All posts by Roger Lipton

LUCKIN COFFEE (LK) revisited – UP 40%+ AT FIRST, NOW DOWN 20% FROM ISSUE PRICE – WHAT NOW?

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LUCKIN COFFEE (LK) revisited – UP 40%+ AT FIRST, NOW DOWN 20% FROM ISSUE PRICE – WHAT NOW?

Below is our report from 4/24/19, the only ANALYSIS of Luckin’s operation that has been made public, to our knowledge. We’ve analyzed the store level economics below, such as they are at this formative stage. As we’ve described, if it’s a store it’s more like a convenience store than a retail store. It’s certainly not “experiential” which is one of the more necessary ingredients these days if you are going to satisfy public demand in a retail setting these days. Not everything is going to be ordered on Amazon and potentially delivered by a drone.

The presumed logic regarding Luckin Coffee as an investment is that it is a “data driven” food and beverage delivery company, more like a ‘cloud kitchen’, as one (excellent) analyst put it: “using technology to successfully reinvent the coffee market, something Starbucks can never accomplish with its asset heavy business model”.

Perhaps. First of all, while Starbucks is more asset heavy than Luckin, the Starbucks unit level economics are good enough that $857 million of Operating Income was delivered in the first quarter alone. There are other contributions to that number than the stores alone, but the stores are the base. Secondly, Starbucks has used technology extremely well, with their mobile app and loyalty program, to best serve the constantly evolving customer base.

Getting back to Luckin, they may change the world, like Tesla, Uber, Lyft, or WeWork (still private) might, just as Amazon has over the last thirty years. The equity marketplace has just provided Luckin with over $500 million to pursue that dream. However: they will go through most of that capital within a couple of years and it will be a race of capital availability versus fundamental progress. One of the reasons that Tesla, Uber, Lyft and even Theranos (“Bad Blood” is a great read) have raised so many billions is that investors (both equity and debt) have been forced to reach for performance and yield in a zero interest rate environment. There is still 11 trillion of sovereign paper selling at a negative yield and that will not go on forever.

There is no “right” valuation for the above listed unicorns, including Luckin Coffee. If any one of them becomes another Amazon, any valuation under $100 billion will prove to be attractive. For our money, however, it’s very much of a long shot.

Roger Lipton

Published 4/24/19

LUCKIN COFFEE INC. – THE CHINESE KNOW HOW TO GROW !!! WANT TO HEAR A GOOD STORY ??

Conclusion: Short and Sweet: Pass

Luckin Coffee, Inc., domiciled in the Cayman Islands, operating in China, has filed a preliminary prospectus which indicates  an IPO of $100M. However, that number is supposedly just a “place holder”. The talk is about raising $700-800M, with a total market value of about $5 billion. The last capital raise, including prestigious investors such as Blackrock, reportedly valued Luckin at about $3B.

The Chinese are drinking increasing amounts of coffee, as evidenced by the rapid development of Starbucks in China, now with 3500 stores on the way to 10,000. In terms of store growth, though, that’s nothing ! The Chinese know how to do it right. Sixteen months ago, at 12/31/17 there were 9 Luckin Coffee locations. As of 3/31/19 there were 2,370. In Q1’18: 281 locations opened (that’s on a base of nine), followed by 334 new locations in Q2 followed by 575 new locations in Q3 followed by 884 in Q4. The growth has scaled back in Q1’19 to only 297 new locations. Not to worry: 2500 new stores are planned for 2019. Talk about a fire drill  😊 Who needs Starbucks when you will soon be able to participate in the growth of Luckin Coffee?

There are three types of Luckin stores: pick-up stores (91.3%), relax stores (4.6%), and delivery kitchens (4.1%). The dominant category, pick-up stores, are only 20 to 60 sq meters in size, with limited seating,  typically located in office buildings, commercial areas and university campuses. Relax stores are generally larger, more than 120 square meters in size. Delivery kitchens are often used to enter a particular market, only deliver, and are sometimes closed once other stores are opened. The 2370 stores are located in 28 cities across 16 provinces and municipalities Delivery was a big deal here at first, 61.7% of sales in Q1’18 and 62.2% in Q2, decreasing to 51.4% in Q3, 40.8% in Q4, and 27.7% in Q1’19.

There is a 200 page preliminary prospectus, plus exhibits, and we haven’t had time to read much of it yet, but the following summary financials provide a “flavor”. The good news is that, as you might expect, costs are being leveraged as Luckin grows out of its infancy. Financials are provided for calendar 2018 and the first quarter of 2019. Comparing the first quarter of 2019 to the full year of 2018, cost of goods is lower, store rental and “other” costs are lower, sales and marketing is a lot lower, G&A is lower, pre-opening expenses is lower, the (to be expected) loss as a percentage of sales is not much more than half of what it was for all of ’18.

Before reading the following paragraph: For those of our readers that are not familiar with line by line economics of restaurants, be aware that (generally) Cost of Goods runs about 30% of revenues, Labor (30%) and Other Operating  Expenses including Rent (20%), which would total to 80% of Revenues. Marketing might be as much as 5%, G&A might be 12-15% when a chain is growing rapidly, Pre-Opening expense could be 3-5% depending on how fast the growth is.  Pretax Income could be slightly positive, depending on G&A, Marketing and Pre-Opening, even at an early growth stage. Modest profitability for a young promising chain can become more meaningful as marketing & G&A are leveraged by the larger Revenue base. With this broad template, you can now see how far the operations of Luckin to date vary from the rough parameters of a successful restaurant chain.

Pay attention now: in Q1’19: Cost of goods was 57.6% of revenues, down from 63.3% for all of calendar ’18. (our template calls for 30%) Store Rental and Other costs (no cashiers but someone has to open and close and keep supplies in the right places) were 59.0%, down from 68.5% (template calls for Labor and Other to be 50%). Sales & Marketing was only 35.1%, down from 88.7% (template calls for under 5%). G&A was 36.1%, down from 45.2% (template calls for 12-15%). Pre-opening (with only 297 locations opened in Q1’19) was 4.7%, down from 11.6% (template calls for 3-5%, closest on this one). The loss of 110.2% of Revenues was emphatically lower than the 190.1% loss for all of ’18 (template calls for roughly breakeven). You read that right: The loss before taxes in ’18 was $238M against Revenues of $125M. In Q1’19 the loss before taxes was only $78M on revenues of $71M. (Maybe Luckin Coffee could merge with Uber.)  Talk about a “leap of faith”.

What’s going on here? These are almost entirely cashless pickup locations. Dividing $71M of sales in Q1’19 by an average of 2225 stores gives quarterly revenues of $32k or $128k annualized. I couldn’t find (yet) the average investment per store but $180M has been spent in capex between inception and 3/31/19 to build 2370 stores which is about $75,000 per store. This is a long way from Starbucks. This is more like a vending operation than a retail facility. It’s already being speculated that the rapid growth of Luckin will impact Starbucks comps in China. I like to travel, but it’s a long haul to Beijing, so I’ll speculate for now that the Luckin cashless pickup or delivery “experience” is a lot different than at Starbucks.

There are lots of details provided in 200 pages of a prospectus, including details about the growth in coffee consumption in China and management makes the point that the apparent cost of customer acquisition is coming down over the last fifteen months. The 54% retention rate of customers who try the product is encouraging as well. On the other hand, I divided the $125M of sales for all of ’18 by the average number of stores for the year, which I calculated at 785 (almost 900 opened in Q4) and that calculates to average annualized sales of $159k, versus an average annualized rate of $128k in Q1. There is a chart in the prospectus that seems to confirm that the customer retention rate is somewhat lower now than at first.  My estimates could be off, especially with unknown dates of opening and Q1 could be seasonally slow, but it doesn’t look like sales per existing store are accelerating. Granted: this is so early in the process that it is impossible to know what the long term model looks like. It is a sign of the times that this uncertainty hasn’t discouraged the private equity investors (at $3 billion) or the IPO underwriters with an apparent $5 billion valuation..

Getting back to unit level economics, aside from the investment per store, it doesn’t matter how small the capex/store, or even what your sales/store are, if your CGS is anything close to 57%, if your lease and other costs are anything close to 59%, if your sales and marketing are anything close to 35%, and obviously if your G&A is close to 36% (all of which will no doubt leverage to a degree with the inevitable growth).

Suffice to say: the jury is out on this one. I can’t know what the likelihood of success of this “concept” is. The Chinese like to construct residential towers, shopping malls, and cities that have almost 100% vacancy rates, planning to fill them out over time. Perhaps customers will fill out these vending facilities or retail stores (whatever you choose to call them) over time.

In terms of the valuation: Look at it this way. If the IPO valuation is about $5 billion, and we think about an aggressive valuation of 50x earnings, it would require $100M of after tax earnings to justify the IPO price. Considering that Luckin lost $78M pretax in Q1’19 and that rate of loss is no doubt going to accelerate as 2500 stores are going to be opened in calendar 2019, safe to say that it will be quite a few years before hundreds of millions of dollars of losses turn into $100M of after tax profits. Would you say: at least five years?  So the IPO valuation will be at least five years ahead of the fundamentals and that is assuming that the whole process is successful, and of that there is at least a little doubt. Of course, markets sometimes go to extremes, and momentum driven growth stock investors could take Luckin higher after the IPO and there could be some quick money made by nimble traders. But: be careful out there.  Case in point: Shake Shack, well managed with a far more predictable model than Luckin Coffee, came public in early 2015, at $21, a ridiculous valuation at the time, and ran to almost $100/share before it retraced to $30 where it sat for almost three years before the fundamentals caught up with the valuation, and those fundamentals have generally come through as planned.

One additional caveat and further sign of the times: There will be two classes of stock here. You wouldn’t expect that the Chinese would allow US shareholders to have equal voting rights, for their $700-800M capital contribution, as the Chinese founders, would you?

