RED ROBIN GOURMET BURGERS – UPDATED WRITE-UP

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Conclusion 

We believe a large portion of the distress that Red Robin is enduring relates to the generally unforgiving macro-environment that includes (1) the market share battle within a still over-stored industry scene and (2) cost escalation. Management is experienced and, in our opinion, accurately defining the problems. Problem is that a major “re-invention” of the Red Robin concept may be necessary if the Company is going to truly differentiate their commodity. At this price, it may appear that all the trouble is priced in. There are still hundreds of millions of private equity dollars still looking for a home. Activist investors, private or public could rise to the bait at what looks like a bargain multiple of EBITDA, especially when there are apparently hundreds of juicy stores that could be franchised. Unfortunately, the store level margins have been seriously compromised and lots of work has to be done to reinvigorate the chain. Roark and Inspire Brands are living through that process with Buffalo Wild Wings, and will have spent lots of time and money spent (out of public view) before the reinvention is unveiled. For my investment dollars, I don’t relish buying into a chain that is well run, but suffering. Even if most of the influences are out of their control, those factors are unlikely to abate any time soon. A private equity investor could afford the time and money to improve the situation. In the absence of that progress, private equity players are often able to restructure the balance sheet and “get out whole”. An investor in the public company will not have those alternatives.

RRGB: Company Overview

 Source of Revenues

Red Robin Gourmet Burgers, Inc. is a casual dining restaurant chain, as of Q3’18 operating and franchising 574 restaurants (485 company, 89 franchised) with system-wide revenues of $1.5 billion in 39 US states and 2 Canadian provinces.

Menu and Dayparts

The Company lays claim to being “THE Burger Authority”, with a range of burgers from its core “Tavern” burger, priced at $6.99 which includes its signature “Bottomless Fries” to their “Finest” gourmet burgers, mostly offered as LTO’s at prices up to $14.99It also offers burgers made from chicken, fish, turkey, and vegetables. The menu features a variety of buns, toppings, sides (including some bottomless ones such as broccoli) and bottomless (non-alcohol) beverage refills.  Alcohol is served and features an extensive selection of beers, while a kids menu is a foundation of the company’s efforts to appeal to families.

Operational Model & Unit Level Economics 

 Of $1.37B T12M revenues to Q3’18, nearly all (98.4%) is generated by the company stores, while the balance consists of royalties and fees. Contrary to the current re-franchising trend in the industry, RRGB went the other way, acquiring 50 franchised units from 2014 through 2016, none since. While franchising of company stores is generally popular these days, in an effort to go “asset light” and free up capital, the previously announced plan to franchise about 100 locations has not generated results. While management says that potential buyers were trying to buy stores unrealistically cheap, it seems likely to us that the recent sales and traffic trends have significantly undermined the appetite (and valuation levels) of franchise partners.

Red Robin units are generally leased and located on in malls (17%) or standalone (75%) or in-line retail & other sites (8%).  Store size ranges from 4.5K to 5.8K square feet and in the trailing twelve months ending Q3’18 generated AUV’s of $2.8M and store level EBITDA margins of 19.3%. Several years ago the company  stopped opening stores in malls as performance deteriorated due to increasing occupancy costs, the drop in mall traffic and because the locations were not suitable for off-premise programs.  In 2016 mall and off-mall AUV’s were $2,827K and $2,998K, respectively and store-level EBITDA margins were 14.6% and 31.2%, respectively.  The company no doubt continues to analyze mall sites in their effort to most efficiently exit under-performing locations.

Though few new stores are opening in the near-term play (8 have opened through Q3’18, and no more are currently planned), as of the end of 2017 a new store required a cash outlay of $2.2M-$2.6M (including pre-opening expense).  At the unit investment midpoint and at the historical off-mall performance levels, we estimate the cash-on-cash return would have been about 26.0%.  Obviously, the returns would be lower today, with generally lower sales and operating margins. The stores are in good physical condition because the company completed a four-year remodeling program in 2016.  The remodels feature new signage, technology, a greater separation of the bar and family areas.  The price tag for the remodels was about $400K, which reportedly generated a sales lift of 3%-5%. If the sales lift is from a midpoint 4% of $2.9M (a couple of years ago), or $116,000, and 50% flows through to store level cash flow, $58,000 incremental cash flow returned 14.5% for a remodeled store. Right now the stated emphasis is on improving current four wall economics and begin development of a new prototype.

History and Current Company Strategy

In the nearly 5 years between a performance low in Q4’10 and Q3’15, growth in sales and earnings steadily improved. Revenues grew at a 7.9% annual pace driven by the 6.6% annual growth of new and acquired company units (including the net gain from store sales vs royalties) and consistently positive comps (average 2.7%).  Below the top line, EBITDA doubled with the recovery,  lifting RRGB’s operational metrics,  reaching near parity with the performance of its casual dining peers with less than 40% franchised:  Restaurant EBITDA margins expanded by 460bps to 21.6% (vs 18.2% peer average); Operating margins expanded by 340bps to 4.5% (vs 5.3% peer avg.), and ROIC expanded by 625bps to 7.6% (vs 10.9% peer avg.).  In 2015 the company embarked on its “Red Squared” initiative to build on the momentum of the prior 5 years, with a goal of doubling EBITDA again by 2020. Other goals of the program included completing the remodeling of its stores, mentioned above; plus improved customer service: increased seating turns & less unproductive seating; improvements in ordering & check wait times: expansion of the take-out, catering and delivery business, technology upgrades; and finally, a step up in new unit growth and stock buybacks.

