Foreword: The restaurant industry, admittedly a minefield for those who don’t do their homework, provides a unique transparency for those of us that enjoy leaving our ivory towers. We could provide a raft of examples where our “legwork” has paid off, from the problems at Boston Market to the success of Panera Bread. This article suggests a number of “pregnant” situations, where fundamental inflection points may be at hand. At the same time the valuations can attract private equity investors, who have longer timeframes than the general public, and lots of creative ways to work themselves out of a situation that does not develop in an ideal fashion. Though we are obviously not in the private equity business, we can use their activities to benefit our own investment results.
Inexpensive Valuations Deserve a Hard Look
We maintain current coverage on over sixty publicly held restaurant/franchising companies and we encourage our readers to avail themselves of our “one stop shop”. We have excerpted from our “Company Detailed Analyses” the information on the table just below. Going private transactions over the last ten years (as shown by the table at the end of this article) have taken place at anywhere from 5x-20x TTM EBITDA. While the mean and media valuations have been around 10X, most non-franchised acquisitions have taken place in the 7-10X range, with franchisors trading at more like 15-20x. With interest rates now the highest in fifteen years, we believe that acquisitions will take place at the lower end of those ranges. We have therefore pinpointed those situations that currently trade below those ranges, so that private equity investors, if they show up, will provide us with a material short term profit as they pursue their longer time goals.
Readers can see from our “step aside commentary” why we have eliminated some candidates, though obviously ours is not “the last word”. The situations remaining are BJ’s, Bloomin’ Brands, Brinker, Dave & Buster’s, Dine Brands, El Pollo Loco, Jack in the Box, Noodles, Red Robin & The One Group. We will summarize the relevant points of each, before concluding which situations seem to have the most significant and probable reward possibilities.
USEFUL INGREDIENTS: THE POTENTIAL FOR MARGIN IMPROVEMENT, ACTIVIST PRESENCE AND/OR LOW INSIDER OWNERSHIP, A (CORRECTABLE) HISTORY OF POOR CAPITAL ALLOCATION,
Potential for Margin Improvement
In this report we will include a history of margin trends in the most important categories including food, labor, occupancy/other and G&A costs. The stocks in this report generally have margins that are 200-400bps below their peak margins. Peak margins occurred in the 2014-2015 fiscal years. Food cost margins are probably the easiest to restore to peak levels because of the company’s ability to change recipes, portion sizes, mix and pricing. Labor costs are second because management can adjust scheduling and efficiency. Of course, rising wages will continue to be a problem in the future. Occupancy and other operating costs are the most difficult to reduce because of mandatory obligations such as rent, taxes and utilities which are out of management’s control. The best way to leverage costs and increase margins is increasing traffic, which is an industry wide challenge.
Presence of an activist + Low Insider Ownership
Some companies on our list already have activists that have filed 13Ds or have taken relatively large ownership stakes. Noodles and Bloomin’s Brands are two examples. We think in these cases, where there is smoke there is fire, and these two companies could trade at significantly higher valuations if the activist proposals are adopted or the companies are sold. With the exception of STKS (with the founder owning 14%), the stocks in this report have active operational ownership levels in the 1-4% level, too small to have the ability to block any takeover votes.
Poor Capital Allocation
Another common theme amongst activist and takeover campaigns is the focus on management’s poor capital allocation decisions over time. The worst allocations of capital tend to be:
- Continuing to grow the store base even as unit economics are deteriorating, thus destroying shareholder value. Companies that are growing rapidly usually outspend their cash flow from operations, which puts pressure on the balance sheet as the companies lever up to fund growth. Acknowledged high quality industry participants, such as Darden, Texas Roadhouse and Chipotle generate free cash after capital expenditures.
- Ill-timed repurchases of shares of the company’s stock. Brinker and Bloomin’ Brands have spent 50% of their current market caps on buybacks, yet the stock prices are no higher than they were in 2014.
- Instead of developing a new brand internally (which requires less capital expenditures up front), many companies acquire an existing brand to accelerate their unit growth. Many of these companies are typically franchise companies, which is not the main focus of this report.
INVESTMENT CANDIDATES – IN THE ORDER PRESENTED WITHIN OUR TABLE ABOVE
BJ’s Restaurants (BJRI)
There is room for improvement of operating margins. Restaurant margin, through June’23 was 690 bp below the 2015 peak. All expense items: CGS, Labor, Other Operating, were at least 150 bp higher. Capex has exceeded cash flow from operations over the last several years. On the positive side, SG&A is a modest 5.3% of Revenues and traffic has been firming lately. T Rowe Price owns 15% of shares. In Mid-’20 T. Rowe Price and Ron Shaich’s Act III Holdings purchased $70M of stock. It is not clear whether Shaich or his representative play any current role, though T. Rowe Price accounts currently own 15% of BJRI’s equity. The Table below shows the stock buybacks from 2015 to 2020 and the stock issuance in 2020 and 2021.