Conclusion: As you might suspect, we’ll follow with interest, but pass on the investment opportunity.  Harvard Business School should do a case study on this one 🙂

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NOBLE ROMAN’S (NROM) – UPDATED WRITE-UP

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Lipton Financial Services

RECENT DEVELOPMENTS, Per Q1’19 Quarterly Release and Conference Call

Our recent full writeup, dated April 3, is provided again, below, with our Conclusion updated in the wake of the Q1 report

The first quarter of 2019 was released two days ago, with management elaboration on a conference call yesterday afternoon.

The highlight of the Q1 report was an update on the post quarter opening, on 5/2, of the first franchised Noble Roman’s Pizza & Pub in Lafayette Indiana. This location, operated by Holly and Patrick O’Neil, franchisee of 18 Dairy Queens in Indiana, averaged $57,000 per week in the first two weeks, perhaps twice the most optimistic expectations. The O’Neils have already subsequently signed on to open their second location, this time in West Lafayette, adjacent to Purdue University. Relative to the first location, all observers are prepared for sales to moderate after a honeymoon period, but sales down the road should still be very impressive and highly profitable. More generally, the O’Neils obviously have the capability to build quite a few more NRCPPs and other potential franchisees will likely surface in the wake of the dramatic results in Lafayette. As demonstrated by the four company operated stores in ’18, store level EBITDA of over 20% (before royalties) is possible, at an average volume of $1.3-$1.4M so higher volumes will obviously be even more profitable.

Per Q1 operating results: As previously disclosed, the abnormally difficult winter weather affected first quarter results, and total revenues was virtually flat at $2.92M vs. $2.95M,  but income before taxes was $627k, up 16.3% year to year, as a result of good cost control in all divisions.  About $15M of earnings is tax protected so taxes will not be a consideration for a  while. EBITDA was $847K, up 9.8%, obviously annualizing to about $3.4M. We should note that cash generation was reduced by $242k, mostly from  outlays that are (contractually) added to long term receivables. Subtracting the $242k from $847k of EBITDA, the conservatively stated $605k of cash generation was promising in a quarter which should be improved upon as the year progresses.

Looking at each division, in order of importance:

The NRCPP saw store level EBITDA margins declined to 11.5% from 21.9%, obviously a function of the abnormal winter weather.  The company release did say that sales rebounded in March, with store level EBITDA at 20.5%. On the conference call, the company further said that weekly sales in April and early May have continued to improve from March levels. The 10Q revealed that March sales were $450,000 for the four stores, which would annualize to $1.35M and be consistent with  previous performance and current expectations. The new Pizza Valet and delivery through Doordash have been well received by customers and promise to add to sales over time.

The total non-traditional revenues were up 3.3% to $1.593M, as non-traditional franchising (C stores, gas stations,  etc.) was up 16% to $1.287M, more than offsetting a decline in the the grocery store segment (which is being de-emphasized, as previously discussed) to only $305k in Q1. It is noteworthy that effective expense control created a margin contribution of 69.0% in this segment, up 1100 bp from 58.0%. 13 new locations have opened in 2019 vs. 8 closed, and the higher volume at new vs. old locations generated the 16% increase in revenues.

In terms of further news, Paul Mobley indicated on the conference call that “we would like to open another five company owned stores over the next 18  months or so…and we’re currently in process of discussions and talks with firms, investors who are interested in that financing, but we–I can’t tell you which ones or what will happen at this point..and that will be debt financing, not equity financing”.

CONCLUSION

We need not make precise projections in terms of cash flow and earnings, other than presenting the rough parameters below, even if some of the developments as described above could affect results. Our statistical template provided above assumes only a continuation of the four company operated stores that are in place, maintenance of the other two operating segments, no material contribution from franchising, and no surprises, positive or negative. Substantial progress has been made over the last two years, both operationally and in terms of balance sheet restructuring. With $3.4M of EBITDA in the last twelve months, and the possibility of substantial growth from here, the stock is obviously cheap statistically. There would normally be a great deal of private equity interest at this kind of a valuation, but this is a very small deal in today’s environment and management has no desire to change ownership at anywhere near the current valuation. Time will obviously tell as to what extent this management team capitalizes on the current opportunity, but it seems like the necessary pieces are in place to take this reincarnated brand a great deal further.

THE COMPANY

Noble Roman’s, Inc. (NROM) is over forty years old as an Indiana Corporation, having operated, franchised and licensed versions of the “Noble Roman’s Pizza” brand. Founder and Chairman, Paul Mobley, formed NROM in 1972, still leads the company from a strategic standpoint, plays an active CFO and shareholder relations role, and his son, Scott, is President and CEO. Locations selling NROM Pizza today include 50 states and Canada. While the company has operated and franchised stores with varying degrees of success over the years, the underlying reputation for serving a high quality product has been generally maintained. This is evidenced by the most recent commentary in social media (Yelp and Facebook) relative to the openings of Noble Roman’s Craft Pizza and Pub locations (NRCPP), the most recent incarnation of the brand.

Though customers of Noble Roman’s mostly remember the brand with the nostalgia of their youth, the long operating history has included a number of starts and stops. In particular, the six years ending in ‘17 were burdened by losses related to the unsuccessful effort to build a “Take ‘N Bake” version of Noble Roman’s, and the Company paid a predictable price for the failure. We describe below, when discussing the improved balance sheet, some of those costs.

THREE OPERATING SEGMENTS

Noble Roman’s today has three primary areas of focus, in order of current emphasis: (1) Expansion of a new generation of NRCPPs, which, following the successful openings of four company operated locations, has recently begun to award franchise rights. (2) Franchises-Licenses for “non-traditional” locations, primarily in convenience stores (often affiliated with gas stations) and entertainment facilities. (3) Licenses to sell Noble Roman’s products within grocery stores.

“NOBLE ROMAN’S CRAFT PIZZA AND PUB” (NRCPP)

This is by far the most attractive expansion opportunity for the Company. The fast casual restaurant features two styles of crust, both thin and Deep Dish Sicilian, with their famous breadsticks served with spicy cheese sauce, specialty salads, four pasta dishes, all “designed to be fast, easy to prepare and delicious to eat.” New pizza oven technology provides bake times of only 2.5 minutes for the regular crust, 5.75 minutes for Sicilian, with the dough preparation room visible to customers.

The concept as we would describe it is: similar to Blaze, MOD, and so many other participants in the fast casual pizza segment, but “evolved” and “differentiated” in major ways. NRCPP serves personal size pies as well as family sized, serves traditional crust as well as Sicilian (for the same price), serves a limited number of salads, sandwiches, chicken wings, and desserts. Wine & Beer (including Craft Beers) is served at a modest but comfortable bar, where you can also dine. Half a dozen TV sets create a low key sports bar “vibe”.  Anecdotally, we have personally been to all four locations, several times to the first of them, and have been impressed with the quality of operations that has been taking place.  Social media commentary, including Yelp and Facebook, confirms our reaction, and the public’s view of The Brand seems to be a combination of nostalgia combined with admiration of the current updated approach. The hospitality quotient provided so far should presumably be replicable in the foreseeable future because the company operated stores, as well as initial franchised locations, will continue to be in NROM’s “back yard”. The first location (Westfield) opened  1/31/17. A second location (Whitestown) opened 11/17/17. The third location (Fishers) opened 1/18/18 and the fourth (Carmel) opened 5/29/18.  The Company has shown an ability to open these four stores, at budgeted cost, in only 3-4 months after lease signing. Naturally, the speed of future openings is dependent on lease negotiations, real estate variance requirements, and the configuration of the proposed site.

UNIT LEVEL ECONOMICS OF NOBLE ROMAN’S CRAFT PIZZA & PUB

The locations are about 4,000 square feet, cost about $630,000 (including about $50,000 of pre-opening expenses). The targeted average annual volume is $1.35M  with a first year store level EBITDA above 20%. Cost of Goods combined with Labor (including fringe benefits) is expected to average no more than 50% of sales. These parameters provide an immediate 43% cash on cash return, allowing for just over a 2 year cash payback. The first four locations are collectively meeting, and sometimes (Westfield) individually exceeding all these targeted parameters (ex the extreme weather in Q4) on an annualized basis, though only the first (Westfield) has been open for more than one year. It is important to note that many successful restaurant franchisors project targeted cash on cash returns in year three much lower than shown above (and don’t include pre-opening expenses in their calculation), obviously far less attractive than the indicated fully loaded immediate returns of NRCPP. Since the company, as well as the first of the franchised locations, will be located near Indianapolis, pre-opening costs and initial opening inefficiencies should continue to be minimized. 

 FRANCHISING OF NOBLE ROMAN’S CRAFT PIZZA AND PUB

While four locations in Indiana (only one of which is two years old) does not imply worldwide expansion opportunities, NROM management has many years of multi-unit operating, and franchising, experience and there are very few concepts in the restaurant industry that have generated the returns as described above. Average Unit Volumes (AUVs) could build further as the Indiana market is penetrated, or perhaps be cannibalized, but delivery (in conjunction with DoorDash) and a new curbside Pizza Valet pickup service has both just started in January, a mobile app is starting its beta test, and many other operating and marketing initiatives are in the works. Greater Indianapolis alone could support at least 20 units, the State of Indiana many more, so an obviously unlimited growth runway is in place. The Company, operationally led by President and CEO, Scott Mobley, has done an admirable job of getting NRCPP off and running, profitable from the very beginning. Noble Roman’s brand is known, to varying degrees, in all 50 states, and could no doubt succeed in well run, properly situated locations almost anywhere, but Indiana and the immediately surrounding geography represent the most obvious expansion opportunities. It is noteworthy that well located non-traditional locations in C stores and hospitals do impressive enough volumes to indicate that NROM pizzas can attract customers far from Indianapolis but stores close to the home base are naturally the current priority.

