All posts by Roger Lipton

ROGER’S OCTOBER 15th MONTHLY ARTICLE IN RESTAURANT FINANCE MONITOR – THEIR “MUST ATTEND” ANNUAL LAS VEGAS CONFERENCE IS COMING UP!

MEMORIES ARE SHORT WHEN CAPITAL IS CHEAP

WHAT GOES AROUND COMES AROUND – Some of us have been around long enough to experience a number of restaurant industry cycles. Whether because “some things never change” or “people never learn”, the supposedly recession resistant restaurant industry too often mirrors the predictably cyclical steel and airline industries or the commodity cycle. Good times stimulate strong sales and profits, easy money creates overvaluation, capacity expansion creates the vulnerability ahead of inevitably weaker sales, followed by margin contraction and a multi-year capacity shakeout. The good news is that memories are short and new concepts invariably incubate while the industry contracts. Once consumer demand picks up, for any combination of reasons, new concepts emerge to serve the latest consumer requirements. As the Covid runs its course, with capital never more available to qualified operators, we now see Dutch Bros, First Watch, Krispy Kreme (again) all publicly held, soon to be joined by Portillo’s and probably Sweetgreen. All these situations are carrying valuations that are historically on the high side, most notably Dutch Bros. Additionally, restaurant related SPACs have raised almost a billion dollars, which will lead to $4-5 billion of deal activity. Lastly, easy money has also been instrumental in the emergence of a new group of multi-branded restaurant platforms, including publicly held FAT Brands, BBQ Holdings and BurgerFi, and it’s happening privately as well. Before you fall in love with the emerging names and corporate strategies, allow us to provide some therapy by way of remembering departed favorites such as: Flakey Jakes, Delites, Po Folks, G.D.Ritzy’s, Chi-Chi’s (with franchisees, Consul and Kelly Johnson), Green Burrito, Shoney’s, El Torito, Bennigan’s and Bob Evan’s Farms. Surviving, but a frail shadow of their former selves are Arthur Treacher’s, Ponderosa, Village Inn, Sbarro, Fuddrucker’s and, my personal favorite, Boston Market. Lastly, from a historical perspective, two of the most successful companies in the 1980s were Chi-Chi’s and Ryan’s Family Steakhouses. On the positive side, however: while some of the above concepts were never ready for prime time, the demise of virtually every other prominent concept was the result of self inflicted wounds, not competition or industry overbuilding. It was new products introduced prematurely, inadequate attention to operating details, too rapid widespread geographical expansion that could not be properly supported, poorly selected or supervised franchisees. It may also have been founders and/or top management getting outgrown by an expanding business, leaders becoming adequately wealthy and distracted one way or another, or just running out of steam in a very demanding game. Those obvious general pitfalls aside, an operator sufficiently driven toward day to day “blocking and tackling” need not fear the competition. There are many examples of perseverance overcoming competition as intense as one can imagine. Just a couple at top of mind are (1) the extraordinary success, in spite of Starbucks, of Dutch Bros and (2) Chic Fil A, doing twice the volume, in only six days a week, of a little Company called McDonald’s.   There is hope!

RECENT IPO VALUATIONS – There have been three IPOs this year: Krispy Kreme (DNUT) again, Dutch Bros (BROS), First Watch (FWRG) and Portillo’s (PTLO) is on deck. Krispy Kreme came public mid-year at $17/share, now trades at just above $14  with an Enterprise Value of $2.6B, about 14x the $185M current run rate of EBITDA. First Watch came public two weeks ago, at $18, now trades around $21/share, with a current Enterprise Value of about $1.2B, about 18x the current run rate of EBITDA. Dutch Bros (BROS) came public just a month ago at $23/share, and now trades at $50 with an Enterprise Value about EIGHTY TIMES trailing adjusted EBITDA. Portillo’s (PTLO) is due soon, with an Enterprise Value at the $17 contemplated IPO price of about $1.4B, about 14x the current run rate of EBITDA. These situations obviously differ substantially, with Dutch Bros checking all the boxes. There are writeups on all four companies on our website and as the previous segment, above suggests: be careful out there!

 

OPERATORS IN A CAPITAL INTENSIVE BUSINESS CANNOT IGNORE MONETARY DEVELOPMENTS – The talk has been about the Fed’s plan to “taper”, that is to reduce the amount of securities they are purchasing (which has been running about $120B per month) and allow interest rates to rise. For months Fed Chair, Powell, has been describing the escalation in consumer prices (lately at 5%, well above the 2% Fed target) as “transitory” and reiterating the Fed’s intention to reduce their monetary “accommodation” soon. Among the problems with the plan are (1) The economy is not strong enough to withstand a material rise in interest rates (2) The Fed has been the “buyer of last resort” with their newly printed currency, its purchases approaching half of all Treasuries issued.  You would think that the hundreds of PHDs at the Fed would have noticed that oil and gas prices have risen, menu prices are up, the minimum wage is a lot higher, supply chain challenges are commonplace and higher prices are hardly ever rolled back. Taper “talk” is just that. Recall that the Fed balance sheet rose from under $1 trillion to $4.3 trillion in coping with the ’08-’09 crisis, was reduced a few years ago, got all the way down to $3.7 trillion before the weak stock market and the politicians provided a “taper tantrum”. In the wake of Covid-19, the Fed’s balance sheet has grown from $7.06 trillion on 9/30/20 to $8.49 trillion last week, growing at about $120B a month on virtually a straight line, and we don’t believe it flattens much any time soon. Our best guess remains that a 1970s type “stagflation” has already begun. All is not lost, however. While consumer spending will remain constrained, well positioned operators will continue to find capital available at historically low rates.

Roger Lipton

FAT Brands (FAT) – WASTING NO TIME IN BUILDING MULTI-BRANDED FRANCHISED PORTFOLIO

FAT BRANDS (FAT) – CLOSES $250M SECURITIZATION, ANNOUNCES EXPANSION IN MIDDLE EAST, COMPLETES TWIN PEAKS ACQUISITION, WITH FIFTEEN BRANDS SETS STAGE FOR $80M OF POST-COVID 2022 EBITDA.

We last updated our previous reports on FAT Brands (FAT) on September 2nd, all of which can be accessed by way of the SEARCH function on our Home Page.  A great deal of progress has been announced in a short six weeks since then. Recall that, including the acquisition of the Twin Peaks sports bar chain, the company, now franchising fifteen brands, has guided to $80M of post-Covid 2022 EBITDA.

We provide below a summary of the group of press releases since September 1st, as well as publicly disclosed remarks relative to the third calendar quarter ending September 30th.

On September 7th, the Company announced a new 200+ unit development deal in the Middle East, including 136 brick and mortar locations plus 70 ghost kitchens. In partnership with Kitopi, the master franchisee of this deal, the expansion over the next five years will cover six FAT concepts, namely Fatburger, Johnny Rockets, Buffalo’s Café, Great American Cookies, Elevation Burger and Yalla Mediterranean. The brick and mortar locations, to be located in the UAE, Saudi Arabia, Bahrain, Qatar and Kuwait, will add to Kitopi’s existing 70 cloud kitchens

On September 15th, the Company priced an offering of $250M of “Series 2021-1 Fixed Rate Asset Back Notes”, which have been used to partially fund the $300M acquisition of Twin Peaks. The weighted average fixed interest rate on the notes is 8.00%. As Andy Wiederhorn, CEO, stated: “This issuance gives us ample time to increase franchised locations of this extremely successful concept…prior to refinancing”. Wiederhorn obviously expects that the interest rate can be renegotiated in a relatively short time, just as he has done with previous securitizations.

