All posts by Roger Lipton

SEMI-MONTHLY FISCAL/MONETARY REPORT – GOLD LOOKS GREAT TECHNICALLY, HERE ARE THE FUNDAMENTALS!!

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SEMI-MONTHLY FISCAL/MONETARY REPORT – GOLD LOOKS GREAT TECHNICALLY, HERE ARE THE FUNDAMENTALS!!

The capital markets these days are driven by computers, and their technical charting algorithms (“algos”). We believe, however, that over the long term it’s the fundamentals that matter. Chart patterns can carry the day, but at some point the fundamentals have to support the valuation. It’s been a painful six or seven years for investors in gold related securities, from 2011 when gold bullion topped out at $1850 and when the gold miners peaked a year later. Six years, though, within the context of modern economic and political history since 1913 when the Federal Reserve Bank was established, is obviously a small part. We believe that, even a few years from now,  2011-2018 will be viewed as a relatively brief price consolidation in the long term bull market for gold-related assets.

As we discuss the last 95 years of fiscal/monetary history, please refer to the chart we have provided below.

The Fed was established in 1913, to manage the money supply, in those days (since 1792) backed by gold, with the single stated objective of controlling inflation. It was hoped that management of the economy by the Fed would reduce the likelihood and severity of financial cycles (i.e.panics, booms, busts, etc.). In those days, it was a single mandate: inflation control, not including employment as is the case today.  105 years later, while we can’t say definitively whether more booms and busts would have taken place without the Fed, inflation control has been dismal. The 1913 US Dollar is worth about $.02 today. We suggest that the way we are going, in a lot less than 100 years from now, the US Dollar will be worth 2% of today’s paper currency. Our overriding thesis is that “gold is the real money”, as proven over 5,000 years of economic history. The fact is that there has never been an unbacked currency (“fiat” money) that has survived. It’s just a question of how long the politicians of the day take to destroy it. Every indication continues to be that the current crop of politicians, around the world, will be no different.

The table below shows, since 1929, the amount of debt the US owes (without unfunded entitlements). We have provided a commentary as to major economic and political events, especially relating to the status of gold in relation to the economy.

As a broad overview of the last ninety years in the table below, you can see that the debt as a percentage of GDP started rising materially through the depression of the 1930’s, peaked at over 100% of GDP when we were paying for WWII, came down materially until the late 1960s when LBJ instituted his “great society” and was paying for the Vietnam war. The Bretton Woods Agreement of 1944 created the US Dollar as the world’s reserve currency, to be the primary unit of exchange for worldwide trade. The US, in return for this huge privilege, was obligated to manage our economy, money supply, and spending in a responsible fashion. The US had the largest stash of gold among the world’s trading partners, with over 20,000 tons,  and our dollar was convertible into gold, at $34/oz. (after FDR raised the exchange rate from $20.67 during the depression).

The Bretton Woods Agreement worked fairly well, and the US, including the Fed, managed fairly well through the postwar rebuilding, until the late 1960s under LBJ. As spending increased and deficits loomed, major countries around the world, led by France’s Charles DeGaulle, started exchanging dollars for gold. The gold backing of our dollar, got down to about 6-7% of our currency in circulation, from the area of 25-30% in the postwar period. (It is worth noting that 6-7% is approximately the percentage where it is today, in the US and among major worldwide economies in total).  The US stash of gold was taken down to about 8,400 tons from over 20,000 tons in just a few years prior to 1971. Richard Nixon, his Treasury Secretary, John Connally, and Fed Chairman, Arthur Burns, made the decision in August’71 to “close the gold window”, ending convertibility into gold. Nixon, naturally, told the American public it was all for the best, would strengthen the economy, etc.. Predictably, however, over the next eight years, the price of gold went from $35 to $850, stagflation set in as the inflation rate went into the teens, interest rates went to the high teens by the time Jimmy Carter hired Paul Volcker in 1979.

Volcker started raising interest rates further, to squeeze out inflation, and Ronald Reagan,  taking office in early 1981, backed him in that process, tolerating the three year recession that ended in 1983. The stock market took off in August, 1982, anticipating the economic upturn.

At this point, you might suggest that a dedicated Fed chief today, backed by a financially astute President and legislative branch, could correct today’s problems, just as in the 1980s.

The problem is that debt as a percentage of GDP is over 100% today, versus 32% in 1980, the annual deficit is about 13-14x as big ( in an economy that is 6x as big), interest rates are very, very low now, so can’t be lowered by much to help the rebound, versus very, very high in the early 1980s, and the unfunded entitlements overhanging us now are a huge headwind that didn’t exist 39 years ago. You also didn’t have today’s worldwide co-dependency that complicates our ability to manage our own economy.

Moving on: from 1980 to 2000, with some fits and starts, the US economy grew fairly steadily, especially under Reagan and later under Clinton. While the debt was still rising, it was well below the 100% of GDP thought to be a troubling level. Relative to gold, the urgency of the 1970s had dissipated, with good reason as stagflation had been defeated, so gold retreated from $850 to a low around $250 by 2000.

From 2000 to 2009 gold went from $250 to $900 as GW Bush, financed by Alan Greenspan and then Ben Bernanke, spent money to offset the dotcom bust of 2001, the war on terrorism after 9/11 and the financial crisis of 2008-2009. The US Debt as a percentage of GDP went from the mid 50s to almost 100%, closely correlating with the rising gold price. When President Obama was elected, and it became clear that spending would continue, not only to close out the wars but on health care and other social initiatives, gold doubled again to over $1800/oz.

From 2011-2012 until today, gold and gold miners have suffered, because the annual deficits came down, from about $1.4T in 2010, to about $400B by fiscal 2015, and still “only” about $800B in fiscal 2018. This modest progress in controlling spending (we suggest “on the surface”) reduced the urgency for gold as a “safe haven”, an “uncorrelated asset”, or the “real money” (which is our primary motivation). At the same time, the stock market has risen steadily, as the Fed  (joined by other central banks) have provided minimal interest rates, to drive a stated “wealth effect”, also reducing the demand for gold. Even bitcoin, now largely abandoned, provided an alternative to traditional precious metals. It is noteworthy that the stated “on budget” deficits, have almost always been substantially exceeded by the increase in the total debt which includes borrowing from the social security trust fund and other emergency measures. You can see from the table below that, even with the lack of concern over deficits,  the total debt/GDP % never came down between 2011 and 2018, continuing to rise above the 100% danger threshold where it seriously drags on an economy.

Which brings us to where we are today:  We can anticipate, as far as the eye can see, sharply rising deficits and total debt, an economy that is already slowing from the 2.9-3.0% peak of calendar 2018, not much above the 2.3% of the Obama years. We note that a material portion of the modest 0.6-0.7% improvement has come from higher government spending, and the balance in a one time benefit from lower taxes. The public has spent their tax windfall on carefully selected items with Amazon, value meals at restaurants, and more pizza delivered from Domino’s. Businesses have spent their repatriated dollars and tax savings to a major extent on stock buybacks rather than capex. Government receipts are down, spending is up for defense, health care, interest payments and storm remediation (but not Nancy Pelosi’s travel). All projections call for a slowing economy over the next several years as well as higher deficits, which will be substantially exceeded by the increase in total debt. Of course, something like $100 Trillion of unfunded entitlements still loom.

In conclusion: The fundamental stage seems to be set for higher gold prices, which should carry gold mining stocks (even more depressed than bullion) much higher as well. In a long term sense, gold had a twelve year bull market from 2000-2011, has gone through a consolidation, in our view, unjustified by fundamentals. Justified or not, market place inefficiencies get corrected over time, the long term fiscal/monetary fundamentals support a much higher gold price, and most technical signals indicate that the long term bull market is about to resume.