The franchising strategy for NRCPPs is to sign single unit, experienced, operators close to home. Further away, only very well capitalized operators, fully committed (operationally, financially, psychologically) to building out markets, will be enrolled. Since an operating organization is in place at NROM that can support local franchisees in their startup phase, and multi-unit franchisees will pay non-refundable up front franchise fees that should more than offset support services, the franchising effort should contribute immediate incremental profits and cash flow to NROM. The initial franchisee fee is $30,000 for a single unit, $25,000 for the second, $20,000 thereafter. Ongoing royalties are 5%, plus a 2% contribution to a creative fund.

The first franchisee is under construction and should open around 5/1/19, a highly regarded Indiana based Dairy Queen franchisee, Holly and Patrick O’Neil, who currently operate nineteen DQ locations. Since they have been expanding their number of DQ locations in recent years, they seem to have the financial and operating resources to open additional NRCPP locations if the first location is successful. The excellent reputation of Holly and Patrick (who has been head of the DQ franchise association) will no doubt be encouraging to other potential franchisees. They could also provide operating expertise to the NRCPP system. Nobody has all the answers and every successful franchisor has learned a great deal from their experienced franchise partners. Their first location will be in Lafayette, Indiana, a previously successful jurisdiction for Noble Roman’s.

NON-TRADITIONAL FRANCHISING

The company has franchised about 750 units, including convenience stores, travel plazas, entertainment venues, hospitals, most several Wal-Mart and Circle K locations.  A prototype counter top unit was introduced in early ’16 and expansion within this division is picking up momentum in recent months. There is obviously a time lag from when a new license is signed to when a location opens for business. This steady source of revenues amounted to $4.5M in ’17, up from $4.4M in ’16. Revenues from this segment were flat at $4.5M in calendar ’18, but up about $100,000 (9%) in Q4, presumably a harbinger of more growth to come. 38 non-traditional franchised locations joined the system in calendar ’18, and 19 left. Since signings, reflected by “Upfront Fees” increased from $286k in ’17 to $379k (which included $30k from the first NRCPP) in ’18 (up 22% net of the NRCPP fee), an increase in non-traditional royalty revenues can be expected in the future. This momentum is continuing in Q1’19, as the company announced that, through 3/26/19, 14 new locations have been signed up versus 6 in ’18. It should be noted that non-traditional locations closed are typically older low volume units, and are being replaced by higher volume new units. It should also be understood that while a few units have opened within Circle Ks and WalMarts, those retail systems are difficult to quickly penetrate for a number of reasons and we expect independent operators to be the more predictable source of growth. Overall, the pace of signings within this segment, with tens of thousands of potential outlets throughout the country, has clearly picked up over the last eighteen months, and could be capable of, at least offsetting the current slippage in the grocery channel described below. The initial franchise fee is $7,500, except for $10,000 at hospitals. The ongoing royalty is 7% of sales, with no advertising contribution since customers in these locations are mostly on the premises for other reasons.

GROCERY STORE LICENSING

Noble Roman’s has licensed, by way of a supply agreement, sales of its products to 2,106 grocery stores. The licensed grocery store must purchase proprietary ingredients through a Noble Roman’s approved distributor. The deli department of the grocery store then assembles the products and displays them using Noble Roman’s point of sale marketing materials. The distributors collect for Noble Roman’s a fee in lieu of royalty as they sell ingredients to the grocery stores and remit this amount within ten days of each month end. While the number of grocery stores under license expanded steadily for several years, especially until the end of 2016, the labor requirement within the grocery deli departments has limited further growth, and the improving economy has reduced the number of budget driven pizza consumers, so license revenues from this segment has contracted in the last two years. It is unknown how many of the 2106 grocery locations are currently offering product, especially since stores sometimes are removed and then later return. NROM management has explored the possibility of assembling the pies at the distribution level, reducing the labor requirement at the individual grocery store, but a solution has not yet been developed. Royalties and fees from grocery store distribution was $1.4M in calendar 2018, down from $1.8M in ’17. While this division’s revenue has slipped in the last two years, the economy seems to be slowing once again, which would make deli-workers more available and consumers more interested in a take and bake product. This division can therefore be considered “counter cyclical”. With two other far larger and more promising divisions, NROM management is concentrating efforts elsewhere and a change in results from this division shouldn’t affect overall performance by much.

THE BALANCE SHEET – SUBSTANTIALLY IMPROVED

During ’15, ’16 and early ’17, as the Take ‘n Bake version was winding down, and the NRCPP version was incubating, the Company was carrying short term debt with an interest rate over 20%, especially burdensome when the company was still reporting operating losses from termination of the Take ‘N Bake adventure. $2.4M was raised in late 2016 and early 2017 in the form of 10% debentures, maturing in December 2019 and January 2020, convertible at $0.50/share, with 2.4M warrants @ $1.00 attached. It is worth noting that both Paul Mobley, Chairman, and Marcel Herbst, Director, participated in this private placement. While the terms of the convertible debt were not pretty, it was a lot better than what had been in place. More importantly, in September ’17 the Company put in place $4.5M of conventional bank debt, maturing in September 2022, at an interest rate of LIBOR plus 4.25%. Additionally, a $1.6M Development Line of credit facility was established to fund three new company operated locations.  Each tranche of the Development Line is repaid starting four months after being drawn, on a seven year amortization schedule. As described earlier, the rapid cash on cash returns from the new locations are easily capable of servicing the Development Line and generating excess cash as well. Overall, the new financing arrangements have provided NROM with adequate financial flexibility, allowing steady further development of NRCPP locations, building a franchise operation, also further developing the two other segments. Calendar 2018 results benefited from over $500k of cash interest savings YTY. It is also important to note that NROM has a Deferred Tax Asset on their balance sheet of $5.6M, sheltering about $15M of pretax earnings.

In the Q3’18 report, the Company indicated its plan to extend the maturity date of the 10% convertible (at $0.50) notes, (with warrants at $1.00/share attached), by three years, $650k of which has been accepted to date. According to the 10-K, “The Company is prohibited by its loan agreement with its senior debt lender from repaying the Notes as long as its senior debt is outstanding. In order to meet the maturity schedules in late 2019 and 2020, the Notes must either be converted to common stock, extended beyond the maturity of the senior debt or replaced with other like securities. The Company may not be able to accomplish any of those alternatives. The Company intends to extend or refinance with external capital the Notes maturing in 2019 and 2020. However, the Company may not be able to refinance its debt or sell additional debt or equity securities on favorable terms, or at all.”

The above paragraph in the 10-K is appropriately conservative in its description. We believe that the Company can “remarket” the 10% Convertible (at $.50, with warrants attached) Notes, since the balance sheet and cash generation of the Company is much improved since those securities were originally placed in late 2016.

It is noteworthy that Current Accounts Receivable, at 12/31/18, were down 12.4% to $1.574M from a year earlier, and the Company stated in their year end report that all existing franchisees are current in their payments. Non-cash writedowns of the Carrying Value of Receivables over the last several years, including the largest, $4.1M in calendar 2018, do not relate to current franchisees. While there will be an ongoing collection effort, legal expenses in this area are expected to be lower than in the past.

RECENT DEVELOPMENTS – Q4 AND FULL YEAR ’18 RESULTS

2018 as a whole demonstrated significant corporate progress. Adjusted Net Income was $2.5M, up 70% from 2017. Adjusted EBITDA was $3.4M, up 6.6% from 2017.

The largest addback adjustments to the GAAP net loss of $3.1M were $4.1M non-cash adjustment of receivables from 2014 and 2015, and $930k adjustment of the value of deferred tax credits. Adjusted EBITDA was affected by the same items, with Depreciation and Interest comparisons added. We supply the full tables of Adjustments to Net Income and EBITDA as an Appendix to this article.

The dominant portion of fourth quarter results was the operation of four NRCPP units versus two a year earlier, which obviously affected revenues and related costs. Weather, especially in December, affected sales, so store level EBITDA margin was 10.5% from 18.4% in Q4’17. Store level EBITDA for the year was 18.9% (vs.23.7%), still impressive considering the inefficiencies of operating three units less than a year old and the Q4 weather. Most importantly, the Company stated in their latest  release that March sales were running 23% over the December level and “the margin is expected to move back above 20% in the coming months”. While Q4 average annualized sales were about $1.15M, the full year annualized average volume was $1.36M by our calculation of operating store-weeks. The demonstrated recovery in March, combined with the customer (and staff) enthusiasm over the Pizza Valet service, delivery through DoorDash, and other operating and marketing initiatives, should continue to support the targeted average annual run rate of $1.35M per unit.

Up front fees, reflecting franchise signups were up 13.6% for the quarter and 32.5% for the year. Non-traditional franchise fees (ongoing royalties) were flat for the year but up 9.1% in Q4. As the signups convert to operating units, and with new signups in ’19 (14 vs 6 as of 3/26), both of these categories should build further.

Grocery store license fees were down 28.2% in Q4 and 22.2% for the year. As discussed earlier, this division can be considered counter cyclical and could at least stabilize in a slowing economy. Moreover, with only $1.4M of revenues for all of ’18, $323k in Q4, this division is far less important going forward than non-traditional locations generating $4.5M annually and now growing and, of course,  the expansion of the NRCPP division.

The conference call discussion briefly discussed the results, talked about the recovery of sales and margins in March, estimated that the first franchised location in Lafayette, IN, will open around May 1st. Most importantly, CEO, Scott Mobley, discussed the success of the Pizza Valet curbside pickup and the implementation of delivery through DoorDash. He described at length a large number of recent and planned initiatives, including: a bar enhancement program, expansion of an already successful catering effort, introduction of daily food specials, pending introduction of online ordering,  expansion of their award winning social media effort, and others. Paul Mobley, Executive Chairman, indicated that two new company operated locations could open later this year. He disclosed, as we have already  referenced,  the signup rate of non-traditional locations and the recovery in NRCPP sales in March.

