom. It is true that the Car Wash segment margins fell by more than 10 points (17.1% vs. 27.9%) compared to 3Q22 due to softness in retail volumes caused by macro and competitive pressures; however, the near-term outlook commentary by management is optimistic as trends have not worsened further during 4QTD. I also like to point out that, from a mix perspective, margin performance is being hampered by the fact that the 57 stores opened in the past year have not yet reached their mature margin profile. As they gradually mature, it would have a positive impact on margins. In addition, Danny Rivera, the new COO, is also instituting a more disciplined pricing strategy while increasing variable margins at less profitable locations. These dynamics should help to improve margins on a sequential basis if they play out as I expected.

As for the Glass segment, the 3Q23 update was a positive one that gave reasons to believe margin should improve in the coming quarters. DRVN has made significant strides in consolidating its recently acquired glass businesses, with all stores now using the same point-of-sale system and sharing a centralized call center. DRVN is currently working to centralize all product purchasing, a process it plans to have completed by 1Q24's end. If this schedule holds, DRVN should enjoy favorable margin comparisons beginning in the 2Q24.

Lastly, I figured one of the major concerns with DRVN might be its balance sheet. DRVN ended the quarter with net debt of ~$2.7bn and a net debt to EBITDA ratio of 5x. Based on my analysis of the DRVN balance sheet, I don't see this as an issue. The first thing to note is that there are no major debt maturities due until CY25, so there is no immediate risk to liquidity. Second, DRVN has not violated any debt maintenance covenants that limit its ability to raise capital or use existing cash reserves. Finally, despite all the macro headwinds and consumer spending concerns, DRVN is still a growing business. It has indeed decelerated but has not turned negative. As the business continues to grow and margins improve (due to the reasons mentioned above), the leverage ratio should come down.

Valuation

In my model, I have updated the revenue growth downward by 100bps to reflect the FY23 reiterated guidance. However, I have improved the net margin by 100bps for the forecasted period, as I expect margins to improve on management-rolled-out initiatives, the closure of unprofitable stores, the maturity of its store base, and the lapping of margin headwinds driven by the integration efforts, which will end in 1Q24. I have modeled out two scenarios to show the attractiveness of the stock if things play out as I expected. In the first scenario, DRVN continues to trade at the current multiple as the market remains wary about the business outlook. In the 2nd scenario, I expect multiples to inflect upwards (midpoint of 10x forward PE and 17x forward PE, DRVN's -1stdv multiple over the past few years) as the market price in the positive outlook due to the improvement in margins.

That said, I think there is no rush to go long the stock at the moment. There will be opportunities to buy the stock as the business shows that margins can improve in the coming quarters. At the moment, while indicators and management comments are favorable for the margin outlook, I would rather wait for things to crystallize in the earnings report before I turn bullish. I reiterate my hold rating as I monitor the margin performance.

Risk

Risks to DRVN's upcoming performance include the possibility of a further slowdown in demand, driven by a major recession or management mis-execution of newly implemented strategies by the COO. Also, integration issues with the U.S. glass business could further delay the timing of margin improvement.

Conclusion

My hold rating on DRVN remains unchanged. While the recent 3Q23 results showed promising aspects such as growth in the Maintenance segment, concerns persist regarding weaker segments like Car Wash and PC&G, impacting overall margins. The bullish part of me expects margins to improve driven by strategic closures of stores, maturation of recently opened store locations, and focused initiatives by the new COO. However, I recommend investors be cautious and wait for clearer evidence of margin improvement before turning bullish.

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