Roger Lipton

FISCAL/MONETARY HISTORY – 1929 TO PRESENT
Fiscal Yr. 9/30 Debt ($Billions) Debt/GDP Percentage MAJOR EVENTS BY PRESIDENTIAL TERM
1929 $17 16% Market crash. Depression reduced tax receipts.
1930 $16 18% Hoover raises taxes, worsens depression
1931 $17 22% Smoot Hawley tariffs don’t help
1932 $19 33%
1933 $23 39%
1934 $27 40% FDR’s New Deal increased both GDP and debt.
1935 $29 39% GOLD AT $35/OZ.-FDR HAS OUTLAWED PRIVATE OWNERSHIP
1936 $34 40% HOMESTAKE MINING GOES UP IN PRICE BY 7X from 1930-35
1937 $36 39% US OWNS OVER 20,000 TONS
1938 $37 43% FDR cuts spending, Fed tightens. Serious recession.
1939 $40 43% Debt & GDP start rising, preparing for war.
1940 $51 50% Depression ends though employment doesn’t recover
1941 $58 45%        until after war, US enters war after Pearl Harbor in Dec.’41
1942 $79 48% Increased debt and GDP to support war effort
1943 $143 70%
1944 $204 91% BRETTON WOODS GOLD/MONETARY ACCORD –
1945 $260 114%  US DOLLAR TO BE WORLDWIDE RESERVE CURRENCY
1946 $271 119% Truman’s 1st term tight  budget. Peacetime recession
1947 $257 104%  US STILL OWNS OVER 20,000 TONS
1948 $252 92%
1949 $253 93%
1950 $257 89% Truman’s 2nd term. Korean War(1950-1953) higher debt & GDP
1951 $255 74% Recession after Korean War ends.
1952 $259 72%
1953 $266 68% Korean war ends
1954 $271 70% Eisenhower’s budget. Rate rise worsened recession.
1955 $274 65%
1956 $273 61% POST WAR DEBT FAIRLY CONSTANT
1957 $271 57%
1958 $276 58% Eisenhower’s 2nd term. Recession.
1959 $285 54%
1960 $286 53%
1961 $289 52%
1962 $298 49% JFK budgets. Cuban Missile Crisis. U.S. aided Vietnam coup.
1963 $306 48%
1964 $312 46%
1965 $317 43% LBJ’s budget. War on Poverty. Vietnam War. Fed raised rates.
1966 $320 40%
1967 $326 38%
1968 $348 37%
1969 $354 35% DEBT RISING, EXPECTATIONS WORSE, GOLD FLOWING OUT
1970 $371 35% Recession. Wage-price controls. Oil embargo. Int.rate double.
1971 $398 34% US GOLD DOWN TO 8400 TONS, NIXON ENDS CONVERTIBILITY
1972 $427 34% INFLATION TAKES OFF, GOLD GOES FROM $35 TO $850 BY 1979
1973 $458 32%
1974 $475 31% Stagflation. Watergate.
1975 $533 32% Ford budget.
1976 $620 33%
1977 $699 33%
1978 $772 32% Carter budget.
1979 $827 31% GOLD PEAKS AT $850/OZ.
1980 $908 32% Volcker raises rates to 20%. Iran oil embargo. Recession.
1981 $998 31% Reagan budgets 1st term.
1982 $1,142 34% Recessionn continues, stock market ramps in August.
1983 $1,377 37% Recession ends.
1984 $1,572 38%
1985 $1,823 42%
1986 $2,125 46% Reagan lowers taxes.
1987 $2,340 48% S&L crisis costs US gov. $50B
1988 $2,602 49% NO URGENCY TO OWN GOLD, FOR TWENTY YEARS (1980-2000)
1989 $2,857 50% DEFICITS RISING BUT ECONOMY IS STRONG
1990 $3,233 54% Bush 41 budget. Desert Storm. Recession.
1991 $3,665 59%
1992 $4,065 62%
1993 $4,411 64%
1994 $4,693 64% Clinton budget.
1995 $4,974 65%
1996 $5,225 64% Budget Act reduced deficit spending.
1997 $5,413 62%
1998 $5,526 61% No defict, but debt still up. Last Clinton budget.  Recession.
1999 $5,656 58% No deficit, but debt still up
2000 $5,674 55% NO DEFICIT, BUT DEBT STILL UP – GOLD AT $250/OZ.
2001 $5,807 55% Bust adds $22.9B to ’01 budget for War on Terror
2002 $6,228 57% First GW Bush budget.
2003 $6,783 59% War on Terror costs $409.2B. Bank bailout costs $350B.
2004 $7,379 60% Bush Tax cuts.
2005 $7,933 60%
2006 $8,507 61% Wars cost $752.2 billion.
2007 $9,008 62% Katrina Costs $24.7B
2008 $10,025 68% FINANCIAL CRISIS COSTS $242B, GOLD AT $900/OZ.
2009 $11,910 83% Great Recession and tax cuts reduce revenues.
2010 $13,562 90% Obama Stimulus Act cost $400 billion.  War cost $512.6 billion.
2011 $14,790 95% DEBT APPROACHING 100% OF GDP, GOLD  AT $1850/OZ.
2012 $16,066 99%  US CONTINUES TO ABUSE RESERVE CURRENCY PRIVILEGE…………
2013 $16,738 99% BY PRINTING TRILLIONS OF NEW DOLLARS
2014 $17,824 101% War cost $309 billion. QE ended. Strong dollar hurt exports.
2015 $18,151 99% FOR SIX YEARS, DEBT STILL RISING, BUT AT SLOWER PACE
2016 $19,573 104% NO URGENCY TO OWN GOLD, CORRECTS TO LOW OF $1050
2017 $20,245 103% Congress raises debt ceiling, again.
2018 $21,658 99% Trump tax cuts,spending up. Debt ceiling suspended ’til 2019.
HERE WE GO AGAIN! THE STIMULUS, AND DEFICITS, HAS NEVER, IN PEACETIME,
BEEN SO LARGE AND ACCELERATING,
ESPECIALLY IN THE MIDST OF SUPPOSED PROSPERITY
2019 $23,000 109% assumes no recession, $1.1T deficit, debt up by $1.342
2020 $24,500 111% assuming no recession, $1.2T deficit, debt up by $1.5T
2021 $26,000 113% assuming no recession, $1.2T deficit, debt up by $1.5T
YOU CAN MAKE YOUR OWN ASSUMPTIONS AS TO WHAT THE PRICE OF GOLD DOES FROM HERE!
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CHUY’S HOLDINGS – UPDATED WRITE-UP

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Conclusion: Hardly different from our Conclusion in May ’17

The more things change, the more they remain the same. The biggest difference is that CHUY trades closer to $20 today than $30 twenty months ago. The operating results in the interim have justified our May’17 conclusion. CHUY is statistically cheaper today, but the prospects have not improved, especially in light of a macro environment that is clearly weakening and a still challenging competitive situation. The best hope for a higher stock price (other than a “meltup” in the general equity market) would be interest by private equity investors. However, we don’t believe these company stores could be easily franchised, which is often the appeal for “asset light” driven private equity players. Secondarily, the real estate is entirely leased, removing the potential liquidity from a sale/leaseback. The balance sheet is debt free but the store level returns have slipped on existing stores, and results at the newest openings are “mixed”, possibly on the low side. We therefore wouldn’t bet on private equity providing a premium to the current 20x ’19 earnings and almost 13x trailing EBITDA.

In May of ’17 we said:

“While the details of operating performance provided above could be considered “sobering”, management of CHUY can be commended for an excellent record of growth, maintenance of a strong balance sheet, and continued opportunities for unit expansion and earnings growth. Almost all of the variables described above are typical of almost all operators in the restaurant industry. Sluggish traffic trends (especially for full service dine-in locations), higher labor costs, commodity costs that have probably seen their best levels, competitive pressures, and occupancy expenses that continue to edge higher are not a happy combination. This is more a commentary on the current headwinds affecting even the better managed restaurant companies.”

The Company

Source of Revenues 

Chuy’s Holdings, Inc. is a steadily growing Austin, Texas-based full-service restaurant chain featuring freshly-prepared Mexican and Tex-Mex fare.  As of Q3’18 it operated 98 stores in mostly suburban locations in 19 states, two more opened early in Q4, with about 35% in its home state and the remainder throughout the southeastern states, Virginia suburbs of Washington DC, Ohio and Indiana.  The company, until a year or so ago, targeted 20% annual growth, making the jump from a regional chain to a national one while admittedly encountering challenges in entering some secondary markets in 2015.

Menu  

The company’s menu offers endless taco chips and salsa and items with irreverent names, generous portions and value prices. The following price point indications are a mix of a presentation after Q2’18 and Q3’18. Favorites have included “Big as Yo’ Face” Burrito” ($8.69-$10.49) or “Chicka-Chicka Boom-Boom” ($10.69) which are 2 of only 10 items priced over $10.  The other 40 items are less than $10 and the average ticket (including 18.3% alcohol) was $15.03 in Q3’18, which is one of the lowest of its competitive set.  For example, as of Q2, a typical CHUY’s “Big as Yo Face” Burrito Oven-Roasted Chicken which includes a side of rice and beans and unlimited complimentary chips and salsa sells for  $9.99, comparing favorably with Chipotle’s $6.85 chicken burrito plus an order of chips and salsa for $2.05 for a total of $8.90.

Operational Model & Unit Level Economics

The company prides itself on the un-chainlike look of its stores with the slogan “If you’ve seen one Chuy’s, you’ve seen one Chuy’s.” The flexible prototype is suitable for a wide range of sites including conversions. The only standard feature of the design is the kitchen which is strictly identical in every location.  Despite the variances in store design, the stores in the comp base as of Q2’18 (the last time fully described) averaged close to 8.8K square feet in size generating AUV’s of $4.4K and unit-level EBITDA margins of 18.7%. These historical results are materially higher than the conservatively targeted model, which calls for targeted EBITDA margin of 15.0-16.5%s by the third year, by which time the company model calls for AUV’s growing to $3.75M.  At this possibly conservative stated level of performance, targeted cash-on-cash return on the average new unit cash investment of $2.1M in a leased location net of landlord allowance ($2M) plus our estimate(100k), of pre-opening expense, would be 27-29%.  Currently, on the comp stores, for an average cash investment of $2.3M, the actual cash-on-cash returns, at 18.7% store level EBITDA, calculates to 35.9%. Obviously, if the future results move closer to the Company’s conservative targets, the margins would be contracting materially. The difficult competitive environment is not helping at the moment, but we have sufficient respect for this management team that we viewed their model as “theoretical”, and results could exceed expectations if and when industry conditions improve.

Company History and Strategy 

Until 16Q4 CHUY’s comps were positive for 25 consecutive quarters.  During this stretch, it outperformed the industry by about 240bps on average as measured by Knapp-Track. This was true even in 2014-2015 when the company struggled as it entered new secondary markets, and, importantly, the company’s comps averaged about 2.6% driven by a healthy balance of traffic and price. It is noteworthy that despite the relatively robust comps and store-level performance, operating margins were somewhat uneven during that period.  Similarly, the company’s ROIC has averaged less than 10% in the last 5 years.  The variability is partly explained by poorly performing stores in newly penetrated secondary markets in 2014-2015. Management addressed this challenge in 2015 by slowing new store growth from a 20%+ pace to 12% and backfilling new markets to achieve area efficiencies.  Operating margins, which had fallen as low as 6.5%, recovered to 8.4% by 16Q1. However, the company has finally succumbed to the restaurant industry malaise.  Comps steadily weakened before going negative 1.1% in 16Q4 (on – 2.4% traffic offset by +1.3% price) and that YTY decline in comps and traffic has continued through Q3’18.

The performance of new stores is an important analytical parameter. The Company provides us with revenues from all stores and the total operating store/weeks.  It also provides the store-weeks for non-comp stores, so analysts can track the annualized performance of the newest stores versus the chain average. At year end ’16 it appeared that the newest stores were annualizing at about $4.1 million, versus $4.58M for comp stores and $4.43 for all stores. The company pointed out then that the $4.1M was down only 4.8% from 2014, but the trend has continued, even if at a slow pace. As of Q1’18, the trailing twelve months for comp stores slipped modestly further, to $4.411M (down 3.4%, traffic declining more than that, allowing for price increases over that 21 month period. Furthermore, the performance of the newest stores in 2018 is “mixed”, discussed further under recent developments, below.

Going forward, the company’s slower store development plan is the largest change in strategy.  The company has slowed its unit growth from the 20% historical level, to 11 units in 2017 on a base of 80, for a growth rate of 13.7%. As of the end of Q3’18, 7 new units have opened out of a planned 9 for 2018, the last 2 opened in early Q4, which represents 10% unit growth. Development in 2019 will slow further to 5-7 new restaurants. Management typically has been less clear on the trajectory of margins other than targeting G&A growth at half the rate of revenue growth, which, assuming revenue growth consistent with store growth. In the past, this implied net earnings growth of 25%-26%, but that expectation has obviously been scaled back.