Bloomin’ Brands (BLMN)
Starboard Value has taken a 10% ownership stake and issued a proposal to improvement margins and operating performance that can be found here. Potential to spin or sell Brazilian units. Restaurant operating margins have been flat since 2015 and Traffic declines, compared to gains of peers (Longhorn Steakhouse and Texas Roadhouse). Since 2015, stock buybacks equal to 50% of market capitalization (80% of total is pre-2020). Peers trade at TWICE the EV/EBITDA (TXRH, DRI) multiple of BLMN. Starboard Value helped turn around Darden several years ago. The firm hopes to achieve similar success with Bloomin’ Brands. We encourage readers to look at the presentation and decide for themselves if Starboard’s plan will be successful. The stock is certainly inexpensive by any measure.
Brinker International, Inc. (EAT)
The institutional ownership consists mostly of passive/non-activist holders. The annual cash flow from operations is $100M lower than the $400M peak in 2015 and capex has been 25% higher than CFO. EAT has bought back 50% of current market cap since 2015 while the dividend was suspended in 2019. A new CEO was installed last year and the company recently hosted an investor day which can be found here, similar to an activist presentation to fix the Company. Brinker’s restaurant margins are 500bps below their peak levels, which means there is substantial room for improvement by an activist. Cash from operations is $100M below the $400M peak in 2015. Brinker has been a leveraged buyout candidate for years now, buying back lots of stock ($1.3B since 2015), constantly trying new concepts (Wings to Go) and menu changes. Brinker’s main brand, Chili’s, is a well-established name in a very tough segment of the casual dining space. We were privileged to know Norman Brinker, the “Babe Ruth” of full-service casual dining.
Dave & Busters (PLAY)
Hill Path Capital owns 17% vs. 2% by management and PLAY represents one of their three top holdings, 14% of their capital, so they are not a casual holder. Since 2015, Cap Ex spend was $500M below cash flow from operations. Investors may be unsure that the $820M acquisition of Main Event in 2022 will be successful, which could prove to be a “bet the Company” deal, since most current top leadership team came from Main Event. Debt has increased by almost $1B since 2015. $674M in stock buybacks partially offset by $183M in equity issuance in 2020. Margins are 200bps below peak, labor actually better by 50bps. Operating margin of 20.3% relatively high for potential acquisition candidate. PLAY was our “Stock of the Month” recommendation in September at 20% below the current level.
Dine Brands Global (DIN)
This pure franchise model has shown no growth in recent years. Total domestic Applebee’s units have declined by about 300 units since 2016. IHOP has grown minimally. In spite of a 20% increase in AWS at Applebee’s since 2016, the decline in total units at the chain has resulted in a $9M decline in segment gross profit dollars. IHOP AWS and gross profit dollars are flat since 2016. Acquisition of Fuzzy’s is intended to be the growth vehicle but total Fuzzy’s units account for only 4% of total restaurants. This Company has been over $1B in debt for over a decade, ever since IHOP purchased Applebee’s. They recently extended the debt maturity on 2019 4.194% Notes ($653M) with new 2023 7.824% ($500M) notes, obviously reducing cash flow. The Fuzzy Taco concept appears to be a good brand, but very small relative to Dine’s other chains fast casual oriented rather than full service. There are no apparent activist investors involved here.
El Pollo Loco (LOCO)
CEO, Larry Roberts, recently retired. Sardar Biglari has taken a 13% stake. He also owns about 9% of Cracker Barrel and 6% of Jack in the Box. Management owns 15%. El Pollo Loco, long established in California has consistently had limited success elsewhere. In Spite of a 460bps improvement in food costs, operating margin is still 640bps below 2015. G&A is still on the high side at 8.3% of revenue. It is interesting that JACK bought previously publicly held Del Taco at about 7.6x trailing EBITDA, which doesn’t speak too well of the upside at LOCO.