On September 27th, the Company announced the opening of the 100th Fatburger, cobranded with Buffalo’s Express, in Arlington, TX. This is the second location for this particular franchisee, whose first location opened in June, 2020. This is the third location in the Dallas/Fort Worth area and the fourth in Texas.

On October 1st, only one month after announcing the planned transaction, the Company closed the deal. As reiterated in the release, the acquisition of Twin Peaks is expected to add $25-30M to FAT Brands’ previously expected post-Covid 2022 EBITDA, bringing the total to about $80M. Twin Peaks is especially notable for its steady unit growth, high average volumes, and impressive recovery (post-Covid) to well above 2019 AUVs and Same Store Sales.

THIRD QUARTER DATA POINTS

The above releases relate to long term growth objectives. In the meantime, The Company has publicly disclosed a number of data points relating to the third quarter, ending 9/30/21.

In the second quarter reported results, the Investor Presentation showed that the first three weeks of Q3 produced a portfolio AUV of $22,674, up 13% from $20,056 in Q2.

Within the Investor Presentation relating to the Twin Peaks acquisition, it was disclosed that, at Twin Peaks, Period 7 (July) annualized at $4.7M and Periods 5 through 7 annualized at $5.1M, compared to $4.5M in 2019 and $4.4M in 2018. Furthermore, Same Store Sales at Twin Peaks, compared to 2019, turned positive by 0.6% in P2,’21, and have increased every month to a positive 17.8% in P7’21.

The data points provided above, along with previously discussed development pipeline and unit openings, indicate that the third quarter should be encouraging to both equity and debt investors.

LD MICRO CONFERENCE on October 12th – WIEDERHORN COMMENTARY

CEO, Andrew Wiederhorn, pointed out that the development pipeline, across all brands is about 300 units, to be developed over the next four to five years, expected to grow the portfolio organically at 5-10% annually. The most recently acquired Twin Peaks, now 84 units, is expected to add eighteen restaurants in the next nine months, two thirds of which will be franchised. There are sixteen different franchisees within the Twin Peaks system. The Twin Peaks locations, without tenant allowances, cost $5-6M each, but sale/leaseback transactions generally reduce the out of pocket investment to approximately $2M, on which the franchisee can earn close to $1M annually, or a 50% cash on cash return. Wiederhorn expects that Twin Peaks can grow from the 100 unit level, to be achieved within a year, to double or triple that number over time.

CONCLUSION

FAT Brands is improving the quality of acquisitions over time, reflecting the growing level of acceptance from the lending community. Since FAT Brands came public in 2017 each  of the major brands that have been added have represented not only an expansion to the portfolio but an upgrade relative to stability and growth. While a number of smaller brands were acquired as well, Hurricane Grill and Wings was followed by Johnny Rockets, followed by Round Table Pizza and, most recently, Twin Peaks. Unit growth potential has been increasingly evident, especially so with Twin Peaks. The near term objective of $80M in EBITDA during post-Covid 2022 has been paid for with $750M of securitized funding at an average of about 7%, or $50M of interest expense. The current portfolio, without considering growth, would therefore be throwing off about $30M of free cash flow in the next year or so, about $2.50 per common share, hopefully more over time. At the same time, the Company has demonstrated an ability to refinance its early securitizations at reduced rates, has indicated an expectation to do the same in the future, which obviously increases the potential free cash flow from the current portfolio. As this strategy comes to fruition, the credibility of FAT common stock could obviously sell at a much higher level.

Roger Lipton

RESTAURANT SPAC UPDATE – A QUICK ROAD TO RICHES IT IS NOT

RESTAURANT SPAC UPDATE – A QUICK ROAD TO RICHES IT IS NOT

The excitement in the marketplace relative to SPACs (Special Purpose Acquisition Corporations), as evidenced by the chart shown just below, has clearly abated (as we have repeatedly suggested over the last six months).

 

Readers can find more extensive discussions about the individual situations discussed below by using the SEARCH function on our Home Page.

CONCLUSION

Of the restaurant related SPACs:

The only completed deal, BurgerFi (BFI), is trading almost 50% down from its high and below the $10 IPO price of the original SPAC.

Fast Acquisition Corp II (FZT), (USHG), Tastemaker (TMKR) and Bite (BITE), are sitting on a total of almost one billion dollars (which can be leveraged), are looking for deals at an acceptable price, and one that will excite the shareholder base that has to approve the transaction. However, with the stock price below the $10 IPO level, the opportunity must be compelling, or the shareholders will choose to redeem their ($10/share) funding.

Do It Again (DOITU) and Sizzle (SZZLU) have yet to be funded.

Only Fast Acquisition Corp (FST) is trading above the IPO price, about 20% higher, with the Fertitta deal pending. Even here a great deal can happen in the marketplace by the time the SEC approves the proxy material and the shareholders vote.

Bottom Line: SPACs have been very productive for some, but, as usual, the “early adopters” will have been most fortunate. Later participants are finding that the process is riskier (because Sponsors have to fund the SPACs organizational expenses), the IPO process takes longer, the search process is tedious (especially when competing with many other bidders), and the business combination may or may not be approved by shareholders. Even then, long term success is not assured and the liquidity process for Sponsors is not always easy. Some Sponsors and SPAC investors will do just fine, and they likely will have earned it.

Roger Lipton

 

G

FIRST WATCH (FWRG) COMES PUBLIC, TOWARD THE BOTTOM OF ITS FILING RANGE, TRADES UP OVER 20%, WHAT TO DO?

FIRST WATCH (FWRG) COMES PUBLIC, TOWARD THE BOTTOM OF ITS FILING RANGE, TRADES UP OVER 20%, WHAT TO DO?

First Watch sold 9.5M shares today, at $18/share, raising $170M, and valuing the Company at about $1 billion.

There are currently 423 locations, 335 Company owned (which is the growing segment) and 88 franchised. The restaurants are open for business from 7am to 2:30pm. The current 335 company owned stores are heaviest in FL (98), TX (40), OH (35), AZ (25), CO (18), VA (16, PA (15), MO (15), GA (14), TN (12), and KS (10). Most recently, 42 locations were opened in calendar 20 and 18 in the first six months of ’21. In the six years pre-Covid, ending in calendar ’19, SSS averaged 6.3% annually, traffic averaged 1.4%, AUV’s moved from $1.3M to $1.6M, and company operated restaurants averaged C/C returns of 50.8%. Same store sales increased for 28 consecutive quarters. In the most recent six months, ending June ’21, versus Q2’19, same store sales was up 16.3% with traffic growth of 1.0%.

As shown above, franchised stores have not grown. It appears that 34 franchised stores were bought by company in 2019, and 17 company stores were built in’19 as well. Growth via company locations has been steady since 2015 when there were 277 locations systemwide.