Other than the development plans and margin focus described above, current broad initiatives include a new partnership with a national-level marketing firm, more intense attention to off premise sales such as catering, online ordering and delivery, and integration of a new labor management system.

Balance Sheet 

At the end of Q3’18 CHUY continued to have no debt and its $25M credit facility (expandable to $50M) remained untapped.  While free cash flow will likely be sufficient to fund virtually all the new store development without tapping the credit line, the remaining $28M stock purchase authorization, if exercised in the next twelve months, could require a modest amount of debt.

Shareholder Returns 

In the nearly 5 years since its July 27, 2012 IPO at $17.17, CHUY’s stock has been as high as $43/share, in late 2013 and early 2014, but has retreated during the last several years from the mid-30s down to the present level, no doubt affected by the flattening of the previous growth in EPS. There is no dividend, and a large stock purchase programs has not been part of the financial strategy, though a $30M authorization was announced in October, 2017. During the first nine months of 2018, 65,000 shares were bought for $1.6M, none during Q3, leaving $28.4M under this plan.

Recent Developments (Per Q3’18 earnings release and conference call)

Operating results in Q3’18 continued to be lackluster, though far from disastrous. Comps were up 0.5% on a calendar basis but down 0.4% on a fiscal reporting basis. There was a one week shift between “calendar” and “fiscal” reporting  YTY, with a 13 week quarter involved, but an explanation of the timing difference is “above my pay grade”, perhaps not yours. Let’s just call the comps “flat”. More importantly, the comps were negatively affected by the wettest September on record in the core Texas market, reducing patio sales by 18%.

EBITDA restaurant margin for Q3 was 14.0%, vs, 15.9% in ’17. Results were negatively influenced by higher labor, higher insurance, delivery charges, increased marketing expenses and occupancy expense. Benefits came from lower commodity costs and less training expense for new managers. G&A was flat in dollar terms, 40 bp better as a percentage of sales. There was an income tax benefit of $1.6M vs. an expense of $1.0M in ’17. The GAAP results showed a net loss of $0.44/share vs. $0.19/share profit, but Adjusted Net Income was $0.20 vs. $0.19. Two new restaurants opened in the quarter, two more early in Q4, completing the year’s expansion plan with 100 locations in total.

Guidance was adjusted downward: Net Income/Sh. goes to $0.88-$0.92, vs. $1.09-$1.13 previously. Comps in ’18 will be flat vs. 1.0% previously. Pre-opening expenses will be $4.3-$4.4M vs. $4.4-4.8M previously. G&A, taxes, new units, shares outstanding, and capex were also revised modestly downward.  There was no formal guidance provided for ’19.

The conference call provided further discussion about the unusually bad weather in Texas, the new marketing effort with increased social media and mobile usage. Online ordering using Olo is being expanded to all restaurants, now represents 8-10% of all to-go orders, and is a stepping stone for a new loyalty program. As indicated, 5-7 new restaurants are planned in ’19, the slower growth allowing for greater focus on the existing fleet. Pricing in the quarter was 1.5-2%, cost of sales was down 110 bp to 25.6% with favorable produce and chicken pricing, but this benefit will moderate in Q4 as beef, tomato and avocado cost is higher.  Labor cost was up 180 bp to 37% as a result of higher wage rates and new store inefficiencies, with labor inflation amounting to 3-3.5% for all of ’18. Other Store Operating expenses increased 50 bp to 14.8%, due to delivery charges (14% increase in to-go sales), occupancy expenses (up 60 bp to 7.6%, from new stores and lease extensions). There was a  non-cash impairment charge of $11M after taxes relating to six restaurants.

During the Q&A, the performance of new restaurants was discussed, a “mixed result in Chicago, two a little bit lower than expected and one doing more than expected….Miami, one that we’re very disappointed in, one we’re very excited about and one is in the middle. Overall..a little bit lower from our expectation.” The cadence of sales during the quarter was discussed, inconclusive other than the weather impact, a weather break and sales improvement finally in early November.

Margins were discussed, in terms of possible improvement, and 2.5-3.5% of sales improvement is necessary for margins to stabilize. The loyalty program could help but it is too early to quantify. Pricing will once again be in the 1.5-2.0% range. Importantly, sales away from the rains in Texas and the southeast were better, but obviously not enough to overcome the core market weakness. Marketing expense has traditionally been light, inching up to 1.0-1.1%, and could go higher by about 20 bp if the new programs seem to be helping.

Conclusion: Provided at beginning of this article

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RED ROBIN GOURMET BURGERS – UPDATED WRITE-UP

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Conclusion 

We believe a large portion of the distress that Red Robin is enduring relates to the generally unforgiving macro-environment that includes (1) the market share battle within a still over-stored industry scene and (2) cost escalation. Management is experienced and, in our opinion, accurately defining the problems. Problem is that a major “re-invention” of the Red Robin concept may be necessary if the Company is going to truly differentiate their commodity. At this price, it may appear that all the trouble is priced in. There are still hundreds of millions of private equity dollars still looking for a home. Activist investors, private or public could rise to the bait at what looks like a bargain multiple of EBITDA, especially when there are apparently hundreds of juicy stores that could be franchised. Unfortunately, the store level margins have been seriously compromised and lots of work has to be done to reinvigorate the chain. Roark and Inspire Brands are living through that process with Buffalo Wild Wings, and will have spent lots of time and money spent (out of public view) before the reinvention is unveiled. For my investment dollars, I don’t relish buying into a chain that is well run, but suffering. Even if most of the influences are out of their control, those factors are unlikely to abate any time soon. A private equity investor could afford the time and money to improve the situation. In the absence of that progress, private equity players are often able to restructure the balance sheet and “get out whole”. An investor in the public company will not have those alternatives.

RRGB: Company Overview

 Source of Revenues

Red Robin Gourmet Burgers, Inc. is a casual dining restaurant chain, as of Q3’18 operating and franchising 574 restaurants (485 company, 89 franchised) with system-wide revenues of $1.5 billion in 39 US states and 2 Canadian provinces.

Menu and Dayparts

The Company lays claim to being “THE Burger Authority”, with a range of burgers from its core “Tavern” burger, priced at $6.99 which includes its signature “Bottomless Fries” to their “Finest” gourmet burgers, mostly offered as LTO’s at prices up to $14.99It also offers burgers made from chicken, fish, turkey, and vegetables. The menu features a variety of buns, toppings, sides (including some bottomless ones such as broccoli) and bottomless (non-alcohol) beverage refills.  Alcohol is served and features an extensive selection of beers, while a kids menu is a foundation of the company’s efforts to appeal to families.

Operational Model & Unit Level Economics 

 Of $1.37B T12M revenues to Q3’18, nearly all (98.4%) is generated by the company stores, while the balance consists of royalties and fees. Contrary to the current re-franchising trend in the industry, RRGB went the other way, acquiring 50 franchised units from 2014 through 2016, none since. While franchising of company stores is generally popular these days, in an effort to go “asset light” and free up capital, the previously announced plan to franchise about 100 locations has not generated results. While management says that potential buyers were trying to buy stores unrealistically cheap, it seems likely to us that the recent sales and traffic trends have significantly undermined the appetite (and valuation levels) of franchise partners.

Red Robin units are generally leased and located on in malls (17%) or standalone (75%) or in-line retail & other sites (8%).  Store size ranges from 4.5K to 5.8K square feet and in the trailing twelve months ending Q3’18 generated AUV’s of $2.8M and store level EBITDA margins of 19.3%. Several years ago the company  stopped opening stores in malls as performance deteriorated due to increasing occupancy costs, the drop in mall traffic and because the locations were not suitable for off-premise programs.  In 2016 mall and off-mall AUV’s were $2,827K and $2,998K, respectively and store-level EBITDA margins were 14.6% and 31.2%, respectively.  The company no doubt continues to analyze mall sites in their effort to most efficiently exit under-performing locations.

Though few new stores are opening in the near-term play (8 have opened through Q3’18, and no more are currently planned), as of the end of 2017 a new store required a cash outlay of $2.2M-$2.6M (including pre-opening expense).  At the unit investment midpoint and at the historical off-mall performance levels, we estimate the cash-on-cash return would have been about 26.0%.  Obviously, the returns would be lower today, with generally lower sales and operating margins. The stores are in good physical condition because the company completed a four-year remodeling program in 2016.  The remodels feature new signage, technology, a greater separation of the bar and family areas.  The price tag for the remodels was about $400K, which reportedly generated a sales lift of 3%-5%. If the sales lift is from a midpoint 4% of $2.9M (a couple of years ago), or $116,000, and 50% flows through to store level cash flow, $58,000 incremental cash flow returned 14.5% for a remodeled store. Right now the stated emphasis is on improving current four wall economics and begin development of a new prototype.

History and Current Company Strategy

In the nearly 5 years between a performance low in Q4’10 and Q3’15, growth in sales and earnings steadily improved. Revenues grew at a 7.9% annual pace driven by the 6.6% annual growth of new and acquired company units (including the net gain from store sales vs royalties) and consistently positive comps (average 2.7%).  Below the top line, EBITDA doubled with the recovery,  lifting RRGB’s operational metrics,  reaching near parity with the performance of its casual dining peers with less than 40% franchised:  Restaurant EBITDA margins expanded by 460bps to 21.6% (vs 18.2% peer average); Operating margins expanded by 340bps to 4.5% (vs 5.3% peer avg.), and ROIC expanded by 625bps to 7.6% (vs 10.9% peer avg.).  In 2015 the company embarked on its “Red Squared” initiative to build on the momentum of the prior 5 years, with a goal of doubling EBITDA again by 2020. Other goals of the program included completing the remodeling of its stores, mentioned above; plus improved customer service: increased seating turns & less unproductive seating; improvements in ordering & check wait times: expansion of the take-out, catering and delivery business, technology upgrades; and finally, a step up in new unit growth and stock buybacks.

Unfortunately, Q3’15 proved to be the high point of RRGB’s 5 years of progress, which was interrupted by the macro environment afflicting the entire industry, but also exposed operational missteps and oversights masked by the improving financials. Since then comps turned increasingly negative, driven by lower traffic, even if outperforming competitors’ traffic. Not surprisingly, margins and profitability plunged, leading to turnover at the top.  In June 2016 the CFO resigned and 2 months later, coincident with the Q2’16 announcement, CEO Steven Carley resigned. Denny Marie Post, President of RRGB since February 2016, was appointed as his successor.  Ms. Post had joined RRGB in 2011 as SVP and Chief Marketing Officer, was promoted to EVP Chief Concept Officer in 2015, and then President in Feb.’16. Guy Constant was recruited as CFO and Carin Stutz was promoted to COO. Most recently, in the wake of Carin Stutz leaving, Guy Constant became COO, now replaced as CFO by Lynn Schweinfurth, previously CFO at Fiesta Restaurant Group (FRGI).

