ARK RESTAURANTS (ARKR) – UPDATE – A “SMALL CAP” WITH AN UNUSUALLY ATTRACTIVE REWARD/RISK RATIO – Business continues to improve in spite of significant headwinds in New York City and Washington, DC.
On February 14th, Ark Restaurants reported 1Q’22 (ending 12/31) results and management provided further “color” on the conference call. Our previous articles describing more completely the outlook for ARKR can be accessed by way of the SEARCH function on our Home Page. In this update we will review what we believe are the most important takeaways from the formal corporate release as well as highlights of the conference call.
We have followed ARKR since it came pubic in the mid 1980s operating with a few large-scale dinner houses in NYC (e.g., 500 seat “America” on 18th Street) catering to “yuppies”. There was often a “story” and the Company has been consistently profitable, though not on a straight-line upward path. For a combination of reasons, the publicly owned stock was hardly ever embraced. The lack of a “cookie cutter” brand with visible “white space”, operating results that proved to be inconsistent, and the Company’s ability to pursue growth initiatives without fresh capital from the public resulted in a lack of “coverage” by research analysts and statistical undervaluation of the stock. There has also been a limited amount of liquidity in ARKR since founder and CEO, Michael Weinstein, has always owned a practical controlling interest (27%) and outside public investors, with a long-term confidence in the Company, do not often trade.
An inflection point could well be at hand. The balance sheet is the strongest in many years, easily capable of supporting the contemplated growth. The current base of cash flow generation (in spite of the Covid’s remaining drag in NYC and DC) seems secure and there is a growth strategy that is more predictable (though not quarter by quarter) with an adjacent opportunity to build shareholder value through real estate ownership. ARKR stock is statistically cheap based on trailing results alone, on top of which are (1) recovery of sales in NYC and DC (2) more growth in the southeast (3) long term participation in Las Vegas, which is booming again and (4) a material “kicker” by way of Ark’s ownership in The Meadowlands gaming venue. With an Enterprise Value only 5.6x/9.6x times trailing twelve months EBITDA (without/with capitalized leases), there seem to be a lot of ways to win with ARKR.
The December Quarter – Total Revenue Above 2019 Levels
In spite of revenue in New York being 27% below 1Q99 and Washington D.C. revenue being lower by 19%, ARKR reported an 8% increase over 1Q99. ARKR’s strategy of diversifying away from New York and Washington DC by acquiring restaurants in Florida and Alabama continues to pay off. Importantly, Alabama (+26%), Las Vegas (+12%) and Florida (+109%, aided by acquisition) now account for nearly 70% of the company’s revenue, which is up substantially from 53% in 2019. We do not believe investors are giving the company enough credit for reducing its exposure to the northeast (25% in ‘22 vs. 36% in ’19).
Even though New York and Washington DC make up a small percentage of the company’s revenue, a closer look at what is going on in New York and D.C. suggest that the back half of 2022 is going to be a very strong year for those two city segments. If revenue just returns to normal levels in restaurants like Bryant Park and Sequoia, there will be a significant uplift in revenue ($2M-$3M). CEO Michael Weinstein highlighted how much revenue has been lost due to the impact of the epidemic and the magnitude of the potential rebound.
CEO Weinstein, on the Conference Call:
“I mean, we do $800,000 a week at Bryant Park in the summer and good weeks. That drops down to 120,000, 140,000 in the winter when all the outdoor areas are closed. This year, we weren’t doing $120,000, $130,000 a week. We were doing $40,000 because of Covid, because there’s no one in the office buildings to have lunch, to walk across the street and have lunch…. The same thing could be said at Sequoia in Washington, D.C. Sequoia in Washington, D.C. has $400,000 weeks. Right now, they’re having $40,000 week…… So, we think that when we get into especially the September quarter and the first quarter of 2023, which saw this — the calendar December quarter that the event schedule bookings are going to be enormous.”
As indicated, the return of high margin events in both New York and Washington D.C., post Covid will provide a substantial lift to revenue and cash flow. In our attempt to interpret Weinstein’s use of “enormous”: In the most recent 10Q, the Company disclosed the amount of catering /event revenue it recognized in the quarter. As highlighted in the table below, catering/event revenue in 1Q22 was approximately 57% below 1Q20. For the FY21, the company recognized $3.24M compared to $7.36M in FY20 and $13.8M in FY19. Almost 100% of this revenue comes from the Bryant Park, Robert, and Sequoia restaurants. We believe that in 1Q23 the company could realize between $4M-$5M in catering revenue (30-60% YOY improvement). On the negative side, Clyde’s, which is now closed, did generate a modest amount of events business ($200K-$400K) which will not return.