UNIT LEVEL ECONOMICS

Restaurants are 3,400-4,000 square feet, seating 120-140 indoors, some with patio seating as well as bar/counter space and to-go areas.  New and planned restaurants are 4,000-5,000 square feet. Average net build out costs are $900k. Projected sales are $1.8M in year 1, $1.9M in year 2, $2.0M in year 3. Third year restaurant level profit margin (EBITDA) is projected at 19%, generating an approximate 40% Cash on Cash return.

 

RESULTS FROM CALENDAR 2019 THROUGH SIX MONTHS OF ‘21

More important to understanding the state of the business today versus 2019: In the first six months of 2021 vs calendar 2019: CGS ran 170 bp better at 21.8%. Labor ran 360 bp better at 31.0%. Other Operating Expenses ran 310 bp WORSE at 16.9%. Occupancy was 80 bp better at 10.0%. Store level EBITDA, in the first six months of 2021, has been 20.2% vs 17.4% in calendar 2019. Below the store expense line, G&A ran 9.7% of sales in the first six months of ’21 vs 12.8% in calendar ’19. After deducting Depreciation of 5.6% (vs. 6.4% in ’19) and adding in franchise royalties (only 1.4% of total revenues) Income from Operations in the first six months has been a profit of $16.1M (5.7% of sales) vs. a (loss) in calendar ’19 of $37.6M (8.6% of sales).

CURRENT EBITDA RUN RATE

Adjusted EBITDA is the name of the game these days, so we will play along, though it’s never as simple as it sounds. Adjusted EBITDA in the first six months of ’21 has been $35.2M vs a loss of $11.8M in ’20 and a positive $38.1M in calendar 2019 (negative $5.7M in calendar ’20). The table shows, though, that there were material non-recurring additions in calendar ’19. We therefore consider “EBITDA” before the Adjustments to be the most relevant comparison, which is $32.2M vs a loss of $9.8M. Bottom line: the first six months of ’21 has generated $32M or so of cash flow from operations, annualizing to a current run rate of about $70M, which the Company plans to build on. This material improvement from calendar 2019 is a result of materially higher sales per location, dramatically so in Q2’21, combined with 280 bp improvement in store level profit.

THE VALUATION and our CONCLUSION

With approximately 57.6M shares outstanding, FWRG, is currently trading at $22.54 (up from the $18.00 offering price), therefore valued at about $1.3 billion, just under 20x the apparent current EBITDA run rate. We will fill in more of the operating details in the near future, but for the moment we consider FWRG fairly valued. While trading up over 20% from its IPO price, it doesn’t have the excitement of Dutch Bros (BROS), for example. This may have something to do with the fact that BROS generates almost as much revenues per store, with higher margins, in a space half the size. Also, First Watch guides to a store level EBITDA of 40%, but not until year three. This is admirable but also not as compelling as BROS. Of course, the valuation of FWRG, as a multiple of the Adjusted EBITDA run rate, is about one third that of BROS. There is sometimes a method to the market’s madness😊

Stay tuned.

Roger Lipton

SEMI-MONTHLY FISCAL/MONETARY UPDATE – CAPITAL MARKETS ARE WORRIED BUT “TAPER TALK” IS JUST TALK

SEMI-MONTHLY FISCAL/MONETARY UPDATE – “TAPER TALK” IS JUST TALK

September was a weak month in all the capital markets: stocks, bonds and gold related securities as well. Gold bullion was down about 3.2%, with the gold mining stocks down more because of their leverage relative to the gold price. In the wake of congressional testimony from Fed Chair, Jerome Powell, and Treasury Secretary, Janet Yellen,  gold bullion went up almost 2% yesterday, the 30th, and the gold mining stocks followed. Perhaps it is beginning to dawn on investors how disingenuous the presentations were and how hopeless the fiscal/monetary situation is.

First, we have to comment on the absurdity of Powell and Yellen appearing together before Congress, presenting a united front. This is directly contrary to the guiding principle for the last 108 years, that the Federal Reserve and the US Treasury are designed to be independent of one another.

In any event, the talk all month was of the plans for the Federal Reserve to “taper”, that is to reduce the amount of securities they are purchasing (which has been running about $120B per month), allow interest rates to rise, in turn strengthening the US Dollar, which tends to weigh on the price of gold in the short run. For months now Powell has been describing the now obvious escalation in consumer prices (lately at 5%, well above the 2% Fed target) as “transitory” and “isolated”, and reiterating the Fed’s intention to reduce their monetary “accommodation” soon. The Fed would then purchase fewer Treasury securities, leading (some day) to a reduction of the Fed’s $8.5 trillion balance sheet, and allow worldwide interest rates to normalize from levels unseen in the 4,000 year recorded history of interest rates. Recall that after building the Fed balance sheet from $1T to $4.2T in ’08-’09, the taper at the time took it back 10%, to $3.7T before ramping it up to the current $8.5T. Can anyone say $20 trillion?

The problems with the plan, at the moment, are (1) The economy is not strong enough to withstand a material rise in interest rates, and a one point rise in interest rates would cost the US Government an extra $280B a year on its $28 trillion of debt. The burden would not be immediate because existing bonds would continue to exist but more than half of the $28 trillion matures within 5-6 years and it would not take long for the interest expense to build. In addition, the current annual $3T deficit would need to be financed as we go. (2) The Fed has been the “buyer of last resort” with their newly printed currency, its purchases approaching half of all Treasuries issued. China and Japan have been increasingly reluctant to maintain previous buying patterns, which is no wonder as they watch the Fed’s massive dilution of the US Dollar. (3) Jerome Powell was counting on inflation being “transitory” and “isolated”, allowing for the economy to recover without stagnating and allowing for a noticeable but not too burdensome rise in interest rates. You would think that the hundreds of PHDs at the Fed would have noticed that oil and gas prices have risen, menu prices are up, the minimum wage is a lot higher, supply chain challenges are commonplace and Dollar Tree Stores says more items will be priced over one dollar. Powell, just in the last few days, has suggested that inflation is running hotter and may not be as short lasting as he previously thought. He, at the same time, admitted that the economy “is not even close to satisfying requirements for a rate hike”. We can add that 25 or 50 basis points of higher rates is going to have virtually no effect, other than window dressing, on risk and reward within the economy. In 1979-80, Paul Volcker took the Fed Funds Rate to 18% to squeeze out inflation, which precipitated a recession that lasted until late 1982. We need not describe what effect a similar discipline would have on the worldwide economy today. The total US debt was $1 trillion in 1981 and the annual deficit was $100 billion. Though today’s economy is six times as big, today’s deficits and debt are 3-4x as big in constant dollars.

On the disingenuous front: Janet Yellen told us yesterday that the debt is not a problem because interest rates are so low. She did not elaborate that interest rates are so low because our Federal Reserve is buying half our debt with currency minted out of thin air. Yellen also informed our legislators that not increasing the debt limit (again) would be “catastrophic”, because we must, at all cost, pay off our existing creditors. A cynic might call this a “Ponzi scheme”, whereby new investors buy out the old investors.  Jerome Powell, after admitting that the current inflation is surprising, says the Fed is “prepared to use its tools” to control the situation, but he omitted details and the congressional legislators did not press the subject.