No one can accuse Ms. Post of glossing over the challenging state of casual dining.  At RRGB’s May, 2017 analyst day, she flatly predicted it will never return to its former glory when the restaurants were a good place to eat when guests were doing something else, like shopping or seeing a movie.  Now, take-out, delivery or meals available at the grocery store are more suitable for today’s lifestyles.  Instead, customers are shopping less in the malls or less frequently heading out for a movie in favor of shopping online shopping or streaming entertainment at home.  Against this gloomy outlook she and her team have endeavored to pare Red Robin down to its core equities: Good value for gourmet burgers, bottomless fries and brews, which she feels will always be relevant. The program, as outlined twenty months ago, continues to includes:

  • The company will concentrate on core value burger line up rather than LTO’s centered on premium burgers.  It will concentrate on improving performance within the existing fleet of stores, rather than building new units. It will expand off-premise, not only via its current on-line order and pick-up business but also through catering and delivery. In fact, off-premise sales have grown from 5.7% of sales to 7.6% to 10.1% of sales in Q3’16, Q3’17, and Q3’18.
  • It aims to increase speed of service and improve guest experience.  These initiatives together with menu simplification and operational streamlining, will drive store-level margin expansion, according to its plan.
  • A new prototype is being developed, for infill of existing territories, new territories, and delivery-only).  The company has planned to jointly develop markets with franchisees, but this strategy is currently on hold.
  • Continue a returns-based capital allocation discipline.

Similar to its competitors, much of the strategy boils down to basic blocking and tackling for which management has set itself measurable objectives and milestones.  As described above, the company has slowed company unit growth from 16 units in 2017 to only 8 through Q3’18 (with 3 closed).  While traffic trends over the last two years has generally outperformed competitors (reversed in Q3’18 with a negative 1.5%), nominal comps, as shown in our table above, have suffered, which, combined with cost pressures, have pressured store level margins.

Shareholder Returns   From mid-2015, when RRGB peaked over $90/share, the stock fell to around $40 in late 2016, rallied to over $70 in mid-2017, declined to under $50 in late 2017, rallied to about $65 in mid 2018 and has declined to the current level as results have disappointed investors. Longer term, the original IPO was in 2002, at $12.00 per share. The stock had a run to over $60 by late, 2005, declined to about $10 at the market low in 2009, had a great run to the high over $90 in mid-2015. Safe to say that long term shareholders have had more than their share of excitement. There is no dividend.

RRGB: Recent Developments (As of Q3’18) (Per Q3 release and Conference Call)

Both GAAP and Adjusted Earnings declined, as a result of lower sales (comps down 3.4%) and lower traffic (down 1.9%). Costs were well contained with Cost of Sales flat at 23.8% Labor Costs also flat at 35.3%. The sales weakness was a result of dine-in traffic, to some extent the result of an advertising shift to heavier weight later in the year.  As indicated above, off premise sales continued higher, up 22.7% YTY, now 10.1% of total food and beverage sales. Management pointed out that restaurant teams are being retrained to provide a higher level of peak-hour service, and pilot locations have improved ticket and wait times. Restaurant EBITDA margin was 16.8% in Q3 vs. 18.6% a year earlier. Flat CGS was achieved by a decrease in ground beef cost and reductions in food waste. Flat labor expense was a result of improvements in labor productivity which offset higher average wage rates. The EBITDA reduction was a result of Other Operating Costs higher by 120 bp (restaurant technology, equipment repairs and maintenance, third-party delivery fees, utility costs) and Occupancy Costs higher by 60 bp (real estate and property taxes). G&A was 5.7% of sales, 40 bp lower YTY, due to decreases in salaries and team member benefits as a result of the reorganization in Q1’18, as well as lower incentive and equity compensation. Selling expenses were 4.1% vs. 5.0% benefiting from the media shift discussed above. Pre-opening expenses were only $0.4M vs. $1.5M due to fewer openings. There were “reorganization costs” of $0.5M vs. nothing a year earlier. There was a tax benefit of $2.2M vs. normal taxes of $0.7M in ’17. Two company restaurants opened in Q3 (8 YTD), and a franchisee opened one (total of 3 YTD).

The Company pointed out that, though comps have been increasingly negative through Q3’18, the two year traffic comparison continues to beat the competition, by a stacked 2.5% in Q3. Also, there has continued to be an improvement in labor productivity, still 8% in Q3, down a bit from 10.9% in Q1 and 11.8% in Q2. On the conference call, there was lots of discussion of marketing direction and initiatives regarding menu mix. Management clearly hopes/believes that the retraining of store level employees will improve service levels, both in terms of table turns as well as the dining experience and satisfaction. Discounting is being viewed as a tool, not to be overused, to be used along with other operating initiatives. The Red Robin Loyalty program now has 8.5M members, and we can attest to the frequent communication with that base of customers, and the deals in the last month or so have been not as frequent or aggressive as previously.

Conclusion: Provided at the beginning of this article

 

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CHIPOTLE MEXICAN GRILL INC. – UPDATED WRITEUP

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Conclusion

Putting it all together, barring  further poor publicity from customer illness, legal problems, or other corporate issues, the worst should be behind Chipotle.  It seems that there is a lot more that can go right than wrong at this point. However, based on a multiple of forward earnings and EBITDA, CMG is now priced toward the high end of its historical price range. Over the short to intermediate term, the next three to six months, we consider that the stock has more downside risk than upside potential, especially in the light of the weakening general economic backdrop and the well known industry challenges. Longer term, if the fundamental recovery persists, we think the stock could at least keep up with the earnings progress.

Company Overview  

Chipotle Mexican Grill (as of 9/30/18)  is the owner and operator of a 2,461 unit (2,424 in the US and 37 internationally) fast casual chain of with a narrowly focused menu of burritos, tacos and salads generating $4.7B in sales in TTM through Q3’18. Two Pizzeria Locale restaurants, a fast casual concept, are also operated but not currently being expanded, by a consolidated subsidiary.  The company has long been a top performer in the industry but in 2015 its progress was interrupted by outbreaks of food-related illnesses in its stores. It has been in turnaround mode ever since. An incident of a norovirus in a Virginia store in mid-July 2017 was an unwelcome reminder the company may have not fully put the past problems behind it. New CEO, Brian Niccol, formerly CEO at Taco Bell, was installed in early 2018, which has led to numerous operational and marketing changes that have been viewed positively by employees, analysts and investors and CMG stock recovered from a low close to $250/share in early ’18 to a high above $500 just six months later. As Part of the restructuring, the Company announced in May that headquarters would be moved from Denver to Newport Beach, CA, with certain administrative functions consolidated in Columbus, OH as well as New York, NY. As a result, total related costs would be $44-$58M, of which $28.5M was incurred as of 9/30/18. The opening rate was approximately 200 stores per year, maintained for the first year or so after the 2015, moderated to about 130 for ’18, expected to be 140-155 in ’19.

Menu

The vision of founder and CEO, Steve Ells, is “food served fast but not fast food.”  It aims to be distinct from typical fast food in being prepared from fresh, high-quality ingredients using classic cooking methods, or “Food With Integrity” (FWI).   The FWI objective includes serving meats from humanely raised animals, without non-therapeutic antibiotics or added hormones.  FWI extends to sourcing a portion of its produce that is locally and organically grown when in season, among other related aims.

The menu is simplicity itself. The several burritos, tacos and salad items are assembled to order from 4 proteins (beef, chicken, pork, tofu) prepared with just 47 other ingredients. Sides are masa corn chips with guacamole or salsa. Beverages consist of soft drinks, fruit juices and (in some locations) beer and margaritas. Under the new management team, the menu  being carefully expanded, with many items currently in a test mode.

Operational Model & Unit Level Economics

(Per 2017 10-K)The average cash outlay for the 2017 class stores  (size 2,550 sq.ft. seating about 58) was $735k, net of $100k from landlords, plus estimated pre-opening expense of $75k.  For this total cash outlay of $810k  cash-on-cash returns of 40.4% can be calculated based on calendar ‘17 AUV of $1,940K & store-level EBITDA margin of 16.9%. However, we should point out that new stores have been disclosed to generate $1.4-$1.5M in the first year, presumably with a lower EBITDA than the company average. If the first year EBITDA is 12%, for example, on $1.5M, that would generate $180k of EBITDA which would represent a first year cash on cash return of 22.2%, so the 40.4% described above could be considered a “target” return in year three. Obviously, the magnitude of returns described above, both year one and targeted, are still impressive relative to industry peers, especially considering the difficulties of the last several years which are hopefully in the rear view mirror.

Company Background

 In 1998, with only 14 units, the company was bought by McDonald’s (NYSE: MCD) which spun it off in 2006 to the public by which time it had grown to 500 locations. For the next 10 years CMG had an extraordinary run on the strength of its FWI brand promise.  The store count quadrupled (including establishing small beachheads in Canada and Europe).  Comps were consistently positive, averaging 8.4%, and Store AUV’s increased from $1.63M to $2.53M, driving 20% revenues CAGR.  Below the top line EBIT margin expanded over 1,000 bps to 18.8%, net income grew at a 29.8% annual pace and returns on invested capital hovered in the low to mid 20% range.

By 2015 the rapid growth outstripped the company’s ability to manage the quality of a widely disbursed supply chain consisting largely of small producers.  Early in the year, a pork supplier had to be eliminated due to quality issues, so pork products were not available in the stores for nine months.  Later in 2015 and in early 2016 outbreaks of food-borne, e-coli related illnesses among its guests were widely reported.  The reports triggered criminal and SEC investigations, and an investigation by the Centers for Disease Control and Prevention (CDC).  While the CDC investigation ended in June 2016, remnants of the other legal issues, including class action lawsuits are still pending.