Cost of Goods – Still Volatile
Food and beverage costs increased 340bps (28.5% vs. 25.1% or $1.5M) as a percentage of revenue compared to 2019. ARKR was able to offset some of that increase with lower payroll costs, which were 240bps lower than 2019 (32.4% vs. 34.8% or $800K). There are several dynamics going on here that investors should understand.
The increase in F&B costs as a percentage of revenue is due to two factors. The first factor is the rapid rise in seafood costs that we discussed in our last report. On the conference call, management stated that it is starting to see a plateau in these costs. “While we do not expect the company to return to the 25-26% range in terms of food costs as a percentage of revenue, we do believe we are nearing peak margin compression on food costs.” However, any improvement in food costs is mostly likely to come from a decline in food prices and not menu price increases. The company is carrying over $1M in excess inventory in an attempt to manage these costs and we do think that some of the $1.5M in additional costs from higher prices can be reduced in future quarters.
The second factor contributing to the compression of F&B margins is the reluctance of management to take large enough price increases to fully offset the higher costs, in the interest of maintaining customer loyalty. After listening to numerous conference calls of other restaurant chains, we believe ARKR has been less aggressive than many other operators and we respect the long-term viewpoint. Our quotes below demonstrate the general philosophy as well as the sensitivity to the customer base of each individual location.
Per CEO Weinstein:
“As I have been in touch with all our managers, we’re not just raising prices because we think we can because everybody else is doing so and customers could be accepting it. What we’ve been looking at is, what is your customer makeup? So, for instance, at a Blue Moon in Florida, that’s a very high-end restaurant, entrees high $30 to low $40. There, we’ve been able to raise prices because there’s no customer that we’re going to get a backlash from…But when you get to JB’s, we have — or Rustic, we have a very mixed demographic. And you just can’t raise prices as aggressively because a portion of your customer base just can’t afford the increases. So there, we have to be more careful……. We’re also very concerned about the future in terms of as things get normal, cross our fingers, we hope they get normal. When there are other entertainment opportunities for disposable income, will people all of a sudden look at restaurant prices and say, ‘This is crazy’ because honestly, they are crazy in many instances. So, we’re increasing prices modestly…. This supply chain disruption stuff is not over. I mentioned to people a couple of months ago, there were 3 or 4 days in Southern Florida where you couldn’t get French fries because they can’t find truck drivers to deliver them. It’s crazy.”
Labor Costs – Manageable
There are also several factors impacting labor, which could offset each other and allow the recent leverage of labor costs to continue. While ARKR is understaffed in many locations, including Las Vegas, the company is actually overstaffed relative to the sales volume in New York and Washington D.C. This results in an interesting dynamic. The company is paying overtime in order to keep staff in some locations, while in others it is paying staff to retain them, even though unit volumes do not support their staffing levels.
Per CEO Weinstein:
“I got a call yesterday from JB’s that they got to give increases to some of our line cooks because they’re being poached by the restaurant next door to us. Not 3 miles away, next door. They’ve been offered $3 an hour more. They’re long-term employees, but $3 an hour more, another $120 a week in their pocket plus some overtime is significant to them. If they leave, we have no one else…. There’s some 6 million square feet of office buildings facing Bryant Park. They’re empty. So, we’re doing $40,000. Do we cut payroll? No, can’t cut payroll because if we tell people you’re on furlough, they go get another job, and we never see them again. And we can’t replace them. But they’re working too hard. They’re exhausted. And when I say exhausted, I really mean exhausted…. The same thing could be said at Sequoia in Washington, D.C. Sequoia in Washington, D.C. has $400,000 weeks. Right now, they’re having $40,000 weeks. Again, with full employment. We can’t afford to lose anybody.”
If labor markets loosen up, the company may be able to find additional staff, which could reduce the dependency on expensive overtime pay. In addition, as business returns to normal in New York and Washington D.C., we would expect to see significant operating leverage as the sales normalize in the overstaffed restaurants.
Las Vegas Lease Renewal Update
There was little news on the lease negotiations that are occurring on the Las Vegas properties. As a reminder, these leases expire in early 2023. Management remained confident that a deal would get done. As of the call, the finalized lease documents have not been delivered. While the company will need to spend a couple of million dollars on improvements, management believes the strength of the Las Vegas market in terms of pricing and volume will offset the higher lease costs and be fairly neutral to operating cash flow. In spite of virtually no conventions or conferences, Las Vegas revenue is 12% above 2019 levels.