Our conclusions are not drawn out of thin air. Taper “talk” is just that. The Fed’s balance sheet has grown from $7.06 trillion on 9/30/20 to $8.49 trillion last week, growing at about $120B a month on virtually a straight line, and we don’t believe it flattens much any time soon. It is interesting that the $1.43 trillion increase is almost exactly half of the $2.7 trillion US deficit in the last eleven months. In short, the beat goes on, and the reasons referenced above indicate that there is no graceful way out of this situation.

Our best guess remains that a “stagflationary” period is ahead of us, perhaps begun already,  similar to the 1970s. On January 6, 1974 the NY Times said “There is One Surfeit: Shortages.” In August, 2021, they said “The World is Still Short of Everything. Get Used to It.” In 1973 the CPI was rising at 5.3% and the Fed Funds Rate was 6.75%. The Federal Reserve predicted that the jobless rate, then at 5%, would average 4.5-5.0% over the next few years, with consumer prices up 4.0-4.5%. Their objective at the time had been 2.5%, similar to today, ex “transitory” influences. By May, 1975, unemployment hit 9% and inflation averaged more than 10% in 1974-5. By 1979, the CPI hit 12% and the Fed Funds Rate reached 18%. In more recent times, Ben Bernanke, Fed Chairman in 2007, predicted that housing prices would remain elevated for the foreseeable future. So much for the Federal Reserve’s predictions and control over the situation. From 1971 to 1979 gold bullion went from $35/oz. to $850/oz.

We believe that the “taper talk”, valid or not, affected all capital markets in the last couple of months, increasing interest rates and improving the US Dollar’s relative value (which weighs on the price of gold), at the same time backing off both the stock and bond markets. On the last trading day of September, while the stock and bond markets meandered, gold and the gold miners were strong, so perhaps this was a case of “selling the rumor and buying the news” (after the Powell/Yellen testimony).

We continue to feel that gold bullion, and the gold miners leveraged to the price of bullion, should be an important asset class within any diversified portfolio.

Roger Lipton

 

PORTILLO’S FILES FOR IPO – HOT ON THE HEELS OF (BROS) AND (TOST)

Hot on the Hot Heels of Dutch Bros (BROS) and Toast (TOST) Portillo’s (PTLO) files Preliminary IPO Prospectus

THE MARKET ENVIRONMENT

The financial music is playing so the dancers are taking the floor. The Cost of Capital is negligible so it makes compelling sense to sell (if you can) a small percentage of your company, provide working capital and/or pay off existing debt. Among restaurant companies that have been public for years, Shake Shack (SHAK) sure looks wise in retrospect when, in March of 2021, they sold $225M of seven year ZERO COUPON convertible notes. Their stock (now $84) was trading at about $120 and the notes are convertible at $170/share. At the conversion price, the value would be 269x Shake Shack’s previous high earnings, $0.63 per share in 2019. Back in May we called it the Financial Transaction of the Year in our monthly column within the Restaurant Finance Monitor. Shake Shack’s still-nosebleed valuation (at $84) has now been joined by Dutch Bros (BROS), a fine company, having more than doubled from the IPO price, which is now selling at about 75x the trailing twelve month EBITDA. A technology platform serving the restaurant industry, Toast (TOST), is trading at about $50 (up from the $40 IPO price) and, while growing at about 100%/yr., is valued at about twenty five times trailing twelve month sales. There are no earnings yet. Does anybody else remember 1999-2000?

PORTILLO’s

THE DEAL, and the valuation – The terms of the offering have not been set, nor the percent ownership by the current holders versus the public, a major objective of the IPO is to pay off a material portion of the current $470M in debt. The expected IPO valuation is about $1.4 billion.

THE COMPANY

Originally founded in 1963 in Chicago, purchased in 2014 (with 38 units) by Berskshire Partners, Portillo’s has become an institution in that market, selling a diverse menu featuring Chicago style hot dogs and sausages, Italian beef sandwiches, salads, burgers, crinkle cut fries, homemade chocolate cake and milkshakes. As of 6/30/21, there were 67 company operated locations within nine states (44 in IL, 6 in IN, 4 in AZ, 1 each in Iowa and MI, 3 in FL, MN & WI, 2 in CA). In terms of unit growth: since 2015 compound annual growth has been about 9.3%, and the long term objective is about 10%. Nearly all the restaurants have double drive thru lanes as well as dine-in and carryout service. The restaurants average 8,000 square feet and the new prototype is 7,200-7,800 sq.ft.  Per the prospectus: “Our near-term restaurant growth strategy is focused on leveraging our proven unit economic model primarily in adjacent and national markets outside Chicagoland with favorable macro-economic tailwinds where we already have a presence. We will also add select new restaurants in the Chicagoland market.”

The average ticket/guest is about $9.60. In calendar 2020, drive-thru accounted for 63% of sales (up from 41% in 2019), dine-in was 27% (down from 53% in 2019) and delivery was 10% (up from 6% in 2019). In the first six months of 2021, the percentages were about the same as in calendar 2020. Dayparts are about equal, with 52% of sales at Lunch, and 48% at dinner. Sales are steady through the week as well, from a low of 12% (of weekly sales) on M,T,W, 13% on Th, 17% on Fri, 18% on Sat and 16% on Sunday.

UNIT LEVEL ECONOMICS

AUVs were $7.9M in the TTM ending 6/27/21 with a restaurant level Adjusted EBITDA margins of 28.6%. The initial investment to build a new restaurant ranges from $4.5-$5.0M, excluding pre-opening expenses.  If we assume a cash cost of $5.0M (the high end), and a store level EBITDA of a conservative 25%, $7.9M of revenues generates almost exactly $2.0M, or an obviously handsome 40% cash on cash return.

However: as stated “Restaurants in our Chicagoland market had AUVs of approximately $9.6 million in 2019, $8.7 million in 2020 and $9.1 million in the twelve months ended June 27, 2021 and Restaurant-Level Adjusted EBITDA Margins of 28% in 2019, 31% in 2020 and 32% in the twelve months ended June 27, 2021. Restaurants outside of Chicagoland had AUVs of approximately $6.3 million in 2019, $5.6 million in 2020 and $5.8 million in the twelve months ended June 27, 2021 and Restaurant-Level Adjusted EBITDA Margins of 22% in 2019, 25% in 2020 and 26% in the twelve months ended June 27, 2021. When considering new restaurant locations each year as part of our growth strategy, we target AUVs of approximately $5.8 million and average Restaurant-Level Adjusted EBITDA Margins of approximately 22%, each in the third year of operation, with targeted cash-on-cash returns of approximately 25%, which we calculate by dividing our Restaurant-Level Adjusted EBITDA in the third year of operation by our initial investment costs (net of tenant allowances and excluding pre-opening expenses).”

Revenues/Unit and (predictably) Operating Margins are materially less outside of “Chicagoland”.