Customers fled in the wake of these developments, voting with their feet that their belief in the FWI brand promise had been broken.  Needless to say, comps fell abruptly, dropping as low as a shockingly negative 29.7% in Q1’16 after which they recovered quarter by quarter, finally returning to positive territory, posting +17.8% in Q1’17 against the bottom in the prior year’s quarter (8.1% in Q2’172).   AUVs followed suit, dropping steadily in 2016 before rebounding to $1.957K in Q2’17 in sync with the bounce back in comps. As sales had risen through the years, quarterly corporate operating margins peaked at 19.3% (with 28.3% store level EBITDA) in Q3’15, before plunging to -5.6% (with 6.8% store level EBITDA) in Q1’16, after which they recovered somewhat steadily to 9.1% by Q2’17 (18.8% store level EBITDA), with store level EBITDA relatively stable since then, at 18.7% in Q3’18. Net income most recently has been materially affected by adjustments such as asset impairments and restructuring costs. Investors are not minding the adjustments, focusing on the slow but steady recovery in comps.

As indicated by the numbers, the worst is probably over and the company, under Brian Niccol’s leadership, continues to shift from damage control to sustaining a turnaround.  To this end the company is simplifying its operations. Despite the vision of simplicity for the model, management concedes operational procedures had accrued unnecessary complexity over the years, particularly in hiring and developing employees. The company has also overhauled its digital platform, making it more user-friendly, aiming to halve order fulfillment time. It has installed second make-lines for on-line sales at 750 locations as of Q3’18, expected to be system-wide by the end of ’19. These second lines can produce as many as 130 additional entrees in a typical 3 hour peak without additional labor. CMG is also expanding its catering business and exploring delivery.

The company believes these initiatives will propel it back to $2.5M AUV’s over time, 20%+ store level EBITDA margins and EPS comfortably above $10 in 2019, more like a $15.00 run rate longer term, but no timetable has been provided.

 Shareholder Returns

In the last 10 years, since a low of around $50/share in early 2009, CMG has appreciated about 9x in value to this point. While down from a high of $749 in July 2015 at the onset of its food-borne illness crisis, bottoming at around $250 in early ’18, the recovery has been dramatic since new management has been installed. CMG has always been richly valued with the forward P/E trading pre-crisis in a range between 25X and 55X, so the stock is currently assuming a successful turnaround and resumed growth. The company does not pay a dividend, but has long made modest repurchases of its stock. In the wake of the crisis, there was a material increase in repurchases, spending well over $1B to repurchase shares, mostly in the high $400 range. In Q3’18, a comparatively modest $19M of stock was repurchased, at an average price of $474, leaving $100M in the current buyback authorization. The Company remains debt free with over $300M of cash equivalents and an additional $300M of “investments” (not specifically defined).

Recent Developments (Per Q3’18 EPS Report and Conference Call)

Earnings in Q3’18, after adding back adjustments of $0.80 from charges related to asset impairment, corporate restructuring and other costs, was $2.16 vs. $1.33, up 62.4%. Comps were up 4.4%. Transactions declined by 1.1%, but a 3.8% price increase and menu mix upgrade provided the comp gain. Store level EBITDA increased from 16.1% to 18.7%, driven by lower marketing costs, partially offset by repair and maintenance. Since store level EBITDA was 19.3% for nine months, Q3 obviously represented a sequential downtick, from 19.5% in Q1 and 19.7% in Q2. Cost of goods declined 160 bp to 33.4% of revenues. Labor costs were flat YTY, at 27.2%. The price increase offset wage inflation of 4-5%. G&A expense increased 10 bp to 8.9% of revenues. Digital sales grew to 11.2% of sales, increasing 48.3% YTY. New restaurants in the quarter totaled 28, with 32 closed or relocated. A new marketing strategy, “For Real”, was unveiled, accompanied (of course) by continued operational focus. Guidance for all of ’18 continues to be comps in the low to mid single digit with new openings at the lower end of the previously announced range of 130-150 units. The only formal guidance for 2019 is for 140-155 openings.

On the conference call: management talked about the encouraging attitude by managers at the annual All Manager’s Conference. The Company is making a conscious effort to participate with their millennial customer in terms of “cultivating a better world, seeking to disrupt the current food landscape, etc.” In addition to the expanding list of 750 second make lines, digital pick up shelves are in nearly 350 restaurants, with an aim to be in all stores by mid-’19. App downloads increased 25% QTQ, and there is strong momentum with delivery. Doordash has been a new partner since Q2, delivery service can also be made through the CMG app and website, and there seems to be “very little customer overlap”. There is a digital pick up lane at restaurants that physically accommodate the feature, and it will be expanded where possible. A loyalty program launched in September in three test markets looks promising. Lots of new products are being tested and key management personnel are still being added.

October sales started strong, up 4%, but Q4 comp is expected to be “penalized” by about 100 bp since a price increase last November is being lapped in about 1,000 restaurants. No guidance for 2019 comps is being provided since there are so many product and operational initiatives in progress. New stores have “opened at stronger levels” and the pace of new stores will be up modestly in ’19 vs. ’18. As mentioned after Q2, about 55-65 underperforming restaurants will be closed in the current year, 32 of which took place in Q3, a total of 38 for the YTD, so another 17-27 are targeted for Q4. Lower marketing expense of 2.5% in Q3, down 70 bp YTY was due to a timing shift into Q4 for the “For Real” campaign, which began in late September, and Q4 will therefore be in the low 4% area. Calendar ’19 is expected to be in the range of  3%. Depreciation in Q3 was 4.3%, an increase of 60 bp, due to accelerated depreciation on the closures. It was indicated that the relatively modest share repurchase program will remain at the current level until the restructuring program is completed.

When questioned about store margin objectives, management responded that it is a function of higher AUV’s. “When we get to $2.1M, we can be in the 21% margin. $2.2M is a 22% margin. Wage inflation is a bit of a wildcard. We can’t overcome that with transaction growth alone. That will require some careful timing and place in a menu price increase…..and there’s efficiencies of moving our customers from the front line to the second make line. And then it’s a matter of working with our delivery partners to make sure that the economics work for both of us and them.”

SO THAT’S A PRETTY GOOD WRAPUP !! (with thanks to CFO, John Hartung)

Conclusion (provided at the beginning of this writeup)

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – IT’S GETTING INTENSE!

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The general equity market had its worst December on record, with the averages down 10% and more. Gold related securities, however, began to prove their worth as an undervalued “safe haven” and an “uncorrelated” asset class. Gold bullion was up 4.9% and the gold mining stocks were up more than double that. One month of outperformance is not enough to establish a new trend, and the gold miners were still down for the entire year, but December does demonstrate how quickly trends can change. For lots of reasons which we outline below, we believe December may have been just the beginning of the resumption in the long-term bull market for gold related securities. The charts below provide a vivid picture of the most important long-term trends, and the prospects for substantial gains in our portfolio of gold mining stocks.                                                                               

While short term fluctuations and volatility can often dominate our thinking, we think the following charts provide valuable long-term context. There is no question that gold related securities are influenced by trends in the general capital markets, viewed as a “safe haven” from a decline in other assets, and heavily influenced by the direction of the US Dollar. The recent strength in the US Dollar, and the continuous rise in the general market have clearly undermined the performance of gold related assets. We believe the charts below show that the S&P average is likely closer to a long term high than a low, that the US Dollar is closer to a high than a low, gold bullion has been “consolidating” for 4-5 years, while gold related securities (represented here by the GDX ETF), are clearly near a long-term low, and may be emerging from its base.

First, the chart below shows the performance of the S&P 500 index, virtually straight up from the bottom in 2009, an unprecedented continuous rise. Most important, of course, is the decline which began in December, the sharpest correction in the last decade, and that has continued the first day of 2019. Should this decline continue, and there are lots of reasons why it should, gold related securities may be one of the very few safe havens.

The next chart is the performance of the DXY, the ETF representing the performance of the US Dollar, since 2005, versus other major trading currencies. You can see that the US Dollar has been trading very near its high and that has no doubt undermined the price of gold bullion in US Dollars. There is a lot of discussion as to whether our Fed, led by Jerome Powell, will be able to raise interest rates further at the same time the Fed balance sheet is reduced, both of which has contributed to the strong US Dollar. Should he decide to back off these programs, which we believe will be the case, that should contribute to a weaker US Dollar, and the chart shows the downside risk over time. A materially weaker US Dollar would be a strong tailwind to the price of gold related securities.

The next chart shows the price of gold bullion, represented by the GLD ETF, since its decline in 2012. You can see that the decline was 39% from the high to low. Since 2013, GLD has been in a trading range of about 20% from a little over 130 to a low of 105.  Right now GLD is trading about 8% below its “breakout” point of just over 130.

The following chart shows the performance of gold mining stocks, represented by the GDX ETF. You can see how substantially GDX has underperformed gold bullion, down 75% from the high of 2012 to the low in late 2015. The “trading range” since 2013 has been a very wide 56%, and you can see that GDX is still a lot closer to its low within the trading range than GLD. The “catchup” in GDX to get back to the high of the trading range in 2016, when GLD was a little over 130, would imply a 48% move, versus only 8% in GLD. We believe that December may have demonstrated the beginning of a positive move in GLD, and the beginning of the inherent upside leverage in GDX. We believe that the gold miners, which declined twice as much as GLD on the downside, could demonstrate even more leverage on the upside from this historically low base. Their December performance begins to demonstrate that potential.

Lastly, we provide a chart of Homestake Mining versus the Dow Jones Average during the depression of the 1930s, so even the prohibition of private gold ownership in 1934 was not sufficient to end that bull market in gold mining companies, even as the official gold price remained at $34./oz.

In terms of current news that supports our long term conviction, both bond and stock markets have had to digest lots of news in recent weeks, and it hasn’t always been pretty. Capital markets don’t like uncertainty, which exist relative to trade tariffs, the clearly slowing economies worldwide (US, Europe, Japan, China), the uncertainty regarding our Fed’s plan relative to interest rates, the exploding US deficits, Mario Draghi’s announcement of an end to QE in Europe, the ongoing political turmoil in and out of the White House, the collapse of Bitcoin and the crypto-currency market. The result has been more volatility, especially in the stock market, than we have seen in years. Intra-day moves of 3-4% have become common place, which in and of itself creates a level of discomfort among investors.