THE CURRENT BALANCE SHEET AND ENTERPRISE VALUE

There is currently about $6.8M of total debt, and about 21.6M shares currently outstanding. The debt consists of $4.8M bank debt, including the current portion, and $2.0M of convertible debt (at $0.50/share). There are 2.4M warrants, that were attached to the original convertible debentures, at $1.00 per share, which would obviously bring in $2.4M of equity if exercised. There are about 1M additional shares due to various options and warrants, which would bring in roughly $500k if exercised. In total therefore, about 27M shares would be outstanding, fully diluted, but that would have brought in over $5M of equity, reducing the current $6.8M of current debt very substantially. We can therefore consider that the total enterprise value of NROM is something like ($0.47/share x 27M shares=$12.7M) plus $1.8M of remaining debt after cash generated from exercise of all options and warrants, or a total enterprise value of about $14.5M. Dividing by the $3.4M of trailing twelve month EBITDA, the Enterprise Value is 4.3x TTM EBITDA.  When questioned on the conference call about the possibility of broadening the Board of Directors (currently four members, two of which are independent, plus Paul and Scott Mobley), Paul Mobley indicated that this is under active consideration.

CONCLUSION – Provided at the beginning of this article

 

 

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SHAKE SHACK (SHAK) REPORTS Q1’19 – REVENUES UP, NOT PROFITS !!

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SHAKE SHACK (SHAK) REPORTS Q1 – REVENUES UP, NOT PROFITS

On March 22, 2019, we updated our basic writeup on Shake Shack, and, provided a conclusion that is more “reserved” than most of the analyst and investor commentary. This once spectacular concept is coming down to earth, as a result of industry wide economic realities, a highly aggressive expansion plan that is guaranteed to have inherent inefficiencies, and store level economics that are not what they once were. We provide below our complete analysis from 3/22/19, with the most important ingredients provided just below our Q1 summary:

RECENT DEVELOPMENTS – Per Q1’19

Guidance was adjusted just slightly for ’19, overall Revenues by about 1%, and comp sales by about 1%, due to Q1 comps that came in at 3.6%, including traffic up 1.6%. Cutting through certain adjustments and changing tax rates, we like to look at pretax income, which was $2.546M, down from $3.508M. Though analysts and investors don’t seem to care much, at SHAK or many other companies, preferring to focus on Adjusted numbers, Q1’19 after tax fully diluted GAAP earnings per share for common stock was $0.08 vs. $0.13.

The key for us is store level economics. Cost of Goods was up 140bp to 29.5%. Labor was up 110bp to 28.9%. Other Operating Expenses were up 90bp to 12.1%. Occupancy was up 50bp to 8.5%. Depreciation was up 20 bp to 6.8%. G&A “leveraged”, improving 140 bp to 10.5%. Management continues to predict store level EBITDA margin of 23-24% for all of ’19, but that number was 21% in Q1, down 400bp year to year. If the full year is going to get back to 23-24%, there will have to be very healthy margin improvement later in the year. Looking at the line by line pressure in all the key ingredients during Q1, and management’s admission in their supplemental materials that “labor inflation, increased regulation in key markets combined with higher costs in new Shacks remain a headwind for margin”, their 23-24% guidance could be a “reach”. Supporting management’s expectations that AUVs and store margins will moderate over time, with an annual AUV of about $4.1M by the end of ’19, Average Weekly Volume in Q1 was 79k, down from 81k in Q1’18.

There is, of course, a bright side to this story, including strong international licensed development supported by recent openings in Shanghai and Singapore. Digital channels, including delivery, have very large long term potential. Menu innovation is a key strategic focus, and can impact sales materially, though the recent nationwide well received launch of Chick’n Bites was apparently underpriced and hurt margins. The admirable “commitment to excellence” in terms of personnel development, will no doubt pay off in the long run but likely also has a short term impact on operating margins.

We need not itemize today the long list of operating initiatives that continue. The main point today is that our previous expectations continue to play out in early ’19. Every indication is that the rest of ’19 and then 2020 will provide more of the same. We stand by our Conclusion from 3/22/19, which goes as follows:

FROM 3/22/19 – CONCLUSION (with SHAK at $55, vs $59 today)

SHAK came public at $21 a little less than 3 years ago, ran to a high above $90 in June of 2015, “fully valued”, to say the least, at $90.00 compared to the $0.32 per share reported in 2015 and $0.46 in 2016. It is obviously somewhat more rationally valued today versus the Street estimate of $0.60/share in 2019 (lowered to $0.57 5/13/19). We point out, once again, that, in our mind, there is no other publicly held restaurant company that has more well regarded management, a still attractive store level operating model, and a virtually unlimited runway for future expansion. However, a number of the operating parameters (such as AUVs, store level margins, and EPS growth rate) are “coming down to earth”. Most noteworthy, as we point out below, the cash on cash EBITDA return on investment for stores currently being developed, is less than half of what it was in calendar 2016, in the wake of the 2015 IPO. This should be no surprise, and correlates to the deterioration of the Sales;Investment Ratio, as detailed at the end of this article.  Furthermore, the very aggressive growth of company units (35-40% on the base) has its own set of risks. In fact, we can think of no other restaurant company, in the last thirty or forty years, that has expanded at this rate in diverse geographical markets without a noteworthy degree of inefficiency (to say least). As admirable as this operating team is, we suspect that the Street estimates going forward will continue to be overly optimistic.  We consider the Shake Shack brand and its fine management team more than adequately valued at over 90x expected ’19 EPS and 33x trailing EBITDA.

From 3/22/19

Rather than itemize the adjustments (for ’18), we think it is more productive to focus on the store level operating metrics. New stores, as predicted, are opening at levels closer to $3M than the current $4.4M domestic company AUV. Store level EBITDA of new stores is closer to 20% than the 25.3% of ’18. Accordingly, management is guiding, for ’19, to AUVS of 4.0-4.1M, with store level EBITDA of 23.0-24.0%. This guidance could prove to be conservative, but realistic expectations is lower relative to past years. This is a result of guidance, including total revenues up 28-29%, SSS of 0-1%, including 1.5% price. There will be a continued aggressive opening pace (36-40 new company openings plus 16-18 licensed), G&A of 66.4-68.2M, up 26-29% (leveraging slightly against the revenue gain), depreciation expense up 40% or more (higher investment per store?), pre-opening expense of $13-$14 M (a constant 350-360k/store).

Relative to Q4’18 and ’18 as a whole, and implications for ’19 and ’20, our bottom line is that, based on cost expectations at the store level, corresponding lower store level margin, combined with ongoing corporate spending to support the aggressive growth plan, it will be hard for SHAK to show improvement in net income per share. Of course, we are of the old school, unable to lose (we almost wrote “shake”) our attachment to Generally Accepted Accounting Principles.

Our contribution to the dialogue is that, while the revenues per store have been, as management predicted, coming down, the investment per store is going UP.  The following three short paragraphs are copied from the ’16, ’17 and ’18 10k filings.

 Construction: per the ’16 10K

“A typical Shack takes between 14 and 16 weeks to build. In fiscal 2016 the cost to build a new Shack ranged from approximately $1.2 million to $3.4 million, with an average near-term build cost of approximately $1.8 million, excluding pre-opening costs. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

 Construction: per the ’17 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 million to $3.3 million, with an average near-term build cost of approximately $1.7 million, excluding pre-opening costs. The total investment cost of a new Shack in fiscal 2017, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.6 million to $3.7 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Construction: per the ’18 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2018, the total investment cost of a new Shack, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.4 million to $4.0 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Editor’s comment: With depreciation guided to increase by more than 40% in ’19, it’s possible that the investment per store is moving higher still.

WHAT DOES IT MEAN?

You can see that, while there have been some changes in wordings (your interpretation is as good as mine), the $1.8M average investment, as described in the ’16K is a lot lower than the $2.2M investment of ’18. AUV in ’16 was $4.981M, virtually flat with ’15. The pre-opening expense seems to have been about constant at 350k/location. Back in ’16, the store level EBITDA was 28.2% (down from 29.1% in ’15).

So: the store level EBITDA cash on cash return in ’16 (adding the $350k of pre-opening to the $1.8M cost of construction) was 28.2% of $4.981M which implies $1.4M, an awesome 65% of the total $2.15M investment. (No wonder the new issue went to $90/share.) Today, however, the 23% expected EBITDA margin (at most) on new stores doing $3.3M (at most) would be a 29.7% cash on cash return. People…..this is a big difference, and this could be the best case. 

ANOTHER MEASURE: THE SALES/INVESTMENT RATIO

Often forgotten these days, the original Sales:Investment ratio was designed to determine how Revenues covered TOTAL occupancy expenses, including capitalization of the rent expense (which is the landlord’s investment). Back “in the day” a sales:investment ratio of less than 1:1 was considered less than ideal, unless a restaurant was selling flour and water and tomato sauce (for example) rather than protein, allowing for lower food cost to subsidize higher occupancy expense. Over the years, especially as interest rates have been suppressed, “cash on cash” returns have most often been used as a performance measure, and we have presented that parameter earlier in this article. However:  the average rent in 2018 was $309,000 annually for SHAK’s first class locations. Capitalized at 8x, that would be an incremental investment of $2.47M, and brings the total GROSS INVESTMENT, including pre-opening expense, to approximately $5M per location. As we’ve seen, revenues of $5,6, or 7M at early locations allowed for an impressive store level EBITDA, but it’s equally obvious that revenues modestly over $3M per location will generate much lower returns after high occupancy expenses, and that is demonstrably happening.

READERS CAN ACCESS FULL WRITEUP ON 3/22/19, FROM HOME PAGE, CLICK THROUGH “PUBLICLY HELD COMPANIES” FOR LISTING

Roger Lipton

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

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

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

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

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

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

Current Conclusion

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

Recent Developments

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

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

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

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

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

Our interpretation, at that point.

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

The New Guidance:

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

Our reaction to the new guidance:

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

 

Roger Lipton

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

 

 

 

 

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – THE BEAT GOES ON !!

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – THE BEAT GOES ON !!

