Restaurant Finance Monitor
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Our interest in deficits and debt is not an academic exercise. Capital expended by any “organization”, be it an individual, family, business or country, to service debt reduces the ability to invest in more productive pursuits. About a decade ago, “This Time is Different”, written by respected economists, Reinhart and Rogoff, was published. Having studied centuries of business history, they concluded that statistics followed common sense expectations and real GDP growth is increasingly burdened when a country’s debt approaches 100% of GDP. (The USA is currently north of 120%.) A common pushback on this notion is that Japan’s debt at 250% of GDP has long been overcome, albeit with extreme monetary accommodation. In addition, Japan’s experience has been possible because, as opposed to the USA, Japanese consumers have a very high savings rate and Japan consistently runs trade surpluses. both of which are essential to carrying the excessive debt. We additionally suggest that the last chapter of “the financial follies of the 21st century” has yet to be written. Moving on, the imminent debt and interest rate crisis that we described here last month is evident in the US fiscal year that began October 1st. The deficit in the two months ending November 30th was $383B (annualizing to $2.3B) but $314B of that was in November (which annualized at $3.8T).  Interest cost alone, for the two months, is already annualizing to a $300B increase for the current fiscal year, and that will steadily increase as almost $1 trillion per month of old (to be refinanced) and new debt are issued. The US Debt, which stood at $33.167 trillion at September 30th, will approximate $34 trillion at 12/31/23, which annualizes to an increase of $2.7T. We expect the fiscal ’24 deficit to be at least $3.0 trillion, bringing the debt to over $36 trillion. For better or worse, bond ratings firm, Moody’s Investor Service, the second week of November put the US. Government’s credit rating on a negative outlook, raising the possibility of a downgrade.  They cited risks to the U.S. fiscal outlook, namely higher interest rates “without effective fiscal policy measures to reduce government spending or increase revenues”. (We don’t make this stuff up) All of this should inform you that interest rates will be hard pressed to stay down, that monetary ease will soon return to support a flagging economy, and that inflation well in excess of the Fed’s 2% target will continue to be a fact of life.

Beware of “value traps”. Many publicly held restaurant companies look inexpensive, but that’s just a starting point. The companies cited below may in fact present opportunity due not only to valuation, but also potential fundamental inflection points, and/or activist investor involvement. Privatizing transactions over the last ten years have taken place at anywhere from 5x-20x TTM EBITDA. Most company operated chains have been purchased 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. Our website article, on 12/5, narrowed our 60-name coverage list down to a final four, namely Bloomin’ Brands (BLMN – $25.20), Dave & Buster’s (PLAY – $46.34), Noodles (NDLS – $3.14) and Red Robin (RRGB – $10.70).

Highlights regarding BLMN, at about 5.0x TTM EBITDA: Starboard Value has a 10% ownership stake and issued a proposal to improve margins and operating performance.  Restaurant operating margins have been flat since 2015 with traffic declines, compared to better performance and twice the valuations at peers (Longhorn Steakhouse and Texas Roadhouse).  Since 2015, stock buybacks been equal to 50% of market capitalization.

Regarding PLAY, at about 5.6x TTM EBITDA: Hill Path Capital owns 17%. The $820M acquisition of Main Event in 2022 could prove to be a “bet the Company” deal, since most current top leadership team come from Main Event. Almost 20% of the capitalization will have been bought back this year. $500M of incremental EBITDA by late 2026 has been pinpointed.

Regarding NDLS, at 5.2x TTM EBITDA: Within three institutional investment firms are 30% of shares outstanding, Mill Road’s 16% represented on the Board.  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 improved lately but still 410 bp below 2015. Unit expansion, previously targeted at 10% annually has been scaled back a bit. G&A, 10% of revenues, could be improved. Food offerings get high price/value marks from consumers.

Regarding RRGB, at 4.5x TTM EBITDA: CEO, G.J. Hart, most recently had leadership roles at Torchy Tacos, before that at Texas Roadhouse. Long-term investor, Archon Capital, owns 12% and Soviero Capital owns 7%. The turnaround plan is starting to show promise. 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%. Overall, Hart & Co. are checking a lot of boxes within a well-conceived turnaround plan.

Roger Lipton