HISTORICAL RESULTS – 2019, 2020 and SIX MONTHS OF 2021

Comps in calendar 2020 were down 8.3%, after being up 3.2% in 2019. Corporate Adjusted EBITDA margin was $87M in 2020, up from $79M in 2019 (19.3% of revenues in 2020, up from 16.6% in 2019). Restaurant Level Adjusted EBITDA margin was ($122M in calendar 2020, up from $117M. (26.8% of sales, up from 24.4%). Cost of Goods ran a little over 31% in both 2020 and 2019. Labor was lower in 2020 (25.5% vs. 28.0% in 2019), which is why the EBITDA margin, both store level and corporate, improved, and this was a function of the drive-thru capability during  the pandemic.

In the first six months of 2021: Store Level EBITDA was 28.2%, up from 24.3%. CGS was down 210bp to 29.9%. Labor was down 130bp to 25.4%. Occupancy was down 30bp to 5.4% and Other Operating Expenses were down 20bp to 11.1%. The across the board reduction of expenses, in the first six months of 2021 vs 2020, was due to a 6.2% increase in guest traffic and a 6.8% increase in average check (“driven by both an increase in items per order and menu prices”.) As described by management in the prospectus: lower CGS was due to a reduction in beef costs and an increase in average check, while lower labor % was due to a leaner labor model due to COVID-19 dining room limitations, and the increase in average check.

This chart is specific, month by month. To save you the trouble (and eyesight) in calculating the change in 2021 versus 2019,  the 2021/2019 comp was: Jan. +0.6%, Feb.-8.0%, Mar.+1.6, Apr.+4.4, May +3.6, June +3.0. These two year positive comps are obviously due to a combination of traffic, items per order and menu prices.

MANAGEMENT – the key operating positions

Michael Osanloo, President and CEO, has been in place since August 2018. His previous position, from 2015 to 2018 was CEO at P.F.Chang’s.

Michelle Hook, CFO, has been at Portillo’s since December, 2020. Her previous position was VP of Finance at Domino’s.

Jill Waite, Chief Human Resources Officer, joined Portillo’s in June 2019. Previously, from 2017, she was Senior VP  of Human Resources at 24 Hour Fitness

Sherri Abruscato, Chief Development and Supply Chain Officer, has held her current position since August 2014, and has been with Portillo’s in various positions since 1983.

Derrick Pratt, COO, joined Portillo’s in May, 2021. He was previously in a variety of executive operational positions at Starbucks.

CONCLUSION

First. It is worth noting that the class A common shares that the public owns will have inferior voting rights to the class B shares owned by Berkshire Partners. This is becoming commonplace within recent IPO structures. After all, the public can’t be expected to have equal voting rights (per share) as the previous owner. It is privilege enough to be able to participate in the future growth of such a promising company, even if the valuation is a multiple of what used to be considered reasonable. Since the 2020 Adjusted Corporate EBITDA was $88M, and $51M up from $38M, in the first six months of ’21, the contemplated IPO valuation of about $1.4 billion looks to be  about 14x  the current run rate of  corporate Adjusted EBITDA. We consider this to be relatively reasonable, at least in comparison to the examples (BROS, TOST, and SHAK) provided above. However: (1) the currently contemplated IPO valuation (at $17-20/share) could still be changed,  the stock could go to an immediate premium, as with BROS and TOST, or a discount, as in the case of Krispy  Kreme (DNUT) so this valuation may be moot for most of us (2) Units outside of Chicago have been materially less profitable than those at home, with good but not great unit level economics, and that could come increasingly into play over time (3) Store level margins, now at industry highs and all time records for PTLO, are unlikely to expand further. We, therefore, do not expect EPS  to expand much more rapidly, possibly materially less, than the 10% unit growth rate.  We therefore consider the fundamental risks to be at least real possibilities, so would not be inclined to own PTLO at “any price”. As Warren Buffet famously suggested, “you don’t have to swing at every pitch.”

Roger Lipton

DARDEN (DRI) REPORTS STRONG AUGUST QUARTER, DRIVES STOCK TO ALL TIME HIGH, SUPPORTS FULL SERVICE CASUAL DINING SECTOR

DARDEN (DRI) REPORTS STRONG AUGUST QUARTER, DRIVES STOCK TO ALL TIME HIGH, SUPPORTS FULL SERVICE CASUAL DINING SECTOR

Darden (DRI) reported a strong quarter, driving its stock up 6.1% today to an all time high of $159. The “pin action”, as this is written, has moved Bloomin’ Brands up 5.25%, BJ’s up 4.3%, Cracker Barrel up 4.0%, Brinker up 6.3%, Ruth’s Chris up 4.1%, Red Robin up 7.1%, and Texas Roadhouse up 2.5%.

We consider Darden management, led by CEO Gene Lee, to be “best of breed” among full service dining companies, and their conference call commentary is uniquely candid and invariably instructive. The following is a summary of the results and their conference call discussion. We have underlined what we consider the most insightful of their remarks.

Q1’22, ending 8/29/21, in which the Company bought back $186M of stock, showed EBITDA of $370M, and diluted EPS from continuing operations of $1.76/share. That compares to 8/25/19 when EBITDA was about $288M and EPS was $1.38. Over the same two year period consolidated comp sales were up 4.8%, including Olive Garden (OG) down 1.5%, Longhorn Steakhouse (LH) up 20.9%, Fine Dining (FD) up 12.6%, and Other Business Virtually Flat.

MARGIN AND SALES DISCUSSION

The two year comparison, from Aug’19 to Aug’21 showed:  CGS 150 bp higher with investments in food quality and pricing below inflation, labor 110 bp lower due to efficiencies from operational simplification, including a narrower menu at OG, (partially offset by higher wages), Other Operational expenses 110 bp lower due to sales leverage, and marketing 220 bp lower. Consolidated restaurant level EBITDA at DRI was 290 bp better at 20.9%, and G&A was 30 bp higher (mostly stock compensation). Q1 at OG showed flat sales (because two years ago included “Buy One, Take One”) with segment profit margin up 220 bp. LH showed sales up 26% with profit margin up 250bp. Helping at LH is the 40% fewer crew members than at OG and relatively heavy geographical concentration in states such as GA and FL.  Fine Dining sales were up 24% with profit margin up 490bp, as pent up demand and increased Sunday dining have helped. The digital platform continued to grow, representing 60% of all off-premise sales, and off-premise sales were 27% at OG, 15% at LH.  They had previously used PayPal (used for 25% of mobile app transactions) and added Apple Pay and Google Pay during the quarter.  

INTRA-QUARTER SALES TRENDS, SEPTEMBER SO FAR

Q1 sales started strong in June, strengthened further and peaked in July, slowed in August with the Delta Variant, finishing Q1 at +4.8% cumulatively. Company comps are up 7% first three weeks of September. There have been some cancellations of large parties inside Fine Dining, but management still expects a strong holiday season.

STAFFING & SUPPLY CHAIN COMMENTARY

Top priority in Q1 was staffing of restaurants. Introduced was a new talent acquisition program that allows applicants to apply and schedule an interview within 5 minutes or less. Social media and a digital platform is netting more than 1,000 new team members per week, and staffing is now 90% of pre-Covid levels. The success of this enhanced recruiting effort has been more important, one way or another, than the ending of supplemental unemployment benefits. Staffing has been complicated by the contract tracing and quarantining requirements when an employee has been exposed to one of the Covids.  While stores are not 100% staffed, management does not believe they will need as many as previously due to productivity improvements during Covid. Hoping to hang on to current margins, as sales and operations normalize. (“no reason why we can’t hang on to these margins”).