The Balance Sheet – Strong and Flexible
We have covered the potential for sale leaseback opportunities using the four owned properties in previous reports. On this call, CEO Weinstein once again highlighted the potential value created by a sale leaseback transaction.
Per CEO Weinstein:
“We paid $7.5 million for a restaurant. At the time, we figured it was making $1.5 million a year. So 5x, but it came with the land, and the land was appraised at $4 million. If you look at Rustic and you said, “Hey, I’m prepared to give up $1 million of cash flow to rent.” In this interest rate environment, with an Ark guarantee, where we feel very, very comfortable guaranteeing that transaction, I still think you can get $10 million. If interest rates go higher, maybe you get a little bit less. Without an Ark guarantee, you’re probably getting $7.5 million, $7 million, $7.5 million for it. If I syndicated and we’ve done syndications before with our Hollywood and Tampa Hard Rock deals, we syndicated those. That same group, which has gotten enormous returns, would be interested in doing that for probably an 8% return. So maybe you get 12.5x or $1 million. So, I would say conservatively on the pieces of property we own, which are the 2 Alabama properties and the Rustic and the Shuckers property, those 4 properties, probably $25 million right now, give or take a few dollars based upon how you go about structuring the deal, whether with third-party sale leasebacks, syndicating it ourselves. Yes, I think $25 million is pretty easily achievable goal.”
What is important for investors to keep in mind is that a sale leaseback transaction is just another form of financing. The company is currently flush with cash (over $20M in the bank with $2M-$3M in tax refunds due, $28M in debt, plus substantial cash flow). Therefore, we think that ARKR management would only utilize this option if an attractive acquisition or acquisitions were available. However, it does highlight the hidden value of the land and the optionality the company has to enhance shareholder value.
Meadowlands, Steady as She Goes
There is nothing new to report on the status of a casino at the Meadowlands since our last report. At the current valuation, we believe investors are getting a free option on any potential monetization of ARKR’s 8% investment. However, there have a couple of relevant pieces of information to give investors a sense for how much a new Meadowland casino would cost.
Wynn Resorts recently announced it entered into a definitive agreement to sell all the land and real estate assets of its Encore Boston Harbor casino to Realty Income for $1.70B in cash. This represents a 5.9% cap rate. It opened on June 23, 2019, at a total cost of $2.6 billion. MGM Resorts stated on their call that they would be looking to spend somewhere between $1.2B-$1.3B for phase one of a casino located near New York City. The company has 97 acres there.
Regarding Ark’s participation in the Meadowlands, as we described it in our previous report.
Meadowland continues to dominate the sports betting market in New Jersey. 40% of online betting websites and 50% of on-premise betting is captured by the Meadowlands. The handle is around $500M, with a 6% hold (higher than the 5% expected long-term average). CEO Weinstein disclosed that the partnership had $15M in EBITDA, meaning that the partnership is cash flow positive and will not require any additional investments by ARKR. The company expects to receive a cash distribution to offset the reportable taxes from the partnership. On January 8th New York legalized online sports betting on January 8th and industry experts have estimated as much as 25% to 30% of sports bets in New Jersey are placed by New York residents. We expect to see an initial decline in betting at the Meadowlands, but New Jersey will most likely remain the second largest sports betting market in the county.
The next benchmark will be the issuance of three full gaming licenses for downstate casinos in New York City. Lawmakers are already pushing to start the process to award the three licenses by the end of the year. Key politicians to watch are Gary Pretlow, chairman of the state Assembly Committee on Gaming and Wagering and Joe Addabbo, the chair of the Senate gambling committee. According to CEO, Weinstein: “If that is advanced forward, we may get some action by the New Jersey legislature to progress forward the consideration of casino license in the northern part of the state, particularly the Meadowlands. Honestly, what I think happens, if there is a casino license issued, I think it takes about 5 minutes for Hard Rock to come to us and say, how much do you want for your position? “
Is impossible to predict the timing or the magnitude of Ark’s opportunity to monetize their interest in the Meadowlands but we believe it would be material for Ark’s shareholders. If you press us for a number, we would only say “tens of millions of dollars”. (Bitcoins not accepted!)
CONCLUSION – provided at beginning of this article