The general equity markets were up modestly in April. Gold bullion was down a fraction of 1%. The miners, which had outperformed gold bullion in the first quarter gave back their gain. For the year to date both gold bullion and the gold mining stocks are essentially flat. Considering that the US Dollar is at a high and the general equity market has been strong, that is reasonably good performance for a non-correlated asset class.  Fundamentally: nothing has changed regarding the long term fiscal/monetary trends. In fact, the prospect for a major move in gold bullion and an even larger move in the gold mining stocks has only improved. The longer the fundamental factors that we present prevail,  the larger the price move in gold bullion and the mining stocks will be.

 Over the last month, the following bullet points come to mind:

  • Ten years after the sub-prime bubble of ’08-09, new financial excesses have arisen, including a private equity mania (Lyft, Uber,  Wework, etc.), a subprime auto bubble, a student loan bubble, a sovereign debt bubble among emerging economies, a “levered loan” bubble.
  • Central Banks continue to buy record amounts of gold bullion. They understand that the paper currencies are being diluted and are increasingly aggressive in diversifying their foreign exchange reserves away from US Dollar. China and Russia, increasingly considered our adversaries, are the most prominent gold bullion buyers. In India, where the public traditionally accumulates gold, the central bank has again become a substantial buyer, increasing their holdings by 50 tons (the total by over 10%) in just the last 15 months.
  • Debt creation as a GDP stimulant is increasingly impotent. As calculated by highly regarded economist, David Rosenberg, since 2007 “global debt has ballooned by $140 trillion while global GDP has risen by only $20 trillion. The “bang for the debt buck” is clearly diminished, and that will only get worse over time.
  • The highly touted 3.2% growth in US real GDP was largely dependent on non-recurring factors. Inventory build, government spending, and lower imports together contributed 2/3 of the total. The 3.2% number was also calculated based on only 0.8% annualized inflation, and that assumption is questionable. One thing we can count on, however,  is that economic performance in the US will continue to be presented in the most favorable possible  light between now and November, 2020.
  • Following on the previous point, just this morning Steven Mnuchin, Sec’y Treasury, pointed out that the US debt limit, which has already been exceeded, will have to be raised within six months, because our financial flexibility will have been utilized. $22 trillion is comfortably in the rear view window, and $23 trillion is months away.

The following discussion is a bit “technical” in nature, but we feel is crucial in terms of long term expectations for financial markets.

CENTRAL BANKS BUY STOCKS AND BONDS – A RECIPE FOR LONG TERM DISASTER !! – A LESSON IN “MARKET MAKING”

It’s been a number of years since we had an active market in the US for initial public offerings. Decades, and a number of stock market cycles ago, this then young analyst watched quite a few small companies come public, in many cases underwritten by brokers much smaller than the surviving investment bankers of today. Some of those underwriting firms, well intentioned to be sure, supported the brand new issue with a supporting bid, figuring it was just a question of time before the market figured out that the stock was attractive, the supporting bid could be removed, the stock would be freely trading and move up, the public customers would be happy, and the broker might even make a profit when selling their acquired inventory. Other underwriters, not so committed to supporting the new issue price, allowed the stock to trade freely immediately, tolerating the higher volatility, and allowing the free market to establish (“discover”) the price, for better or worse.

The interesting aspect of these two approaches was as follows: The firms that intervened in the marketplace in many cases finally choked on the inventory, their capital was not sufficient to buy the stock forever, and they ultimately went out of business. The more prudent underwriters that allowed for “price discovery” (as the PHDs would put it) by the normal supply and demand of the marketplace lived to play another day.

This small scale example applies to the trading habits of worldwide central banks today. As the US government builds its debt over $22 trillion, which is more than 100% of our GDP, lots of observers say it is no big deal since Japan, for example, has government debt at 250% of their GDP. The Japanese economy is still functioning, with slow growth to be sure, but there is no evident crisis. This reminds me of the cartoon where the guy jumps off the cliff, and, while in the air, calls out: “I feel fine !!”

There are over $10 trillion of government securities trading with less than a zero percent yield. This is as a result of the US, ECB, Japanese and Chinese central banks buying stocks and bonds, supporting the price of stocks and bonds, and suppressing fixed income yields. In this absence of true price discovery by the marketplace, fixed income savers have been penalized, to the benefit of stock and bond holders, creating a wealth effect for the latter. This good fortune on paper could (and will) be temporary, but for the moment, just like the guy who jumped off the cliff, we feel fine !!

Where are we in this process ??  In addition to the negatively yielding fixed income government securities, the Bank of Japan (that has been doing this for almost thirty years) now owns about $250 billion of Japanese ETFs, or 75% of that entire market of ETFs. On the fixed income side, the Bank of Japan owns about 45%, or $4.5 trillion worth of all the Japanese government bonds outstanding. With it all, the Japanese economy is still running well below 2% real growth, with inflation at well under the 2% objective. It is of course an important sub-text that central banks worldwide are trying to stimulate inflation, rather than subdue it, which was the original objective.  Closer to home, we have been informed that our Fed is abandoning QT, preparing for a new form of QE, which, some have suggested, could include the purchase of US equities as well as bonds.

Here’s a quick economic lesson for the hundreds of PHDs that are working within central banks, which we guess isn’t part of the new Modern Monetary Theory. Don’t intervene in a market unless you are prepared to BUY IT ALL, because you will, eventually. Witness the holdings of the Bank of Japan, who have been at this game the longest, still without the result they have been reaching for. Aside from a long list of unintended consequences that have yet to play out, the attempt to lighten the inventory, (Sell to whom?) has just been demonstrated in the US. One down month in the stock market (December) with the two year treasury rate approaching 3% and the US Fed caved. Whom do you think the Japanese Central Bank can sell to?

The above described central bank intervention in capital markets will inevitably destroy most international currencies, including the US Dollar, because the money will have to be created to support the capital markets and the presumed wealth effect that will prevent economic collapse and that will be highly inflationary. This is the “bubble” that Donald Trump described when he was campaigning but that he has forgotten about since he is in office. The politicians and central bankers will continue to chase their long term (NEW) goal of creating inflation substantial enough to service long term debt obligations. We described early in the article how the debt increase in increasingly impotent in terms of stimulating GDP growth. The corollary is that the debt, worldwide, is far too large to be paid off in the currencies of today. Substantial inflation is the only politically acceptable remedy, since outright default is too obvious to the voting public.

Roger Lipton

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RESTAURANT BRANDS (QSR), TEXAS ROADHOUSE (TXRH), BRINKER, INT’L (EAT) REPORT RESULTS — ALL THREE STOCKS ARE DOWN — WHAT’S GOING ON?

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RESTAURANT BRANDS (QSR), TEXAS ROADHOUSE (TXRH), BRINKER INT’L (EAT) REPORT RESULTS — ALL THREE STOCKS ARE DOWN — WHAT’S GOING ON?

Well regarded pure franchising Restaurant Brands, QSR, Best of Breed company operator, Texas Roadhouse, TXRH, mature professionally managed multi-chain company operator/franchisor, Brinker, Int’l.,(EAT) all reported their March quarters within the last 36 hours. What can we learn?

Before we start, because the news is not great and I recently seem to be consistently pessimistic (I would say “realistic”), you should know that I am not “talking my book”. I am neither long nor short two of the three companies discussed, and have a very modest short position in only one of them (which shall go nameless). All three stocks are down since they reported, QSR and EAT more modestly than TXRH, which is down about 10% this morning.

We are not going to provide extensive details, which you can read about elsewhere and which we will discuss in our full writeups to be posted within the next couple of weeks. We will provide just the pertinent highlights as we see them, and our conclusion.

Restaurant Brands (QSR), franchisor of Tim Horton’s, Burger King and Popeye’s, reported EPS down YTY, because of a higher tax rate. Actual Income Before Taxes was up, $302M versus $281M, but it should be noted that Other “Income” this year of $17M was $30M better than Other “Loss” a year ago of $13M. Let’s call it “flat” pretax income, by our simple adjustments. Everybody looks at comps and EBITDA by division here. Tim Horton’s delivered a negative comp of 0.6% in Q1, on top of a negative 0.3% in 2018. Price changes are not discussed relative to any of QSR’s three brands, so we can’t comment on traffic. Adjusted EBITDA at Tim Horton’s was $237M, down from $245M. Burger King had systemwide comps of 2.2% on top of 3.8% in ’18. BK’s Adjusted EBITDA was $222M vs. $214M in ’18. Popeye’s had a comp of 0.6% versus 3.2% in ’18. Adjusted EBITDA was $41M vs. $39M in ’18. The three brands, therefore, had total Adjusted EBITDA of $500M vs $498M a year earlier. Let’s call the results flat, and the bottom line is that, as we have predicted for some time, it will be very difficult to grow the EBITDA and EPS comparisons by more than mid single digits. Combining the “hard” results with the conference call commentary, there is very little happening that will accelerate the cash flow and earnings progress. Readers can refer to our previous commentary regarding QSR, , but, suffice to say: Tim Horton EBITDA growth, which grew from 2015 through 2017 largely by price increases imposed on the distribution chain, is not going to recur, especially in light of the lawsuits by franchisees. Burger King is a steady grower, especially overseas, but the G&A magic has already been imposed on this system so the easy money has been made. Popeye’s is the most rapid growth division, but is too small to move the total needle by much. The dividend of almost 4% supports the stock price, but it has seemed to us for a while that this “mid-single digit” grower is fully priced at 20x trailing EBITDA and 25x forward EPS. It should also be noted that much of the “free cash flow” has been used to buy back partnership interests from their parent, 3G, so this “return to shareholders” has primarily benefited 3G. From 12/31/16 to 12/31/18 the average weighted fully diluted shares outstanding has gone from 470M to 477M to 473M. There is substantial cash flow here, but a great deal of it has been used to buy back exchangeable Partnership interests from 3G. The long term debt was constant at $11.8B in ’18 over ’17 (after $3B was borrowed to buy back Berkshire’s Preferred), and “free cash flow” is not so “free” when debt is over five times trailing EBITDA. The Board of Directors preferred in ’18 to buy back stock from 3G (at 25x expected earnings and 20x trailing EBITDA) rather than reduce the debt. We agree that it seems sensible, from 3G’s standpoint, to lighten up. To be sure, there is a substantial dividend for common shareholders.