Jack in the Box (JACK)
The Company has recently embarked on a renewed growth strategy. Since launching their new development program in 2021, 90 agreements have been signed, representing the potential for 389 Jack in the Box restaurants. Especially encouraging have been initial results in Salt Lake City and Louisville, both new markets. Sardar Biglari owns 6% with no apparent other activist institutional investors. JACK acquired Del Taco in 2021 for $581M and have unit growth plans there as well. Capex has exceeded CFO by nearly $1.3B, resulting in an $800M increase is debt. They have sold $110M worth of restaurants and land and since 2015 company have bought back $1.6B worth of stock. Current market cap is $1.4B.
Activists are steadily increasing ownership. Within three firms there is now over 30% of shares outstanding, with Mill Road’s 16% represented on the Board. There is a new 8% holder in just the last quarter. The CEO recently left, replaced on an interim basis by Board member, Drew Madsen, ex-President of Panera Bread, before that President and COO during his fifteen years at Darden. Traffic and earnings have been “light”, though stabilized in Q3. Store level economics have room to improve (still 410 bp below 2015, with CGS better by 180 bp but labor and operating costs higher) and unit level expansion, previously targeted at 10% annually has been slowed a bit. G&A has been running at 10%, so could be improved somewhat. Since 2015, capex has exceeded CFO by $50M. No doubt the activists and Board will now take a more proactive approach to build traffic, improve store level margins and reduce corporate G&A. At the beginning of 2023, guidance was for $45-50M in EBITDA, most recently reduced by $10M. We recommended NDLS as our “Stock of the Month” in August, at a price about 5% higher than its current level. At only about 5x TTM Adjusted EBITDA, there is substantial upside from either fundamental improvement or a takeover bid.
Red Robin Gourmet Burger (RRGB)
Fairly new CEO, G.J. Hart, has excellent credentials based on his former leadership roles, most recently with Torchy Tacos, before that Texas Roadhouse. Long-term investor, Archon Capital, owns 12% and Soviero Capital owns 7%. The turnaround plan, including a revamp of the menu, improved service approach (including an “investment” in labor, 430 bp higher than in 2015) and weaning from heavy couponing, is starting to show promise. In spite of flat food costs, restaurant margins are nearly 1000bps off their peak, hopefully to be regained as traffic and AUVs improve. G&A has been reduced from 11.7% of revenue to 6.7%, so there is not much more to be gained on that expense line. Overall, Hart & Co. are checking a lot of boxes within a well conceived turnaround plan. At around 4x TTM, with at least two institutions already involved, a takeover bid could surface any time, especially if the fundamentals continue to be promising. While it would cap the upside for public investors, the price would be substantially above the current level.
The ONE Group Hospitality (STKS)
Founder and Executive Chairman of the Board, Jonathan Segal, owns about 14% of the stock. Kanen Wealth Management, not represented on the Board, also owns about 14% of the stock. President and CEO, Manny Hilario owns about 4%. Their STK brand generates one of the industry’s highest unit level cash on cash returns, over 50%, and their Kona Grill brand (with more like a 30-35% cash on cash unit return) also has a long runway for growth. The valuation is obviously inexpensive at about 5x TTM EBITDA, but projections for calendar ’23 have been scaled back with slightly lower SSS at STK (from ridiculously high levels coming out of Covid) and a delay in opening of a number of units. With an aggressive expansion plan, capex, increasing from $14M to $50M, has exceeded operating cash flow by 50%. Debt has also grown, from $10M to $71M, partially to fund stock buybacks, modest so far but potentially much larger at the current valuation. The outstanding results at STK, as well as the improvements at their purchased Kona Grill chain coming out Covid, have made comparisons difficult. In addition, sluggish industry wide traffic trends (especially relevant to the $125+ average ticket at STK) and opening delays have taken a toll in calendar ’23. There is every indication that ’24 will resurrect the growth of EBITDA, to over $50M annually and provide investors with more confidence. Worst case here, if STKS’ valuation does not improve, is a major stock buyback and/or implementation of a material cash dividend. Though we have zero insight in this regard, the possibility also exists that founder, Jonathan Segal could seek a liquidity event that would also provide a large profit to public investors at the current level.
Based on the considerations provided above, we suggest a portfolio including:
Bloomin’ Brands (BLMN-$24.01)
Noodles (NDLS – $3.19) – down 5% since our “Stock of the Month” in August
Dave & Buster’s (PLAY – $43.00) – up 20% since our “Stock of the Month” in September
Red Robin Gourmet Burgers (RRGB – $9.85)
could provide an attractive return on investment over the next 12-18 months.
“In the bullpen” are:
Jack in the Box (JACK – $77.40) -especially on a pullback from its recent 15% runup)
The One Group Hospitality (STKS – $4.91) – too inexpensive to ignore, in particular based on the very attractive store level returns and long runway for unit growth.