There are major macro developments, within the broad brush concerns above:

  • The new US fiscal year started in October, and the stated (now called “on-budget” by some) deficit was $100.5B in October, versus $63.2B last year. November came in at $205B vs. $139B last year. For two months, the deficit is $305B. vs. $202B, up 51%. The actual debt is up $334B, reflecting “off-budget” items, the largest of which is Social Security obligations. We continue to suggest that the “on-budget” deficit will be closer to $1.5 trillion in the current fiscal year, and the total debt will be well over $1.5 trillion, due to government spending (up 18% so far YTY),  higher interest costs, higher defense spending, higher VA support, health care support, THE WALL, etc. There seems to be rare bipartisan agreement right now regarding an unwillingness to talk about the explosion of the deficit and the debt. It is just too disturbing. All the deficit hawks have put their heads in the ground. THERE IS NO POLITICAL WILL in this area.
  • There is an ongoing move away from the US Dollar, the world’s dominant reserve currency since 1944. China, Russia, and mid-east countries are increasingly using the Yuan and gold for oil trades. There is also a consistent reduction within foreign exchange reserves, of US denominated securities. This has been accompanied by accumulation of physical gold, which can’t be diluted by a computer key-tap.
  • There are many indications that China is accumulating far more gold than they have announced. Recall that three years ago China announced that their Peoples Bank of China (PBOC) had increased ownership to 1600 tons from 1000 tons over the previous five years. Considering that China is the largest miner of gold on the planet, 400 tons per year, and nothing leaves the country, an increase of 600 tons over five years is obviously an understatement. It may be Chinese government agencies other than the PBOC that is holding it, but they are government “affiliates”. Various sources have reported that thousands of incremental tons have moved into the hands of various government agencies in recent years, and we would not be shocked if China announces at some point soon that they own 10,000 tons or more.  This would be substantially more than the 8,400 tons owned by the US, currently assumed to be the largest holder.  This would allow the Chinese to create a trading currency backed in some way by their gold ownership, joining, or even replacing the US Dollar as the primary trading currency worldwide. Surprisingly, based on reported gold holdings, Russia (which continues its aggressive gold purchase program) is in the best position to make their currency convertible into gold. Both China and Russia could have multiple political reasons to link the Ruble or Yuan to gold, provide more credibility to their currency than the US can provide.
  • Jay Powell’s newfound uncertainty over the pace of further rate increase provides the possibility that Quantitative Tightening is slowing down, if not stopping altogether should our economy weaken further. It is now clear that fourth quarter GDP will be more like 2% or so than the 4.5% in Q3. Especially in light of slowing economies elsewhere in the world, which will slow further if interest rates are moved higher, Powell may find that the next important course of action is “QE4” or whatever they choose to call the new monetary accommodation.
  • Since September, foreign purchases of US Treasury securities can no longer be made, financed by low interest (or negative interest) borrowing abroad, with currency hedging providing an overall positive carry. Borrowing costs abroad have gone up modestly, hedging costs as well, so the guaranteed positive return has gone away, removing some material portion of the $5-6 trillion of annual demand for US Treasury securities. Since $5-6T of US Treasury Securities have to be “rolled” over the next twelve months, the $1.5T of incremental government debt has to be financed, and the absence of perhaps $2-3T that was previously invested (and hedged) by foreigners, provide a total of something like an incremental TEN TRILLION of US securities that has to be bought in the next twelve months. People… ($10,000,000,000,000) this is a lot of money and could be a strain on the financial system, to put it really mildly.
  • The market for “leveraged loans” and high yield loans has shown serious signs of strain in just the last sixty days. Wells Fargo and Barclays Bank failed to sell $415 million of debt on Ulterra Drilling Technologies, a manufacturer of drilling bits. Blackstone received their funds to help in their buyout of Ulterra, but WF and BB are hoping to market the debt in a better environment in ’19. There were a number of other deals actually pulled from the market in Europe over the last several weeks. The Financial Times said today that the “’junk bond’ market, whether in loans or bonds – has frozen up, and the US credit markets have ground to a halt….not a single company has borrowed money through the $1.2T US high-yield corporate bond market through mid-December…..we haven’t seen the results at yearend, but if the freeze remained in place, it would be first month since November 2008 that not a single high-yield bond priced in the market..”

Our conclusion from all of the above is that our economy and, indeed, the worldwide economy will have very modest growth, at best. The debt load is too heavy, and the unintended consequences of ten years of monetary promiscuity have yet to play out. Equity investors right now assume that Jay Powell will more or less stick to his plan of generally higher interest rates, even if at a much slower pace. If he “cries wolf”, however, the equity markets would rally, but we don’t think for long. The last recession of ’08-’09 required “monetary heroin” to the tune of $4T in the US alone, but each hit has to be bigger to keep the addict functioning. Once capital markets realize that, a more major downdraft is likely. 

In the long run: we believe there will be a new monetary paradigm, and gold related securities will be an important part of a more disciplined fiscal/monetary approach. The ownership of gold has protected one’s purchasing power for the last five thousand years, the last two hundred years, the last 105 years (since the Fed allowed the US Dollar to be diluted by 98%), the last 47 years (since 1971, when the gold window was closed), the last 18 years (since 2000, when deficit spending accelerated once again).

It is of course true that since 2012 gold and gold related securities have been poor investments, but, in the sweep of history, that is a mere blip. With a new level of financial uncertainty compounded by geopolitical concerns and fiat currency dilution rampant around the world, it is only a matter of time before gold establishes itself again as “the real money”. Gold is not the only hedge against inflation, but, among the possibilities, it is currently the most undervalued.  As James Grant, the preeminent monetary historian has said: “A gold backed monetary system is not perfect, but it is the least imperfect system”. We don’t expect a new gold backed monetary system to be in place any time soon, but any small progress in that direction will allow for substantial appreciation in gold related assets.

Best wishes for a healthy, happy, and prosperous New Year!

Roger Lipton

 

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – MAJOR RISKS SURFACE

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – RISK & REWARD IN NEWLY VOLATILE MARKETS

Both bond and stock markets have had to digest lots of news in recent weeks, and it hasn’t always been pretty. Capital markets don’t like uncertainty, which exist relative to trade tariffs, the clearly slowing economies worldwide (US, Europe, Japan, China), the uncertainty regarding our Fed’s plan relative to interest rates, the exploding US deficits, Mario Draghi’s announcement of an end to QE in Europe, the ongoing political turmoil in and out of the White House, the collapse of Bitcoin and the crypto-currency market. The result has been more volatility, especially in the stock market, than we have seen in years. Intra day moves of 3-4% have become common place, which in and of itself creates a level of discomfort among investors.

There are major macro developments, within the broad brush concerns mentioned above:

  • The new US fiscal year started in October, and the stated (now called “on-budget” by some) deficit was $100.5B in October, versus $63.2B last year. November came in at $205B vs. $139B last year. For two months, the deficit is $305B. vs. $202B, up 51%. The actual debt is up $334B, reflecting “off-budget” items, the largest of which is Social Security obligations. We continue to suggest that the “on-budget” deficit will be closer to $1.5 trillion in the current fiscal year, and the total debt will be well over $1.5 trillion, due to government spending (up 18% so far YTY), higher interest costs, higher defense spending, higher VA support, health care support, THE WALL, etc. There seems to be rare bipartisan agreement right now regarding an unwillingness to talk about the explosion of the deficit and the debt. It is just too disturbing. All the deficit hawks have put their heads in the ground. THERE IS NO POLITICAL WILL in this area.
  • There is an ongoing move away from the US Dollar, the world’s reserve currency since 1944. China, Russia, and mideast countries are increasingly using the Yuan and gold for oil trades. There is also a consistent reduction within foreign exchange reserves, of US denominated securities. This has been accompanied by accumulation of physical gold, which can’t be diluted by a computer keytap.
  • There are many indications that China is accumulating far more gold than they have announced. Recall that three years ago China announced that their Peoples Bank of China (PBOC) had increased ownership to 1600 tons from 1000 tons over the previous five years. Considering that China is the largest miner of gold on the planet, 400 tons per year, and nothing leaves the country, an increase of 600 tons over five years is obviously an understatement. It may be Chinese government agencies other than the PBOC that is holding it, but they are government “affiliates”. Various sources have reported that thousands of incremental tons have moved into the hands of various government agencies in recent years, and we would not be shocked if China announces at some point soon that they own 10,000 tons or more. This would be substantially more than the 8,400 tons owned by the US, currently assumed to be the largest holder.  This would allow the Chinese to create a trading currency backed in some way by their gold ownership, joining, or even replacing the US Dollar as the primary trading currency worldwide. Surprisingly, based on reported gold holdings, Russia is in the best position to make their currency convertible into gold. Both China and Russia could have multiple political reasons to link the Ruble or Yuan to gold, provide more credibility to their currency than the US can provide.
  • Jay Powell’s newfound uncertainty over the pace of further rate increase provides the possibility that Quantitative Tightening is slowing down, if not stopping altogether should our economy weaken further. It is now clear that fourth quarter GDP will be more like 2% or so than the 4.5% in Q3. Especially in light of slowing economies elsewhere in the world, which will slow further if interest rates are moved higher, Powell may find that the next important course of action is “QE4” or whatever they choose to call the new monetary accommodation.
  • Since September, foreign purchases of US Treasury securities can no longer be made, financed by low interest (or negative interest) borrowing abroad, with currency hedging providing an overall positive carry. Borrowing costs abroad have gone up modestly, hedging costs as well, so the guaranteed positive return has gone away, removing some material portion of the $5-6 trillion of annual demand for US Treasury securities. Since $5-6T of US Treasury Securities have to be “rolled” over the next twelve months, the $1.5T of incremental government debt has to be financed, and the absence of perhaps $2-3T that was previously invested (and hedged) by foreigners, provide a total of something like an incremental TEN TRILLION of US securities that has to be bought in the next twelve months. People… ($10,000,000,000,000) this is a lot of money and could be a strain on the financial system.
  • The market for “leveraged loans” and high yield loans has shown serious signs of strain in just the last sixty days. Wells Fargo and Barclays Bank failed to sell $415 million of debt on Ulterra Drilling Technologies, a manufacturer of drilling bits. Blackstone received their funds to help in their buyout of Ulterra, but WF and BB are hoping to market the debt in a better environment in ’19. There were a number of other deals actually pulled from the market in Europe over the last several weeks. The Financial Times said today that the “’junk bond’ market, whether in loans or bonds – has frozen up, and the US credit markets have ground to a halt….not a single company has borrowed money through the $1.2T US high-yield corporate bond market this month….if the freeze continues until yearend, it would be first month since November 2008 that not a single high-yield bond priced in the market..”