Unfortunately, Q3’15 proved to be the high point of RRGB’s 5 years of progress, which was interrupted by the macro environment afflicting the entire industry, but also exposed operational missteps and oversights masked by the improving financials. Since then comps turned increasingly negative, driven by lower traffic, even if outperforming competitors’ traffic. Not surprisingly, margins and profitability plunged, leading to turnover at the top.  In June 2016 the CFO resigned and 2 months later, coincident with the Q2’16 announcement, CEO Steven Carley resigned. Denny Marie Post, President of RRGB since February 2016, was appointed as his successor.  Ms. Post had joined RRGB in 2011 as SVP and Chief Marketing Officer, was promoted to EVP Chief Concept Officer in 2015, and then President in Feb.’16. Guy Constant was recruited as CFO and Carin Stutz was promoted to COO. Most recently, in the wake of Carin Stutz leaving, Guy Constant became COO, now replaced as CFO by Lynn Schweinfurth, previously CFO at Fiesta Restaurant Group (FRGI).

No one can accuse Ms. Post of glossing over the challenging state of casual dining.  At RRGB’s May, 2017 analyst day, she flatly predicted it will never return to its former glory when the restaurants were a good place to eat when guests were doing something else, like shopping or seeing a movie.  Now, take-out, delivery or meals available at the grocery store are more suitable for today’s lifestyles.  Instead, customers are shopping less in the malls or less frequently heading out for a movie in favor of shopping online shopping or streaming entertainment at home.  Against this gloomy outlook she and her team have endeavored to pare Red Robin down to its core equities: Good value for gourmet burgers, bottomless fries and brews, which she feels will always be relevant. The program, as outlined twenty months ago, continues to includes:

  • The company will concentrate on core value burger line up rather than LTO’s centered on premium burgers.  It will concentrate on improving performance within the existing fleet of stores, rather than building new units. It will expand off-premise, not only via its current on-line order and pick-up business but also through catering and delivery. In fact, off-premise sales have grown from 5.7% of sales to 7.6% to 10.1% of sales in Q3’16, Q3’17, and Q3’18.
  • It aims to increase speed of service and improve guest experience.  These initiatives together with menu simplification and operational streamlining, will drive store-level margin expansion, according to its plan.
  • A new prototype is being developed, for infill of existing territories, new territories, and delivery-only).  The company has planned to jointly develop markets with franchisees, but this strategy is currently on hold.
  • Continue a returns-based capital allocation discipline.

Similar to its competitors, much of the strategy boils down to basic blocking and tackling for which management has set itself measurable objectives and milestones.  As described above, the company has slowed company unit growth from 16 units in 2017 to only 8 through Q3’18 (with 3 closed).  While traffic trends over the last two years has generally outperformed competitors (reversed in Q3’18 with a negative 1.5%), nominal comps, as shown in our table above, have suffered, which, combined with cost pressures, have pressured store level margins.

Shareholder Returns   From mid-2015, when RRGB peaked over $90/share, the stock fell to around $40 in late 2016, rallied to over $70 in mid-2017, declined to under $50 in late 2017, rallied to about $65 in mid 2018 and has declined to the current level as results have disappointed investors. Longer term, the original IPO was in 2002, at $12.00 per share. The stock had a run to over $60 by late, 2005, declined to about $10 at the market low in 2009, had a great run to the high over $90 in mid-2015. Safe to say that long term shareholders have had more than their share of excitement. There is no dividend.

RRGB: Recent Developments (As of Q3’18) (Per Q3 release and Conference Call)

Both GAAP and Adjusted Earnings declined, as a result of lower sales (comps down 3.4%) and lower traffic (down 1.9%). Costs were well contained with Cost of Sales flat at 23.8% Labor Costs also flat at 35.3%. The sales weakness was a result of dine-in traffic, to some extent the result of an advertising shift to heavier weight later in the year.  As indicated above, off premise sales continued higher, up 22.7% YTY, now 10.1% of total food and beverage sales. Management pointed out that restaurant teams are being retrained to provide a higher level of peak-hour service, and pilot locations have improved ticket and wait times. Restaurant EBITDA margin was 16.8% in Q3 vs. 18.6% a year earlier. Flat CGS was achieved by a decrease in ground beef cost and reductions in food waste. Flat labor expense was a result of improvements in labor productivity which offset higher average wage rates. The EBITDA reduction was a result of Other Operating Costs higher by 120 bp (restaurant technology, equipment repairs and maintenance, third-party delivery fees, utility costs) and Occupancy Costs higher by 60 bp (real estate and property taxes). G&A was 5.7% of sales, 40 bp lower YTY, due to decreases in salaries and team member benefits as a result of the reorganization in Q1’18, as well as lower incentive and equity compensation. Selling expenses were 4.1% vs. 5.0% benefiting from the media shift discussed above. Pre-opening expenses were only $0.4M vs. $1.5M due to fewer openings. There were “reorganization costs” of $0.5M vs. nothing a year earlier. There was a tax benefit of $2.2M vs. normal taxes of $0.7M in ’17. Two company restaurants opened in Q3 (8 YTD), and a franchisee opened one (total of 3 YTD).

The Company pointed out that, though comps have been increasingly negative through Q3’18, the two year traffic comparison continues to beat the competition, by a stacked 2.5% in Q3. Also, there has continued to be an improvement in labor productivity, still 8% in Q3, down a bit from 10.9% in Q1 and 11.8% in Q2. On the conference call, there was lots of discussion of marketing direction and initiatives regarding menu mix. Management clearly hopes/believes that the retraining of store level employees will improve service levels, both in terms of table turns as well as the dining experience and satisfaction. Discounting is being viewed as a tool, not to be overused, to be used along with other operating initiatives. The Red Robin Loyalty program now has 8.5M members, and we can attest to the frequent communication with that base of customers, and the deals in the last month or so have been not as frequent or aggressive as previously.

Conclusion: Provided at the beginning of this article

 

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