DEL FRISCO’S (DFRG) REPORTS Q1 – FUNDAMENTALS FOLLOWING BARTECA DEAL PLAYING OUT ON THE DOWNSIDE SO FAR

Back on 11/27/18 our report on DFRG (then trading at $6.95) concluded:

“For our money, we hesitate to be short DFRG, especially because of the takeover possibility, but the downside risk is too substantial for us to be comfortable on the long side.”

The brief summary of operations, leading up to that rationale was as follows: “ We started our work on DFRG with a positive bias, thinking that the worst was over, they manage three high margin brands, and the fourth (Del Frisco’s Grille) will not hurt. They are no longer distracted trying to turn around Sullivan’s. G&A efficiencies relating to the integration of the Barteca concepts should allow for substantial free cash flow, to be used for expansion of Del Frisco’s Double Eagle, bartaco, and Barcelona Wine Bar, all generating cash on cash returns of at least 40%.

“However: there has been substantial margin deterioration at Double Eagle and the extent and timing of margin recovery is uncertain, especially in a challenging competitive environment. Importantly, $297M of debt, with an interest rate around 9%, obviously uses up a lot of “free” cash flow. Also, while the two Barteca concepts are highly profitable, and optimistic expansion plans always look good on paper, it is always questionable whether new stores will perform as projected, and whether acquired store level (and supervisory) management can be retained and incentivized. We think it is, at the very least, a possibility that corporate cash flow improvements will not take place as quickly as projected. Store expansion plans would need to be adjusted, and the $100M of guided free cash flow in 2021 (we don’t know whether that number is for calendar 2021 or a run rate at the end of 2021) would not be realistic. Overall, we think DFRG from this price could work out well if operations improve as projected. Also, there are still hundreds of billions of dollars out there looking for a home, and three successful brands could be sufficiently seductive, even with the apparent risks. However, the debt burden could become critical if the operational improvement is delayed, and successful integration of newly acquired concepts has been a flawed assumption many times in the past.”

Current Conclusion

With Q4’18 and now Q1’19 “in the bank”, it’s the downside risk that is playing out fundamentally so far. The stock, since our last report, traded up 15% on optimism, and is now down about 15% below that original price.  The corporate progress projected last fall has been, at the least, delayed a bit, and $300M of debt with a high interest rate is a heavy burden on a multi-concept restaurant company of this size. Regarding the possibility of takeover by activist investors, already involved or not, we doubt it. Our observation, based on our personal involvement with private equity investors, is that they are very smart and very careful. They do extensive due diligence, prepared to spend seven figures in a deal of this size, hiring outside consultants including restaurant experts and forensic accounting firms. Every investment is a calculated risk but we suspect there are just too many obvious uncertainties within this situation.

Recent Developments

Adjusted earnings were a loss of $.10/sh. pretty much as expected. The GAAP loss was $0.55. Other headlines included: total comp sales up 1.3%, Adjusted EBITDA  was up 5% to $7.1M, but down 330 bp as a % of Revenues, Restaurant Level EBITDA up 57.9% to $22.7M due to the Barteca acquisition but down 70 bp to 18.9% of Revenues, “primarily due to the inefficiencies from new restaurant openings”. The Company further stated that “our 2018 openings and our latest four openings during the first quarter of 2019 are collectively off to strong starts…positioning these restaurants to hit their three year ROIC targets of 35%-40%” The Company added that the 21 non-comparable restaurants, 25% of the store base, had a 270 bp impact on store level EBITDA margins, down from 290 bp in Q4, especially Double Eagle and Bartaco, which had a 520 bp impact in each brand. Customer counts were down 0.6% overall, with Barcelona Wine bar’s traffic up 3.6%, bartaco traffic up 5.5%, Double Eagle down 1.5% (affected by cannibalization in Boston) and the Grille’s traffic was down 6.9%. G&A costs increased to 13.6% ($16.4M) from 10.6% ($7.8M)  YTY, “primarily related to the addition of Barcelona and bartaco and additional compensation costs related to …..anticipated growth…also $0.4M in non-recurring legal expenses and $0.4M of non-recurring corporate expenses….and $0.5M related to our annual General Manager’s conference.” Backing out the $1.3M of non-recurring items, G&A would have been $15.1M or 12.6% of Revenues, still up 200 bp.

Adjustments between the GAAP loss and the Adjusted loss totaled $14.9M, and included “consulting project costs of $4.5M, lease termination and closing costs of $2.9M, reorganization severance costs of $0.3M, non-recurring legal and corporate expenses of $0.4M and a change in tax benefit of $6.4M.

Overall, the Q1 report was close to expectations in terms of comp sales and traffic, but profitability at the store level and corporate level was below company and analyst expectations. There are long term efficiencies projected from consolidation of the Barteca concepts but apparently unexpected expenses have affected the cash flow so far. The Company has tried to maintain their long term guidance for 2021 through 2023, but the first quarter has not helped. Adjustments can be made in reported numbers, but you need  cash to open new stores, and “non-recurring” expenses eat into that capability. Adjusted EBITDA  was $7.1M in Q1, but that was after adding back $4.5M of “consulting project costs, about $1M of non-recurring expenses, $2.9M of lease  termination and closing costs, and $2.7M of pre-opening costs (which will recur, at least in part). Bottom line in terms of cash flow: the first quarter (even Adjusted) didn’t help get to the $58-66M of projected Adjusted cash flow from operations necessary in ’19 for capex and debt service. Moreover, you can’t open stores and service debt with Adjusted EBITDA. Further undermining the credibility here is that the newest units of Double Eagle, as well as bartaco are apparently bringing down their respective AUVs and margins.

Previous long term guidance, as summarized in our report back in November, went like this:

Management is looking out to 2021, targeting annual revenues of $700M and at least $100M in adjusted EBITDA (corporate), or 14.3% of sales. They expect to get there with 10-12% restaurant revenue growth, comp increases of 0-2%, maintaining strong store level margins, G&A cost leverage, adjusted EBITDA growth of at least 15%. They are also guiding to reducing net debt to 2.5-3.0 EBITDA by 2021, much more tolerable than today’s 7.8x ($297M divided by an adjusted $38M) in the most recent twelve months.

Our interpretation, at that point.

Since capex is expected to be $50-60M in ’19 to provide the new Double Eagles, Barcelonas, and bartaco, no Grilles, which would be 9.4%-11.2% of sales, based on our rough model above, some serious progress needs to be made with operating margins and G&A savings if the stores are to be built without more debt.  Depending on the timing of the improvement in store level profits and G&A, it is likely to be difficult to reduce debt, in 2019 at least. The alternative in terms of debt service, if the economy doesn’t cooperate or the margin improvement does not materialize, would be to cut back on the rate of expansion.

The New Guidance:

“By the end of fiscal 2023, we are targeting….at least $800M in consolidated revenues and $130M in adjusted EBITDA…..with consolidated revenue growth of at least 10%, total comp sales of 0-2% (the same), total net restaurant growth of 10-12% annually, maintaining strong EBITDA margins, G&A leverage, Adjusted EBITDA growth of at least 15%”

Our reaction to the new guidance:

It’s hard to argue with guidance that has been pushed out two more years. Perhaps it can be accomplished, but Q4’18 and Q1’19 don’t provide positive data points. We suggested, back in November’18 the possibility that cash flow would not increase as projected. So far that side of the equation is the one playing out.

Roger Lipton

P.S. Neither we nor our affiliates have any position in DFRG, long or short, though that could change at any time without notice.