Texas Roadhouse (TXRH) is a simpler story. They are truly one of the premier operators in the full service casual dining space, consistently delivering same store sales growth as well as traffic gains. The most recent quarter was no exception, with an admirable comp of 5.2%, including 2.6% traffic. The monthly comps, though decelerating through the quarter were fine, up 7.2%, 4.7%, and 4% in January, Feb., and March. April to date is up 2.9% on top of 8.5% a year earlier. However: Income from Operations was down 6.8%, and diluted EPS was $.70 vs $.76. Restaurant margin (EBITDA) was down 128 bp to 17.9%, and the problem was labor, which cost 118 bp. The discouraging part for investors and analysts is that the Company has predicted ongoing wage pressure, and these guys are not about to disappoint customers by cutting labor.  An additional concern, though a lot smaller, is expected commodity inflation of 1-2% for all of ’19. There’s a lot more that could be detailed here, but the results at TXRH demonstrates what we’ve been saying for a while, that it takes more than even 3-4% comps (and now 5.2%) to leverage the higher costs of operations, labor in particular. We don’t know to what extent the Street will lower expectations for ’19 but at $54.37 at the moment (24.7x ’18 EPS) doesn’t seem like a bargain when it is hard to know when EPS growth will resume. FWIW, $54.37 is 14.5x Bloomberg’s estimate of TTM EBITDA.

Brinker International (EAT) reported Q3 (ending March) with somewhat of a “mixed bag”. The headline indicated that EPS, excluding special items, was up 16.7% to $1.26 vs $1.08. Comp sales for Chili’s was up 2.9% (company) and 2.0% (franchised). Maggiano’s was up 0.4%. Operating Income was 8.4% of Revenues, down 50 bp from 8.9%. Restaurant margin (EBITDA) was 14.3%, down from 16.1% but, excluding the effect of a sale-leaseback transaction, would have been flat YTY. (However, the higher rent is a cash charge vs. depreciation which is non-cash, so the true cash EBITDA margin was truly 180 bp lower). Chili’s results are the main driver of results, and, aside from the sale-leaseback penalty, it was pointed out that: “cost of sales increased due to unfavorable  menu mix, and commodity pricing, partially offset by menu pricing, also partially offset by a decrease in restaurant labor from lower incentive compensation, which in turn was partially offset by higher wages.” So: CGS was up, wages were up, restaurant labor (hours?) was down, and there was less incentive compensation. That doesn’t sound like the industry wide wage increase is abating, and commodity costs are up, which we also heard at Texas Roadhouse. While it is admirable that comps were up again at Chili’s, with traffic up as well, it should be noted that the gain in after tax EPS was entirely due to a lower tax rate and far fewer shares outstanding. Income Before Taxes was $55.5M, down from $58.9M. Adjusted for an Other Gain of $3.5M this year versus a $2.7M loss, the comparison would be $52.0M of Adjusted Pretax Operating Income vs. $61.6M. The number of fully diluted shares was 38.1M vs. 46.0M. From a financial engineering standpoint, EAT chose to do a sale-leaseback transaction, paying higher “rent” vs. non-cash depreciation of the stores in return for retiring a large number of shares. From an operating standpoint, even with flat EBITDA at the store level, we see that same store sales (and traffic) gains of 2 or 3% are not sufficient to overcome higher labor (and other) expenses.

The Bottom Line:

The above capsulized reports show that the operating challenges have not abated, and will not likely relent in the foreseeable future. Restaurant Brands’ results show how ten years of low interest rates have allowed financially astute executives to assemble a portfolio of franchised brands, but mature (Tim Horton’s and Burger King) chains can only be financially engineered to a certain point, especially in a difficult environment. Texas Roadhouse and Brinker results show how operators ranging from a Best of Breed growth company  to relatively mature brands are similarly challenged.

Broader than the Restaurant Industry: There are something like 20M individuals employed in the hospitality industries, including restaurants, retail and lodging and this is a material portion of the entire US workforce. The wage increases that are so evident to us will inevitably start to affect the national averages, and the next step will be price increases. Operators of restaurants and retail stores and lodging will not allow their margins to deteriorate indefinitely. All those surcharges such as baggage fees at airlines, “facility” charges at hotels, and miscellaneous add-ons with car rentals (that add 25-30% to the quote), will increasingly be joined by higher menu prices. It’s not a question of “if”, rather “when”.

Roger Lipton

 

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LUCKIN COFFEE INC. – THE CHINESE KNOW HOW TO GROW !!! WANT TO HEAR A GOOD STORY ??

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LUCKIN COFFEE INC. – THE CHINESE KNOW HOW TO GROW !!! WANT TO HEAR A GOOD STORY ??

Conclusion: Short and Sweet: Pass

Luckin Coffee, Inc., domiciled in the Cayman Islands, operating in China, has filed a preliminary prospectus which indicates  an IPO of $100M. However, that number is supposedly just a “place holder”. The talk is about raising $700-800M, with a total market value of about $5 billion. The last capital raise, including prestigious investors such as Blackrock, reportedly valued Luckin at about $3B.

The Chinese are drinking increasing amounts of coffee, as evidenced by the rapid development of Starbucks in China, now with 3500 stores on the way to 10,000. In terms of store growth, though, that’s nothing ! The Chinese know how to do it right. Sixteen months ago, at 12/31/17 there were 9 Luckin Coffee locations. As of 3/31/19 there were 2,370. In Q1’18: 281 locations opened (that’s on a base of nine), followed by 334 new locations in Q2 followed by 575 new locations in Q3 followed by 884 in Q4. The growth has scaled back in Q1’19 to only 297 new locations. Not to worry: 2500 new stores are planned for 2019. Talk about a fire drill  😊 Who needs Starbucks when you will soon be able to participate in the growth of Luckin Coffee?

There are three types of Luckin stores: pick-up stores (91.3%), relax stores (4.6%), and delivery kitchens (4.1%). The dominant category, pick-up stores, are only 20 to 60 sq meters in size, with limited seating,  typically located in office buildings, commercial areas and university campuses. Relax stores are generally larger, more than 120 square meters in size. Delivery kitchens are often used to enter a particular market, only deliver, and are sometimes closed once other stores are opened. The 2370 stores are located in 28 cities across 16 provinces and municipalities Delivery was a big deal here at first, 61.7% of sales in Q1’18 and 62.2% in Q2, decreasing to 51.4% in Q3, 40.8% in Q4, and 27.7% in Q1’19.

There is a 200 page preliminary prospectus, plus exhibits, and we haven’t had time to read much of it yet, but the following summary financials provide a “flavor”. The good news is that, as you might expect, costs are being leveraged as Luckin grows out of its infancy. Financials are provided for calendar 2018 and the first quarter of 2019. Comparing the first quarter of 2019 to the full year of 2018, cost of goods is lower, store rental and “other” costs are lower, sales and marketing is a lot lower, G&A is lower, pre-opening expenses is lower, the (to be expected) loss as a percentage of sales is not much more than half of what it was for all of ’18.

Before reading the following paragraph: For those of our readers that are not familiar with line by line economics of restaurants, be aware that (generally) Cost of Goods runs about 30% of revenues, Labor (30%) and Other Operating  Expenses including Rent (20%), which would total to 80% of Revenues. Marketing might be as much as 5%, G&A might be 12-15% when a chain is growing rapidly, Pre-Opening expense could be 3-5% depending on how fast the growth is.  Pretax Income could be slightly positive, depending on G&A, Marketing and Pre-Opening, even at an early growth stage. Modest profitability for a young promising chain can become more meaningful as marketing & G&A are leveraged by the larger Revenue base. With this broad template, you can now see how far the operations of Luckin to date vary from the rough parameters of a successful restaurant chain.

Pay attention now: in Q1’19: Cost of goods was 57.6% of revenues, down from 63.3% for all of calendar ’18. (our template calls for 30%) Store Rental and Other costs (no cashiers but someone has to open and close and keep supplies in the right places) were 59.0%, down from 68.5% (template calls for Labor and Other to be 50%). Sales & Marketing was only 35.1%, down from 88.7% (template calls for under 5%). G&A was 36.1%, down from 45.2% (template calls for 12-15%). Pre-opening (with only 297 locations opened in Q1’19) was 4.7%, down from 11.6% (template calls for 3-5%, closest on this one). The loss of 110.2% of Revenues was emphatically lower than the 190.1% loss for all of ’18 (template calls for roughly breakeven). You read that right: The loss before taxes in ’18 was $238M against Revenues of $125M. In Q1’19 the loss before taxes was only $78M on revenues of $71M. (Maybe Luckin Coffee could merge with Uber.)  Talk about a “leap of faith”.

What’s going on here? These are almost entirely cashless pickup locations. Dividing $71M of sales in Q1’19 by an average of 2225 stores gives quarterly revenues of $32k or $128k annualized. I couldn’t find (yet) the average investment per store but $180M has been spent in capex between inception and 3/31/19 to build 2370 stores which is about $75,000 per store. This is a long way from Starbucks. This is more like a vending operation than a retail facility. It’s already being speculated that the rapid growth of Luckin will impact Starbucks comps in China. I like to travel, but it’s a long haul to Beijing, so I’ll speculate for now that the Luckin cashless pickup or delivery “experience” is a lot different than at Starbucks.

There are lots of details provided in 200 pages of a prospectus, including details about the growth in coffee consumption in China and management makes the point that the apparent cost of customer acquisition is coming down over the last fifteen months. The 54% retention rate of customers who try the product is encouraging as well. On the other hand, I divided the $125M of sales for all of ’18 by the average number of stores for the year, which I calculated at 785 (almost 900 opened in Q4) and that calculates to average annualized sales of $159k, versus an average annualized rate of $128k in Q1. There is a chart in the prospectus that seems to confirm that the customer retention rate is somewhat lower now than at first.  My estimates could be off, especially with unknown dates of opening and Q1 could be seasonally slow, but it doesn’t look like sales per existing store are accelerating. Granted: this is so early in the process that it is impossible to know what the long term model looks like. It is a sign of the times that this uncertainty hasn’t discouraged the private equity investors (at $3 billion) or the IPO underwriters with an apparent $5 billion valuation..