Another important influence during Q1 was the supply chain challenge, as shortages and higher freight costs are now leading to 4% cost inflation and a planned 2% menu price increase.

GUIDANCE

Guidance versus the pre-Covid year ending 5/20 includes total sales growth up 7-9% over the two years. Total cost Inflation is expected to be about 4%, with commodities up 4.5% and total restaurant labor up 5.5%, including hourly inflation of about 7%. For the year ending 5/22, management expects EBITDA of $1.54B to $1.6B, with diluted EPS of $7.25 to $7.60 on $9.4B of sales. Have to go back to the year ending 5/19 to get a full year’s normalized comparison, which was $8.5B of revenues and $5.73/share of earnings from continued operations. Over three years, therefore, from 5/19 through 5/22 sales would be up about 10% and EPS (at the ’22 midpoint of $7.43) would be up about 30%.

OFF PREMISE, INCLUDING DELIVERY

They are not going to promote delivery, and don’t want to go too aggressively after off-premise in general  (“on the weekends, we have to throttle the off premise business”) because they don’t want to affect dine-in operations. A modest catering effort is improving but is not significant to the total.

MARKETING

There is very little couponing now, only about 1% of sales, and the check increase has only been about 2.5% over the last two years, less than the industry average of about 5%. The sales strength at LH can be attributed to its geographical footprint in states like Fl and GA.  Fine Dining sales trends are still lackluster in major cities like NYC (down 40%) and others, but there has been an uptick in Suburbia, apparently from pent up demand and better Sunday activity.  “Last 6-8 weeks have felt some pressure in Georgia and Florida….Texas in a world of its own, Northeast is performing OK but  has never really come back, have felt the Variant to varying degrees in Tennessee, KY, West Va…..Doesn’t make sense to advertise aggressively when restaurants are still not 100% staffed…we’re not going to know what the full potential at equilibrium is for a while…we don’t want to be discounting off a value platform……we’ve got to figure that out….we need to see what the competitive environment is…..and see what the economic backdrop is. Darden has not been pushing the Loyalty program during Covid, considering it a form of discounting (to highest use consumers)… “we were seeing positive trends in our loyalty program, a point based discount program, but  we don’t think that is the right way, in the long run, to do loyalty in the restaurant business”.

Roger Lipton

ROGER’S MONTHLY COLUMN (9/15) IN WIDELY FOLLOWED RESTAURANT FINANCE MONITOR – STAGFLATION, DUTCH BROS, BUY THE LAND!

ROGER’S MONTHLY COLUMN (PUBLISHED (9/15) IN WIDELY FOLLOWED RESTAURANT FINANCE MONITOR – STAGFLATION, DUTCH BROS, BUY THE LAND!

 

STAGFLATION IS HERE

There are too many similarities to the 1970s to dismiss the current surge in prices as “transitory”, no matter what Fed Chairman, Jerome Powell, says. Something like $20 trillion has been created by worldwide Central Banks since 2009. Over the last ten years, consumer price inflation (until recently) was subdued because: while the Fed printed money (increasing the M-2 money supply by 25% in the last twelve months alone, at the same time they raised the capital and reserve requirements in banks, reducing the “velocity” of the new funds. Asset prices (stock, bonds, art, homes, etc.) have taken off, largely as a result of “TINA” (There Is No Alternative) because the Fed also suppressed interest rates. As restaurant operators know by now, however, operating costs are rising sharply and menu prices have begun to follow. The CPI is up over 5% in the last twelve months, and the (leading indicator) Producer Price Index (PPI) was reported last week at 8.3%, the highest since 2011. Inexorably rising labor costs have now been joined by higher commodity prices and higher supply chain expenses. Brilliant economists such as David Rosenberg (Rosenberg Research and Lacy Hunt (Housington Research) argue that the slowing post-Covid 19, now Delta Variant suppressed, economy, will control inflationary indications. However: expectations alone can encourage current spending and exacerbate shortages, and the Fed’s primary mission is to encourage inflation at 2% or more (perhaps much more). Let’s theoretically suppose: What if the Central Banks were to create $100 trillion of new currency, with no increase in available goods and services? Prices would be sure to go up, right? Well, $20 trillion didn’t do it over the last ten years but $100 trillion would. Somewhere between $20T and $100T is “ignition” and we suspect it is closer to the former.

IPOs ARE BACK

Dutch Bros Inc. leads the way in terms of valuation and long term growth prospect. In every stock market cycle, a number of newly public restaurant chains present themselves. Within the last twelve months, BurgerFi (BFI)was purchased by a SPAC, and Tilman Fertitta’s hospitality and gaming empire is about to be acquired by FAST Acquisition (FST). Several other SPACs are searching for acquisitions, while Sweetgreen, Portillo’s and First Watch are preparing for IPOs, all at very high valuations by historical standards. Dutch Bros is apparently going to be first of these out of the gate. In preview: we consider Dutch Bros to have huge potential for long term growth, and a highly successful IPO will likely set the stage for the others (deserving or not). In preview: if there is one restaurant company that we would want to own at 37.5x trailing Adjusted EBITDA, Dutch Bros (BROS) would be it. An extensive discussion of BROS is available on our website (use the SEARCH function on our HOME PAGE) and the summary is: Serving hot and cold  espresso-based drinks, the proprietary Blue-Rebel energy drink and other beverages, with a corporate culture and store level experience that is instructive, the numbers are compelling: Growing from its Grant’s Pass, Oregon base, there are now (as of 6/30/21) 471 drive-thru (650-950 sq.ft.) shops in 11 states. The systemwide AUV was $1.7MM in calendar 2020.The Company has grown, systemwide, from 328 in 7 states @12/31/18 to 441, mostly company operated locations, in 9 states at 12/31/20 and 471 in 11 states at 6/30/21. Systemwide Same store sales, up for 14 years running, was up 2% in 2020 and was up 8.2% as of Jun’21. Company stores have generated a 29% shop-level EBITDA margin in calendar ’20 and six months of ’21. Adjusted corporate EBITDA was about $70M in calendar ’20 and $80M in the twelve months ending 6/30/21. The $3B valuation at the contemplated IPO price is 37.5x the trailing $80M of EBITDA but the latter number is growing so strongly that the fundamentals will catch up with the IPO valuation over the next couple of years. The IPO buyers will get a gift. The rest of us will have a decision to make. (As this is posted, BROS has doubled from the $23 IPO price, selling at about 80x the current EBITDA run rate. We expect there to be a more advantageous time to purchase the stock. The valuation is too far ahead of the fundamentals for our investment taste.)