Our conclusion from all of the above is that our economy and, indeed, the worldwide economy will have very modest growth, at best. The debt load is too heavy, and the unintended consequences of ten years of monetary promiscuity have yet to play out. Equity investors right now assume that Jay Powell will more or less stick to his plan of higher interest rates, even if at a slower pace. If he “cries wolf”, however, the equity markets would rally, but we don’t think for long. The last recession of ’08-’09 required “monetary heroin” to the tune of $4T in the US alone, but each hit has to be bigger to keep the addict functioning. Once capital markets realize that, a more major downdraft is likely.

In the long run: we believe there will be a new monetary paradigm, and gold related securities will be an important part of a more disciplined fiscal/monetary approach. The ownership of gold has protected one’s purchasing power for the last five thousand years, the last two hundred years, the last 105 years (since the Fed allowed the US Dollar to be diluted by 98%), the last 47 years (since 1971, when the gold window was closed), the last 18 years (since 2000, when deficit spending again took off).

It is of course true that since 2012 gold and gold related securities have been poor investments, but, in the sweep of history, that is a mere blip. With a new level of financial uncertainty compounded by geopolitical concerns and fiat currency dilution rampant around the world, it is only a matter of time before gold establishes itself again as “the real money”. Gold is not the only hedge against inflation, but, among the possibilities, it is the most undervalued right now. As James Grant, the preeminent monetary historian has said: “A gold backed monetary system is not perfect, but it is the least imperfect system”. We don’t expect a new gold backed monetary system to be in place any time soon, but any small progress in that direction will allow for substantial appreciation in gold related assets.

Roger Lipton

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WENDY’S UPDATED WRITE-UP

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COMPANY OVERVIEW (Per 2017 10-K):

As of December 31, 2017, Wendy’s operates and franchises the third largest hamburger QSR chain with systemwide sales of $10.3 billion and total locations of 6,634 (6,297 franchised and 337 Company operated). The majority of Wendy’s, 92%, are located in North America; this includes all Company owned locations. The remaining 8% are international with the majority of these locations – 83 located in Indonesia. Wendy’s international footprint is much smaller than other QSR chains.

The Company-run stores generated 6% of the total systemwide revenue with the North American franchise system accounting for 89% of total sales and international franchisees accounting for the remaining 5%.

Wendy’s NA (North America) are supplied through a cooperatively operated entity for the purpose of leveraging their purchase power and effectively managing quality distribution and inventories.

LONG-TERM GROWTH STRATEGY (2017 10-K)

Prior to Todd Penegar being appointed CEO (May 2016), Wendy’s growth strategy was mostly stagnant. Once Mr. Penegar came into position, he began a series of growth initiatives, some new and others reutilized.

  1. The Image Activation Program, begun in 2013, includes reimaging existing restaurants and building new restaurants, and remains an integral part of Wendy’s global growth strategy. It includes exterior and interior design and upgrades. At the end of QTR-3, 2018 48% of the global system has been reimaged. This compares with 43% at the end of 2017. The Company expects approximately 50% of the global system to be reimaged by the end of 2018. Also, the addition of kiosk ordering stations has been implemented in approximately 10% of the system as of QTR-3, 2018.

The Image Activation Initiative met strong resistance in its early years    from franchisees. In one instance, Wendy’s Corporation had to sue one of the largest franchisees to force compliance which ultimately led to the buyout of that particular franchisee (DAVCO with 140 locations). Since that time Wendy’s launched a Franchisee Attitude & Optimism Evaluation Program (survey conducted by Franchise Business Review 2018) in the efforts of gaining more buy-in to the reimaging programs. Research shows that as of QTR-3, 2018:

  • 88% of Wendy’s franchisees would still invest in the concept.
  • 87% have a positive attitude about their affiliation with Wendy’s.
  • 84% would recommend Wendy’s to others.
  1. System Optimization Initiative – This is a program whereby: (a) Wendy’s will buy and sell restaurants in an effort to optimize the system. (b) Reduce total Company stores to 5% of total store count. As of QTR-3, 2018 the Company acquired 16 restaurants in the Columbus, Ohio market for approximately $21.4 million. Current Company owned restaurants maintain 5% of total system. (c) Franchise Flips – in QTR-3, 2018 the Company facilitated 9 franchise flips (part of the System Optimization Initiative). (d) New Restaurant Development – in QTR-3, 2018 the Company had 37 global openings; a net increase of 13 new units.
  1. Improving the Customer Experience – The Wendy’s Way is to delight every customer through:

On the technology front, Wendy’s has implemented a series of items to modernize operations. New standardized POS system, new BOH Kitchen monitors and software for scheduling and inventory management and new Mobile App (as of QTR-3, 2018 the Mobile App program has been rolled out and early response has been described as exceeding expectations.) The Rewards Program has been generous – giving away a free Dave’s Single in September as an example.

UNIT LEVEL ECONOMICS (per 2017 10-K; 2018 FDD)

Wendy’s unit level economics disclosure has been less than obvious but the 2018 FDD (Franchise Disclosure Document) provides information on AUV’s, costs and unit level EBITDA.

In 2017 AUV for Company stores was $1,881K. Franchise location AUV was $1,600K. Company store level EBITDA margin was 21.6% and at franchise locations  (EBITDAR), before rent, was 19.7%. Comparison of Cash on Cash returns at new restaurants, company and franchised, is provided below (Source: 2017 10K; 2018 FDD), royalties providing the differential:

 The acceleration in franchisee investment appears to be the result of two factors:

 1.      The performance of the new reimaged locations. The average increase in SSS in 2017 remodeled units was 11.5% up from average SSS increase in 2016 of 6.9%. See table below (Source: 2018 FDD):

Reimage Program with Indicated SSS Increase

2016      2017

Refresh                              7.8%      6.0%

Remodel                           7.5%      8.9%

Scrape & Build              19.2%   22.9%

Average                              6.9%    11.5%

2.  The Company introduced several creative incentive programs for franchisees to invest in the system. To launch the Image Incentivization Program the Company originally offered a 3-year monthly royalty abatement of 2% for new units. (Currently this royalty abatement has changed to 2% royalty abatement, 3.5% advertising abatement for year 1 and a 1% royalty abatement and a 3% advertising abatement for year 2.)

3. For the Remodel Program, franchisees are offered a 1% royalty abatement for 12 months.

The franchisees now seem convinced of the value of remodeling. Initially, there was serious pushback because of the high costs but after learning of the sales lift (see table above) and the added fact the Company adjusted their reimage requirements to 4 options ranging in costs from $300,000 to $1,200,000, now franchisees are embracing the program.

SHAREHOLDER RETURN (2017 10-K):

Dividends:

The Wendy’s Company paid quarterly cash dividends of $0.07 per share on its common stock aggregating $68.3 million in 2017. During the first quarter of 2018, The Wendy’s Company declared a dividend of $0.085 per share to be paid on March 15, 2018 to shareholders of record as of March 1, 2018.

Stock Repurchases:

The following table summarizes the Company’s repurchases of common stock for 2017, 2016 and 2015:

In February 2017, the Board of Directors authorized a repurchase program for up to $150M. An additional $120M was approved in August after the sale of the Company stake in Inspire Brands. In calendar ’18 through October, the Company repurchased 8.5M shares for $146.2M an average purchase price of $17.21. In Q3’19, an additional $120M was authorized, bringing the current outstanding authorization which expires 12/27/19 to $220M.

RECENT DEVELOPMENTS (Per Q3’18 EPS Report and Conference Call)

The reported numbers are heavily focused on “Adjusted” results. By far the largest adjustment was the Investment Income from the sale of their interest in Inspire Brands, for $450M, $353M net of tax. Adjusted earnings per share ($0.17 vs. $0.09), as described by the Company, “resulted primarily from the positive impact of a lower tax rate…..as well as an increase in adjusted EBITDA.” Adjusted EBITDA was $107.2M vs. $97.6M, the largest operating improvement being a $5.2M reduction in G&A expense. The most important operating variables in Q3 was a decrease in North American Same Restaurant sales (on a constant currency basis) of 0.2%, traffic also down,  (vs. 2.0% increase in ’17), global systemwide sales growth of 1.7% (on top of 3.4% in ’17), a decrease in company operated restaurant EBITDA margin of 20 bp to 15.7% (labor rate inflation and higher insurance costs, partially offset by pricing actions and lower commodity costs). There were 37 new openings globally and 24 closings, moving toward 1.5 percent for all of ’18 (1.0% in N.A. and 10% internationally).  At the end of Q3, 48% of the global system was image activated vs 43% a year earlier. 16 restaurants were bought back from franchisees, in Columbus, Ohio, which is historically interesting as that is where Dave Thomas started Wendy’s 49 years ago. Also in Q3, there were 9 “Franchisee Flips”, as part of the system optimization program, with 130 FFs to be completed in ’18.

For all of ’18, the Company now expects N.A. comps of about 1%, Company operated restaurant margin of 16-16.5% (15.8% for nine months, 17.6% in calendar ‘17), G&A expense of $190-195M ($46.5M and 146.1M for 3 mos. and 9 mos.), Adjusted EBITDA  up 6-8% to $415-420M ($107.2M and $291.7M for 3 mos. and 9 mos., $406.2M in calendar ’17, don’t know how ’18 becomes 6-8% growth), Adjusted EBITDA margin of approximately 33% (33.6% and 32.5% for 3 mos. and 9 mos.), Cash Flow from Operations of $295-$310M (was 229.7M for 9 mos.), Free Cash Flow of $225-235M ( $181.1M for 9 mos.). Commodity inflation is expected to be 1-2%, labor inflation of 3-4%, interest expense of $120M ($29.6M and $89.9M for 3 mos.and 9 mos.). In essence, the Q4 results are implied to approximately mirror Q3, with a slight increase in restaurant operating margin.

The Company points out, relative to projected ’18 results, and “certain non-GAAP financial measures”, including “adjustments”: “Due to the uncertainty and variability of the nature and amount of those expense and benefits, the Company is unable without unreasonable effort to provide projections of net income, earnings per share, free cash flow or reported tax rate or a reconciliation of those projected measures.”

The Company refrained from reaffirming previous goals for 2020, since international plans are being updated under new leadership in this area.