Getting back to unit level economics, aside from the investment per store, it doesn’t matter how small the capex/store, or even what your sales/store are, if your CGS is anything close to 57%, if your lease and other costs are anything close to 59%, if your sales and marketing are anything close to 35%, and obviously if your G&A is close to 36% (all of which will no doubt leverage to a degree with the inevitable growth).

Suffice to say: the jury is out on this one. I can’t know what the likelihood of success of this “concept” is. The Chinese like to construct residential towers, shopping malls, and cities that have almost 100% vacancy rates, planning to fill them out over time. Perhaps customers will fill out these vending facilities or retail stores (whatever you choose to call them) over time.

In terms of the valuation: Look at it this way. If the IPO valuation is about $5 billion, and we think about an aggressive valuation of 50x earnings, it would require $100M of after tax earnings to justify the IPO price. Considering that Luckin lost $78M pretax in Q1’19 and that rate of loss is no doubt going to accelerate as 2500 stores are going to be opened in calendar 2019, safe to say that it will be quite a few years before hundreds of millions of dollars of losses turn into $100M of after tax profits. Would you say: at least five years?  So the IPO valuation will be at least five years ahead of the fundamentals and that is assuming that the whole process is successful, and of that there is at least a little doubt. Of course, markets sometimes go to extremes, and momentum driven growth stock investors could take Luckin higher after the IPO and there could be some quick money made by nimble traders. But: be careful out there.  Case in point: Shake Shack, well managed with a far more predictable model than Luckin Coffee, came public in early 2015, at $21, a ridiculous valuation at the time, and ran to almost $100/share before it retraced to $30 where it sat for almost three years before the fundamentals caught up with the valuation, and those fundamentals have generally come through as planned.

One additional caveat and further sign of the times: There will be two classes of stock here. You wouldn’t expect that the Chinese would allow US shareholders to have equal voting rights, for their $700-800M capital contribution, as the Chinese founders, would you?

Conclusion: As you might suspect, we’ll follow with interest, but pass on the investment opportunity.  Harvard Business School should do a case study on this one 🙂

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EL POLLO LOCO HOLDINGS UPDATED WRITE-UP WITH CONCLUSION

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CONCLUSION:

LOCO is fighting the same battles of most QSR and Fast Casual chains, including a myriad of competition, ranging from full service operators to delivery chains to grocery stores and many others in between, higher operating costs, restricted consumer discretionary dining dollars, all resulting in the desperate need to differentiate their offerings. “Experience” is already a cliché’, but the customer must want to be “there”, rather than someplace else, and not for just the “fuel”. Fortunately, LOCO is in a position to do so, with a unique product line and the potential of substantial further differentiation. In a nutshell, the challenge is to make the necessary changes and have the customers notice, in a very unforgiving environment. The stock is trading toward the bottom of its long term price range, is not expensive statistically, and is not “broken” in terms of its operating culture. However, there is no visible relief coming in terms of better operating parameters. Store level EBITDA continues to slip, overall corporate EBITDA is flat over the last 2-3 years, and two or three percent SSS gains are not enough to leverage cost pressures. We thought it was interesting at $10.35 about 17 months ago (and it was). It’s only a couple of points higher now, but the reward/risk ratio is a lot different at $12.35. Much as we admire the job management is doing, we are content on the sidelines at this point.

COMPANY BACKGROUND

El Pollo Loco specializes in Mexican style fire-grilled, citrus marinated chicken. The company originated in the heart of the Latino community in Los Angeles in 1980. Currently, the company headquarters is located in Costa Mesa, CA and became a public company in 2014. As of 12/31/18 it operates and franchises a chain of 484 restaurants (213 company; 271 franchised) located in southwestern United States; specifically: California, Texas, Utah, Arizona and Nevada.

They operate in the limited service (Fast Casual) restaurant segment offering quality food and a dining experience typical of Fast Casual restaurants while providing the speed and value of a traditional QSR segment. A typical El Pollo Loco restaurant is a freestanding building with drive-thru service that range in size from 2200 to 3000 square feet with seating for approximately 50-70 people.

SOURCES OF REVENUE:

El Pollo Loco’s primary source of revenue is from retail sales at its company owned stores and from franchise royalties and fees. A small portion of their revenue comes from rent on locations leased or subleased to franchisees. In 2018 annual revenues were $435.8M. 94.1% was generated by company stores with the remainder from franchise royalties and fees.

In 2016 they opened 18 new company locations and 13 franchised locations with 4 closures. During 2017 El Pollo Loco opened 16 company locations and 7 franchised locations, with 6 closures. In 2018 there were 8 new company stores, 9 franchised, and 10 closed.

CONCEPT / MENU / SALES MIX / DAY PARTS:

El Pollo Loco’s signature product is citrus marinated, fire-grilled chicken which is freshly prepared and fire-grilled in full view of the guests. This experience, along with the colorful décor and value priced menu (items are priced midway between Taco Bell and Chipotle), are aimed to create a value-oriented, Fast Casual dining experience.

The menu includes a variety of Mexican inspired dishes such as family meals, value combos, premium LTO’s, kid’s meals and 500 calorie offerings that are centered on El Pollo Loco’s marinated chicken. They serve family meals as well as individual meals and offer a wide choice of LTO’s throughout the year alternating proteins between shrimp, beef and carnitas. Their salsas and dressings are prepared fresh daily and allow customers to create their favorite flavor profile to enhance their culinary experience.

Daily sales are nearly evenly split between the lunch and dinner day parts; relatively unique among restaurant chains.

Company Store (Third Year Targeted) Unit Level Economics

El Pollo Loco stores range in size from 2200-3000 square feet, seating 50-70 customers. The vast majority of company restaurants are leased. AUV’s in 2018 were $1.825M and the third year target is $1.8M. The cash investment for a new unit, is quoted in the 10-k as a broad range of $0.8M to $1.7M, with a targeted store level EBITDA of 20%. (Company store EBITDA returns were 19.0% in ’18, down from 19.8% and 20.5% in ’17 and ’16.) A cash return of 20% on $1.8M would be $360k, or a broad range of 40% to 20% cash on cash return, depending on the initial investment.  For franchised units, we estimate a C/C return would be 30.5% to 10.5% after royalties and advertising fees – assuming the AUV of $1.8M, store level EBITDA margin of 20.0%,  less 9.5% royalty and advertising fees.

COMPANY STRATEGY: 

1.Expand Restaurant Base – The company has planned to expand their restaurant base at a rate of 8-10% annually with comps of 2-3%, but has fallen short the last two years, particularly relative to the unit expansion, as competitive pressures and the general economy has intruded. To execute this plan, the company has outlined aggressive multi layered initiatives that include: improved site selection, menu evolution, marketing strategy to increase brand awareness and customer engagement, technology to enhance the customer experience, and operations to improve overall store level efficiencies. A significant challenge is to demonstrate appeal beyond its current regional footprint. The stores in its legacy markets have done well consistently but stores, in Houston and Dallas in particular have not performed well. At the end of 2009 the brand had 21 units east of the Rockies. All were closed by 2012.  Management has acknowledged the challenge of invigorating unit growth and comp sales and announced plans a couple of year ago to relax its royalty structure in the hope of stimulating growth.


2. Increase Comparable Restaurant Sales – The company has demonstrated positive       same store sales growth and plans to build on this momentum by increasing customer frequency, attracting new customers and improving check averages (see chart below). Until 16Q4, El Pollo Loco reported 21 straight quarters of systemwide positive comps. As shown in the template above, SSS results were inconsistent from Q4’16 until Q2’18 but have turned positive in the second half of ’18.

3. Enhance Operations and Leverage Their Infrastructure – From 2011 El Pollo Loco increased restaurant contribution margins by 188 basis points to 20.6% in 2016, but it has declined to 19.0% in’18. Management is obviously working diligently to stabilize and then improve thi1 matric.

4. Remodeling – Starting in 2011 the company rolled out a new “Vision” prototype store hoping to improve returns by value engineering the concept. Also, the new unit is designed to elevate the ambiance to be more consistent with its aspirations of a Fast Casual positioning rather than QSR. At this point 85% of the system has been renovated, with a total of 99 stores having the most recent version. The cost of this remodel is $3-400k.

5. Loyalty Program – A recent emphasis has been the development of a Loyalty program, which has now signed up about 1.2M members, and the objective is to have 5M subscribers within the next several years.


FINANCIALS

It is worth noting that El Pollo Loco had reduced its debt (as of 12/31/18) by over half from the $166M level on its books when it came public. Debt, however, will have increased by about $25M as a result of the recent class action settlement. Still, the ratio of debt to EBITDA is currently modest by today’s standards at less than 2.0x, even after the settlement. Adjusted EBITDA at $62-65M (from 2017-2019) will have been very consistent the last several years, and should allow for debt paydown in 2019, with only 3-4 new company stores planned and total capex of $14-19M.

SHAREHOLDER RETURN:

El Pollo Loco is down about 50% from where it started to trade after the IPO in 2014. It traded between $10 and $15/share from late 2015 to early 2018, traded up to about  $18/share very early in 2019 (We said in Dec’17 that it had more upside potential than downside risk at $10.35) but has retreated after reporting Q4’18. The company does not pay a dividend. 66,000 shares were purchased, under a new authorization, in Q4’18. The company’s largest shareholder is Trimaran Capital, LLC, a private equity company, which  has a 43% ownership interest at the end of 2018.