OWN THE LAND, RESIST THE CONSENSUS

In recent years the restaurant industry mantra is to be “asset light”, franchise if possible, lease, rather than own, because you are in the restaurant, not the real estate, business. In days of yore, when leverage was less fashionable, there were some very successful restaurant companies that owned land. Back in 1980, it cost Chi-Chi’s $1.25M for land (owned in fee), building and equipment, and they did $2.5M per unit. Ryan’s Family Steakhouse came public in the early 1980s with an AUV of $1.3M, gross investment in LB & E of $650k. That’s called a fully capitalized 2:1 Sales/Investment ratio. A little company called McDonald’s has also done very well, owning land and receiving rent from franchisees. In New York City, the Reiss Brothers became very wealthy by owning the buildings in which their (generally poorly run, often changing) franchised restaurants were housed. With less financial leverage and an occupancy expense that equates to the cost of capital, it is much harder to get into financial trouble. There are currently a couple of publicly held companies that have begun to use real estate to build long term shareholder value. Ark Restaurants (ARKR), recently written up on our website, has purchased restaurants and underlying land under acquired locations, already paying off handsomely. RCI Hospitality Holdings (RICK) has productively developed real estate under their Bombshell sports bar concept. Why cannot a fast casual operator, looking for an end-cap strip location, find a dry cleaner, a fitness gym and a couple of other tenants, reducing (or eliminating) the remaining occupancy expense? Another business, to be sure, but a potentially productive use of inexpensive capital.

Roger Lipton

LABOR CRISIS STRETCHES OUT! – CAN’T ANYBODY HERE PLAY THIS GAME?

LABOR CRISIS STRETCHES OUT! – CAN’T ANYBODY HERE PLAY THIS GAME? (Casey Stengel, while managing the NY Mets.)

Supplemental unemployment benefits of $300 per week,  tax-free, ended as of September 6th. While it can be argued that this was only one of the ingredients that created a severe labor shortage for restaurants and retail establishments, it was clearly a major factor. Hospitality oriented, consumer facing, businesses all over the country have been looking forward to the first week in September when these benefits will expire.

A cynic might say that you can count on bureaucrat to snatch defeat from the jaws of victory. Within less than one week after supplemental  unemployment benefits ended President Biden has announced a mandated plan whereby all workers within a business that employs 100 people or more must be vaccinated before they enter the facility.  While there are many operators that will not be affected because they are under the 100 employee starting point, there are obviously a great number of multi-unit operators that are affected by the vaccination mandate.

Our conversations with operators indicate that the labor crisis has abated to a noticeable degree before and since September 6th, but the situation is still substantially tougher than before the Covid crisis.  Both management candidates and crew have apparently socked away a financial cushion and, as we have described earlier, lots of ex-employees don’t want to return to this very demanding industry.

The new vaccine mandate has complicated the situation further. Some operators, have told us that the lack of available crew, in just the last week, is worse than ever. Young people either are not vaccinated or don’t want to get vaccinated and it’s not very pleasant to wear a mask for  hours while working in a kitchen heated by fryers and grills. Walking around Manhattan yesterday, we found Chipotle, McDonald’s and Shake Shack with dining rooms closed, only offering off-premise alternatives. The explanation provided was that this limitation was due to an absence of staff.

We suspect that the vaccination mandate will be adjusted at some point soon because just yesterday the President and his staff were getting “feedback” from major retail companies. Changes could be implemented and this “episode” in the midst of an ongoing pandemic can be considered a “teaching moment“ and/or a lesson in unintended consequences. At best, however, current and potential employees will no doubt be confused by the rapidly changing requirements and therefore delay their return to work.

THE BOTTOM LINE: The labor crisis is far from over, and future required wages will be materially higher than pre-Covid. There will continue to be adjustments to service between dine-in and off-premise. Companies have found that they don’t need their dining rooms as much as they thought. With staff  hard to come by, there is  no rush to open dining rooms fully, if at all. Offshoots of Covid-19 are still in play, which will be seriously affect consumer spending. At best, predictability of operating results will be challenged, and will not normalize until well into 2022.

Roger Lipton

ARK RESTAURANTS (ARKR – $16) – UNDERCOVERED AND UNDERVALUED

ARK RESTAURANTS (ARKR – $16) – UNDERCOVERED AND UNDERVALUED

CONCLUSION

 While admittedly there are a number of unknowns in terms of revenue trends and costs, we believe that the future will be more predictable than the past, to a large extent due to a now demonstrated productive evolution of the expansion strategy. Based on (1) continued focus on current highly productive restaurant properties (2) New restaurants to be purchased, rather than built from scratch, based on existing (expandable) cash flow, ideally combined with underlying real estate value (3) Geographical expansion largely in the rapidly growing southeastern US (4) Substantial long term potential from Ark’s involvement in THE Meadowlands, not so much a question of “if”, rather “when” within the next several years (5) Unusually high insider ownership with an obvious commitment to building long term shareholder value: We believe that Ark (ARKR) is unusually attractive with an Enterprise Value at about 4.5x current normalized EBITDA.

BACKGROUND

We wrote our initial report, at $19/share in April, which can be accessed through the SEARCH function on our Home Page. Since then, the reported results have improved dramatically, and the prospects are better than ever.

We believe Ark Restaurants (ARKR) is undervalued, largely due to:

  • Though consistently profitable long term, results have been erratic.
  • There is no “cookie cutter” concept here.
  • The company has not had to raise public equity capital, so analysts have not been motivated to cover it.
  • The stock is thinly traded.

However:

  • Equity has not been diluted over the decades.
  • Long term strategy is relatively unique among restaurant chains.
  • More predictable fundamental progress can be expected.
  • Offsetting illiquidity in stock: high mgt. ownership creates long term value.
  • Major value “kicker” with Meadowlands equity.
  • Enterprise Value roughly 50% of peers.

 THE FUNDAMENTALS

 We estimate that Ark is currently producing “normalized” annual EBITDA at a rate of approximately $14-16M annually. We believe that commodity costs will eventually revert back to normal levels, but wages may stay at a higher level due to increases in the minimum wage and the current labor shortage requiring higher pay to attract workers.

 The company’s recent Q3 earnings release was much stronger than expected, producing $5.6M in adjusted EBITDA (including a $2M drag from lack of revenue in New York) in spite of lagging properties doing a total of $9M less in revenue. Along with other restaurant and retail companies, Ark has not has a “normal” quarter in well over a year.  While sales have been extremely strong in Las Vegas, Alabama and Florida, food and labor costs have risen sharply, negating some of the expected operating leverage. Commodity costs have risen for certain items  as well, and though menu prices can be adjusted over time, management is appropriately cautious in this regard.

The $5.6M of EBITDA just reported was within a generally strong season, though negatively impacted by NYC, in particular. While admittedly there are a lot of unknowns in terms of revenue trends and costs over a full year, especially considering the pandemic and the yet to be experienced seasonal and pandemic influence at the newly owned, highly productive Florida restaurants, we do believe using a simplified back of the envelop calculation indicates the company can produce at least $14-$16M in EBITDA on a more normalized basis. We believe that commodity costs will eventually revert back to normal levels, but wages will likely remain at a higher level due to increases in the minimum wage and the current labor shortage.

Some other assumptions in our model are:

  • Revenue eventually normalizes to 2019 levels for New York, Washington D.C., Atlantic City and Connecticut. While Clyde’s is now permanently closed in New York, we believe the revenue can be replaced at higher margin over time. For example, the events business returns to normal in New York, helping margins.
  • The Las Vegas lease is renewed. Revenue of $49M does not include any benefit of return of tourist or convention business, which would offset potentially higher occupancy expenses, and menu prices may have room for adjustment upward.
  • Modest revenue growth in Alabama.
  • Florida benefits from return of cruise ships, growth at Blue Moon Fish acquired in 2021, offset by some reduction in post-pandemic pent up demand from locals.
  • No acquisitions, obviously unpredictable from a timing standpoint.

Base Case

Bullish Case

 Using these assumptions, we feel that Ark can generate $14M-$16M in EBITDA depending on revenue growth and margins. The most significant upside to our estimates could come from additional acquisitions of restaurants, most likely in the southeastern US.  Downside to our estimates could come from the events business not returning as strongly as anticipated in New York City and Washington D.C. It should be noted that management estimated that New York City’s cash flow was about $2M less than normal in Q3 due to restrictions and lack of events and tourism. Admittedly, it could be early 2022 before complete normalization takes place.

Las Vegas uncertainty: Important leases expire in 17 months

 An important renegotiation is pending of the leases at four restaurants in the New York-New York Hotel & Casino, due to expire in January 2023.  The Las Vegas segment generates about $50M in revenue (25% of total company revenue) and approximately of $7-$8M in EBITDA. We believe Ark pays at least $6M in rent in Las Vegas. Losing this lease would be a significant negative for the company, since it would obviously be difficult for the company to replace this lost revenue and cash flow in the short run. On the Q3 conference call, management indicated that negotiations on these leases is set to begin in early September. While relations with MGM over the years have been friendly, there has been a significant amount of turnover in management at the company and Ark will be negotiating with nearly an entirely new team (one key person remains). We also believe that as part of any lease renewal, Ark may have to spend on the order of $5M to refresh some of the properties.

Our current conclusion is that, in all probability, the leases will be renewed. The company has several factors in its favor, such as, an exemption from using a unionized labor force and successfully operating the current restaurants since 1997. Because union pay and benefits are higher, a new lessor would be less willing to pay percentage of revenue as rent and therefore, MGM would receive less rent than continuing leasing to Ark. CEO Weinstein has proven to be a very effective negotiator, as demonstrated time and again over the decades.

THE MEADOWLANDS

Offsetting Las Vegas uncertainty is increasing clarity relative to the Meadowlands “kicker”:

The following commentary from management took place on the recent conference call, particularly in response to a question about the desirability of taking the company private:

“The Meadowlands to us is a huge positive. First of all, we’re probably the largest sports betting facility on the East Coast.

 “But the geometry of that investment that we made 5 years ago could be really significant to our current shareholders, some of whom I know have their eye on that and are comfortable owning our stock despite the fact that it doesn’t reflect the current operations.

“And for the first time, I think, this year, Meadowlands will make its first distribution. That will not be an insignificant number to Ark that we’ll be allowed to report. (Note: we expect only cash equal to the tax liability will be distributed.)

“But more importantly, as New York state starts to play out with the downstate casino licenses, which there’s been a moratorium on because the guys they’ve built upstate had to deal with Coumo essentially that nothing will happen downstate until 2023, which will give the upstate guys time to recapture some of their capital investments. And there’s a lot of lobbying pressure going on to try to get those downstate casinos issued prior to 2023.

“But even if we wait until 2023, once those downstate licenses are issued, we don’t see any way in which New Jersey doesn’t react and make Meadowlands a casino.

“And if it were to become a casino, I would tell you that our projections from just casino operations would dwarf our current EBITDA. Our percentage would dwarf our current EBITDA.

“So to me, I think our current shareholders should have the advantage of that.”

We view visibility of the year-end Meadowlands distribution as an important first step in giving shareholders some insight into the current cash flow of the partnership. Management has not indicated a dollar range that the distribution could be, but we believe it could be several millions of dollars. On the Q4 2019 conference call, Mr. Weinstein stated that the Meadowlands partnership was on pace to generate around $8M-$9M in EBITDA. ARKR’s share would have been around $800K-$900K. The amount was not distributed. In 2019, the Meadowlands generated about $120M in gross gaming revenue. According to the New Jersey Division of Gaming Enforcement division, the Meadowlands has generated over $245M in gaming revenue through July of 2021. With football betting season just about to begin, the Meadowlands could generate over $500M in gaming revenue or 4X 2019 revenues. However, the only distribution in 2021 would be an amount to cover any K-1 cash tax liabilities Ark would have. But investors can see how strong the underlying business is at the Meadowlands. The company has recently received a payment on the $1.8M receivable from the Meadowlands as well.

STRONG BALANCE SHEET

In January the company had $11M in cash and $46M in debt (including $14M in PPP loans). Included in the debt figure was a $9.7M revolver balance coming due in May. Liquidity has improved substantially since then. On June 27, 2020 the company had a cash balance of $20.7M after receiving $15M in PPP money. At the end of Q3, the company reported $18M in cash, the second highest cash balance in at least a decade. The $9.7M revolver maturity was extended to June 2025. The company is now required to pay $500K a quarter and a balloon payment at maturity. Total debt service is approximately $4.8M a year. Excluding any cash flow between now and the end of the year, the company could have over $22M in cash on the balance sheet and only $30M in debt.

VERY ATTRACTIVE VALUATION

Without taking into account the potential value created by the company’s ownership in the Meadowlands, the company is trading at a significant discount to its peers.

As we discussed above, we think the company can generate between $14M and $16M in EBITDA on a normalized basis. If we assume the company receives the expected $4M in tax refunds (no free cash flow over the next 6 months) and $5M in PPP loans are forgiven as expected, the company’s net debt should be around $8M. This would bring the total enterprise value to about $57M. As a reminder, this valuation does not include the $5.1M investment in the Meadowlands that is generating zero cash flow, any future annual distributions from the Meadowlands, the approval of a casino at the Meadowlands, the value of Ark’s concession at the Meadowlands or the monetization of land under certain restaurant properties.

Based on our estimate of normalized annual results, the EV/EBITDA valuation of Ark is approximately 4.5X, very low for a restaurant company with a strong balance sheet, demonstrated cash flow generation and predictable growth opportunities. For example, J. Alexander’s (JAX) a company that we view as a peer, is currently being taken private at an implied EV/EBITDA of 8.7X. The range of multiples used in the fairness opinion ranged from 7X-13X. This acquisition multiple implies Ark could be worth nearly $30 per share as a standalone restaurant company. This also means investors are getting a free call option on any value creation the company could achieve on the Meadowlands being granted a casino license, as well as the opportunity to monetize real estate under certain restaurants.

Without the Meadowlands, ARKR could be worth approximately double the current price. A casino at the Meadowlands could generate another $10-$20 per share in value depending on how the company’s portion of the cash obligation for the casino and restaurants is structured.

While the company is not immune to the macro factors that are impacting all restaurant companies to various degrees, we believe there is no other publicly traded restaurant stock that provides investors so many unique opportunities to create value.

CONCLUSION: Provided at the beginning of this article