 RECENT DEVELOPMENTS: Per Q4’18 Report, as of 3/7/19

Same store sales improved for the second quarter in a row, up 4.4% systemwide (3.7% for the company and 5.1% for franchisees). Transaction growth of 2.0%, encouragingly, was part of that progress. Adjusted EBITDA was $14.5M vs. $13.4M in ’17. Pro forma net income was $6.1M ($0.16/share) vs. $4.4M ($0.11/share). 12 new company restaurants, and 10 franchised, were opened in the 15 months ending Dec’18, obviously helping systemwide sales.

The GAAP numbers were not as encouraging. Legal settlements of $36M was accrued in Q4 and there was a substantial tax credit as well. Store level expenses were fairly well controlled, but for the year Labor was up 60 bp to 28.9%, Occupancy and Other was up 80 bp to 23.5%, partially offset by 60 bp of savings with 60 of goods, store level EBITDA declined (for the second year in a row) by 80 bp to 19.0%. (Q4 store level EBITDA was 18.7%, up 20 bp YTY)

The Company guided, for 2019, to “flat” earnings per share at $0.70-75, with: systemwide comps of 2.0-4.0%, 3-4 company and 3-5 franchised openings, restaurant EBITDA of 18.2% to 18.9%, G&A Expenses of 8.4-8.6% (vs. 11.5% in ’18), a pro forma tax rate of 26.5%, and Adjusted EBITDA of $62-65M. The savings in G&A are obviously expected to offset continued pressure at the store level.

The conference call filled in a few of the details. The restaurant margins (improvement in Q4, down 80 bp for the year) were achieved in spite of California headwinds in labor costs and wildfires, an avocado shortage, a spike in tomato prices and a nationwide recall of romaine lettuce. Wage inflation of 6% is expected for 2019 and commodity costs will hopefully be more stable, but are planned up 1-2%. The customer Loyalty Program, with 1.2M members is hoped to grow to 5M within two years. All the restaurants offer delivery through Doordash , with Postmates and Uber Eats used in spots. New digital ordering approaches are being added as well. In addition to the openings, there will be 10-15 company remodels in ’19 and 10-15 by franchisees. Responding to a question, the remodels are said to be generating about a 5-7% average sales lift, but most stores have been done by this point, and the remainder are expected to do less. (If 300-400k is spent, and 7% of $1.8M, or 126k is the presumed lift, if 40% of that flows through to EBITDA, that would be 50K, 12-17%, return, at most, but renovations have to be looked at from a competitive standpoint, not just return on capital, and we keep saying that depreciation is not free cash flow.)

The first quarter of ’19 started off slowly, primarily because of the weather and higher gas prices, though still showing positive SSS. Also affecting bottom line results in Q1 will be severance payments, so results for the year as a whole will be back loaded.

CONCLUSION: Provided at beginning of this article

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ON THE GROUND IN RESTAURANT LAND – LATEST TRENDS !!

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ON THE GROUND IN RESTAURANT LAND – LATEST TRENDS !!

I used to think that analysts’ obsessive attention to same store sales was overdone. After all, there is nothing wrong with maintaining sales/store, building new stores if the unit level economics generate an attractive return, controlling store level costs, leveraging corporate administrative expenses. The result would be higher sales and profits and earnings per share as the “cookie cutter” strategy spread  geographically.

However: This is not the restaurant industry many of us grew up with. I remember when Chi-Chi’s was doing $2.5M per copy in 1980 and the gross investment in land building and equipment was $1.25M. Ryan’s Family Steakhouse came public in the 1980s, and it was gold, with $1.3M in sales per store and a total gross investment of $650k per location. Those were the days. Today: Competition is brutal. Consumers are cash strapped and shopping for the best deal on the commercial strip, if they are even leaving their homes. Building costs only go up.  Almost all operating costs are moving inexorably higher with labor leading the way. The return on investment from new stores is obviously nowhere near where it used to be and material same store sales improvement has become an absolute necessity if store level margins are to be maintained and corporate earnings have any chance of improving. Furthermore, as I have previously pointed out, 2-3% SSS is not materially enough to overcome rising store level expenses, labor in particular. The majority of publicly held chains are reporting flat to down pretax earnings, sometimes in spite of 1-3% SSS trends.

Which brings us to the current, through March, sales trends.  With few exceptions, such as Chipotle (finally), Domino’s, Wingstop and part of Darden’s portfolio, the tepid trends of the last several years remain in place. While the headlines may trumpet a rebound in March, it was a bounce off the horrible weather in February.  According to Miller Pulse: Same store sales for the restaurant industry as a whole, were up 2.1% YTY, driven by a 4.2% jump in check (price and menu mix), so traffic was still down 2.1%, for the thirty sixth month in a row.  Over two years, the stacked comp was up 3.9% in March (140 bp better than February), so the trend, over two years, in sales and traffic has been remarkably consistent (i.e.”tough”). In March:  QSR chains, with comps up 2.8% (4.6% check increase, 1.8% negative traffic) did a bit better than casual diners with SSS of negative 0.9% and traffic down 3.6%. Let’s not forget: Backing out delivery and takeout, traffic trends are dramatically worse than same store sales. Too many chains are sitting with oversized real estate, using their seating capacity only part of two or three evenings per week.

Rounding out our commentary: Our observation is that delivery is considered a necessity by most but is very much a mixed bag in terms of enthusiastic adoption. Over time we believe that margins will come down for the delivery companies as they compete for customers, and the margin hit for the restaurant company will not be as significant, but it will still be a challenge to control the “last mile” and not run the risk of damaging the brand. From a marketing standpoint, many chains are trying to move away from ultra low priced deals and get back to core products at full price, but it is a challenge to wean customers from chasing the “deal of the day”. Loyalty or Reward Programs, whatever they are called, are a proven productive approach, and Starbucks sets the best example, recently improving their personalized deal. Burger King has their own Loyalty program, consisting of a $5 per month Coffee Club which offers a cup of coffee every day. We’ve heard about senior citizens making a morning of it, bringing along their checker boards, so it will be interesting to see how this traffic building approach works out.

Roger Lipton

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – CENTRAL BANKS BUY STOCKS AND BONDS – A LONG TERM DISASTER !!

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – CENTRAL BANKS BUY STOCKS AND BONDS – A RECIPE FOR LONG TERM DISASTER !!

A LESSON IN “MAKING MARKETS”

It’s been a number of years since we had an active market for initial public offerings. Decades, and a number of stock market cycles ago, this then young analyst watched quite a few small companies come public, in many cases underwritten by brokers much smaller than the surviving investment bankers of today. Some of those underwriting firms, well intentioned to be sure, supported the brand new issue with a supporting bid, figuring it was just a question of time before the market figured out that the stock was attractive, the supporting bid could be removed, the stock would be freely trading and move up, the public customers would be happy, and the broker might even make a profit when selling their acquired inventory. Other underwriters, not so committed to supporting the new issue price, allowed the stock to trade freely immediately, tolerating the higher volatility, and allowing the free market to establish (“discover”) the price, for better or worse.

The interesting aspect of these two approaches was as follows: The firms that intervened in the marketplace in many cases finally choked on the inventory, their capital was not sufficient to buy the stock forever, and they ultimately went out of business. The more prudent underwriters that allowed for “price discovery” (as the PHDs would put it) by the normal supply and demand of the marketplace lived to play another day.

This small scale example applies to the trading habits of worldwide central banks today. As the US government builds its debt over $22 trillion, which is more than 100% of our GDP, lots of observers say it is no big deal since Japan, for example, has government debt at 250% of their GDP. The Japanese economy is still functioning, with slow growth to be sure, but there is no evident crisis. This reminds me of the cartoon where the guy jumps off the cliff, and, while in the air, calls out: “I feel fine !!”

There are over $10 trillion of government securities trading with less than a zero percent yield. This is as a result of the US, ECB, Japanese and Chinese central banks buying stocks and bonds, supporting the price of stocks and bonds, and suppressing fixed income yields. In this absence of true price discovery by the marketplace, fixed income savers have been penalized, to the benefit of stock and bond holders, creating a wealth effect for the latter. This good fortune on paper could (and will) be temporary, but for the moment, just like the guy who jumped off the cliff, we feel fine !!

Where are we in this process ??  In addition to the negatively yielding fixed income government securities, the Bank of Japan (that has been doing this for almost thirty years) now owns about $250 billion of Japanese ETFs, or 75% of that entire market of ETFs. On the fixed income side, the Bank of Japan owns about 45%, or $4.5 trillion worth of all the Japanese government bonds outstanding. With it all, the Japanese economy is still running well below 2% real growth, with inflation at well under the 2% objective. It is of course an important sub-text that central banks worldwide are trying to stimulate inflation, rather than subdue it, which was the original objective.  Closer to home, we have been informed that our Fed is abandoning QT, preparing for a new form of QE, which, some have suggested, could include the purchase of US equities as well as bonds.

Here’s a quick economic lesson for the hundreds of PHDs that are working within central banks, which we guess isn’t part of the new Modern Monetary Theory. Don’t intervene in a market unless you are prepared to BUY IT ALL, because you will, eventually. Witness the holdings of the Bank of Japan, who have been at this game the longest, still without the result they have been reaching for. Aside from a long list of unintended consequences that have yet to play out, the attempt to lighten the inventory, (Sell to whom?) has just been demonstrated in the US. One down month in the stock market (December) with the two year treasury rate approaching 3% and the US Fed caved. Whom do you think the Japanese Central Bank can sell to?

The above described central bank intervention in capital markets will inevitably destroy most international currencies, including the US Dollar, because the money will have to be created to support the capital markets and the presumed wealth effect that will prevent economic collapse and that will be highly inflationary. This is the “bubble” that Donald Trump described when he was campaigning but that he has forgotten about since he is in office. The politicians and central bankers will continue to chase their long term (NEW) goal of creating inflation substantial enough to service long term debt obligations. The debt, worldwide, is far too large to be paid off in the currencies of today. Substantial inflation is the only politically acceptable remedy, since outright default is too obvious to the voting public.

Roger Lipton

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