The Company stressed on the conference call the ongoing reimaging program, the delivery program now covering 50% of the North American system,  free cash flow generation of $181M for 9 mos. (a 50% increase) and FCF for all of ’18 of $225-235M (vs. 169.9M in calendar ’17, a result of slightly lower capex and a favorable change in working capital, i.e.accrued expenses), further development of the mobile app, the excellent franchisee relationships (strongly evidenced by recent survey results), the ongoing capital allocation process that includes substantial share repurchase.

There was quite a bit of conference call conversation about marketing initiatives and balancing the low priced offerings with premium products in a still fiercely competitive environment. An incentive program was launched to provide franchisees 11.5% of royalty and advertising relief for two years if they sign an incremental development. This is a step up from the previous 6% cumulative abatement over a three year period, with one point of the increased relief in each of the first two years on the royalty side. The Company initiative to reduce costs on reimaging has helped as well to stimulate new unit growth. International unit growth is still strong, on a small base, at 10% after 15% in ’17.

Overall, Wendy’s management continues to do a credible job of “blocking & tackling”, renovating and optimizing the system, encouraging international development and allocating capital to reward shareholders. They are here to stay, but are basically a mature chain operating in a challenging  environment.

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PAPA JOHN’S (PZZA) – JOHN SCHNATTER “ENGAGING FINANCIAL ADVISOR” – WHAT’S IT MEAN?

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,PAPA JOHN’S (PZZA) – JOHN SCHNATTER CALMING DOWN, “ENGAGING FINANCIAL ADVISOR”

We have written several articles regarding Papa John’s since John Schnatter left the company, the first written on July 23rd, when PZZA closed at $46.56. We outlined why it was in the interest of all stakeholders : current management, franchisees, board of directors, stockholders, debt holders, and “even John Schnatter” to arrange a going private transaction.

On August 8th, when PZZA closed at $38.94, after the dismal Q2 was released with North American comps down 6.1%, including July down about 10.5%, we said “it is pretty early to be overly concerned about a collapse of a franchise system that was doing rather well for many years until about nine months ago. This situation could obviously change if the current negative sales trend is not, at the very least, stabilized”.  We concluded: “We feel that sales will more likely stabilize than deteriorate…..especially during Q4 when….YTY comparisons get easier as well. We expect that the most important stakeholders in this equation, specifically John Schnatter …….will come to a rational conclusion that toned down rhetoric is in everyone’s best interest…..there is a great deal of P/E capital looking for a home, and the valuation of the Company supports PZZA as a buyout candidate.”

On October 9th, with PZZA closing at $54.90, after several P/E firms had expressed interest, including Nelson Peltz’ Trian Fund, and comps had apparently stabilized, we said “while PZZA is still statistically cheap relative to other franchising companies….there are some unique uncertainties here”…one of which, and the most important now today…..”to what extent John Schnatter, who owns 30% of the stock will muddy the waters” We suggested investors take partial profits since “we doubt that a deal will be done at much more than $60 per share, and the process could drag on for months. Should a transaction be delayed, or not seem likely, due to continuing weak sales or Schnatter’s requirements, PZZA could fall back to the high 40s.”

Schnatter’s resistance in various forms over the last two months continued to be in place, and when press reports indicated that Trian has lost interest, PZZA came down from $57 on 11/7 to $45 and change..

TODAY’S SITUATION (WITH PZZA @ $45.60)

It  was announced late Friday that John Schnatter has engaged a financial advisor “to assist him in reviewing the financial prospects of the Company and in assessing alternatives for increasing shareholder value.”

We consider this critical in terms of the possibility of a private equity deal, especially with PZZA trading back in the mid 40s. While we have suggested that a transaction would be in the interest of all stakeholders, including John Schnatter,  a “cooling off” period has obviously been necessary for Schnatter, company founder, with emotions playing an important role over a decision relative to his $500M stake. The challenge of satisfying Schnatter, the founder and previous face of the company, and the owner of 30% of the stock, has obviously been an important stumbling block in getting a deal done.

We believe private equity buyers will  be far more interested and Trian could even come back to the table,  now that the stock is back in the 40s and with investment bankers now advising Schnatter. There is a huge difference between the two price ranges, compounded by the fact that Schnatter’s stake  (and his personal future role) could be far more negotiable. We consider the stock to be attractive at the current level.

Roger Lipton

 

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DEL FRISCO’S “IN PLAY” – AS WE SUSPECTED ON 11/27 – OUR CURRENT CONCLUSION

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DEL FRISCO’S “IN PLAY” – AS WE SUSPECTED ON 11/27 – OUR CURRENT CONCLUSION

We concluded on 11/27 that: 

“Overall, we think DFRG from this price ($6.75) 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.

“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.”

Since then:

Engaged Capital has bought 9.9% of the common stock, and complained to management, and the world, that the Barteca acquisition was too expensive and the two steakhouse concepts have been poorly managed. They are urging the sale or breakup of the Company and suggest that “there are multiple parties interested in acquiring DFRG today, either in pieces or in its entirety, at valuations….at a meaningful premium to the current share price”. In our opinion, the conclusions by Engaged Capital as far as operations are difficult to argue with, but we are not so sure that the pieces are worth more than the whole, or the whole is worth a great deal more than the current price.  In response to Engaged Capital, DFRG management has inserted a “poison pill” preventing ownership of more than 10% of the common stock, and said “Del Frisco’s is committed to maximizing long erm value for all shareholderss. While we do not agree with certain characterizations of events or of our business….the Company values constructive input toward the goal of enhancing shareholder value. …..Del Frisco’s will maintain anopen and active dialogue with its shareholders, including Engaged Capital…”

As we have described in more detail on 11/27, provided below, we think there are major pitfalls ahead that could derail management (or activist investors’) plans to improve shareholder value. DFRG paid 10.6x Barteca’s EBITDA run rate, as of a 5/7/18 presentation to investors, and indicated that $3-5M of G&A savings could be achievable. The problem is that DFRG is paying an interest rate of 9.3% on $297M of current. Since the inverse of the 10.6 EBITDA paid is 9.4, that means that DFRG is earnings a 9.4% cash on cash return on the purchase price. However, since the debt carries a 9.3% rate, the transaction is virtually a “wash” in terms of current cash on cash return, and that ignores the need to invest any portion of the EBITDA on maintenance capex. The incremental value of the acquisition, absent refinancing of the debt at a lower rate, is therefore dependent on the contribution from new stores which will hopefully perform as well as the current base.

Since debt service now uses so much of the current corporate cash flow, capex for expansion of all four concepts, Double Eagle, the Grille, bartaco and Barcelona. depends on major improvement of profit margins at the steakhouses. We consider that assumption to be a risk, because a difficult competitive situation in casual dining, as well as macro economic developments provide a generally unforgiving environment.

DFRG has a current enterprise value of about $560M. We doubt that Barteca is worth  more today than six months ago when it was purchased at 10.6x its EBITDA run rate ($325M). That would leave a value of about $235M for the steakhouses. We don’t consider that to be a great bargain, at a little over 1x sales for Double Eagle which is the prime profit and expansion vehicle. The Grilles, doing a little over $100M, with a current store level EBITDA margin of about 9%, down from a high of 14%, admittedly not an expansion vehicle don’t provide a great deal of further value per share relative to the 33M shares outstanding. There is no question that a return to the much higher profit margins at Double Eagle (and an improvement at the Grilles) would provide incremental value from these levels, but that is far from assured.

Our current conclusion is that DFRG is fairly valued at $7.86 today, has upside if operations improve at the steakhouses and Barteca’s concepts perform in terms of operating margins and new store performance.  However, we do not discount the potential pitfalls. Private equity can play if they like. They have a lot of cash to put to work. For our money,  we will pass on this one.

11/27/18 – DEL FRISCO’S RESTAURANT GROUP (DFRG) – NEW WRITE-UP

 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.

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.

COMPANY OVERVIEW (Per 10Q – 9/25/18)

Del Frisco’s was initially organized in 2006 in connection with the acquisition by former principle stockholders of Lone Star Steakhouse and Saloon, Inc. which owned the Del Frisco’s and Sullivan’s restaurant concepts. Following the acquisition, the company was restructured to separate certain other Lone Star Steakhouse & Saloon concepts by spinning off the subsidiaries that owned and operated those concepts.

The Company’s restaurant makeup has materially changed over the last twelve months. On June 27, 2018 Del Frisco’s completed the purchase of the Barteca Restaurant Group, previously privately held and based in Connecticut, which consists of two separate restaurant concepts: Barcelo Wine Bar and bartaco. As of September 21, 2018 Del Frisco’s, sold its Sullivan’s Steakhouse Group. As of 9/25/18, there were a total of 70 restaurants, operating in 17 states and D.C.,  including 15 Del Frisco’s Double Eagle restaurants, 18 bartacos, 15 Barcelonas, and 22 Del Frisco’s Grilles.

The purchase price of Barteca was $331.2M cash, funded with new debt and the proceeds of about 13 million shares of common stock at $8.00/share. The sale price of Sullivan’s was approximately $32M.

Del Frisco’s is the leader in the full-service steakhouse sector based on the average unit volume (AUV) and EBITDA margins of Double Eagle. Barcelona serves as a neighborhood Spanish tapas bar, with an award winning Spanish wine program. Bartaco, as described in the 10Q “combines fresh, upscale street food with a coastal vibe in a relaxed environment, inspired by a healthy outdoor lifestyle.

Del Frisco’s Double Eagle Steakhouse

Del Frisco’s Double Eagle Steakhouse is one of the premier steakhouse concepts in the United States. The Double Eagle is defined by its menu which includes USDA prime grade wet-aged steaks hand cut at the time of order and a range of other high-quality offerings including: prime dry-aged lamb, fresh seafood, and signature sides and desserts. It is also distinguished by its “Swarm Service” whereby customers are serviced simultaneously by multiple servers. Each restaurant has a sommelier to guide diners through an extensive award-winning wine list. Del Frisco’s Double Eagle Steakhouse targets customers seeking a full service experience The décor and ambience are designed with both classic and contemporary design enhancing the customer’s experience and helping differentiate Del Frisco’s from other upscale steakhouse concepts.

Currently, there are thirteen Del Frisco’s Double Eagle Steakhouses in nine States and the District of Columbia. They range in size from 10,000 to 24,000 square feet with seating capacity for at least 300 people. Annual AUV in 2017 per Double Eagle was $13.6 million; average check ran $116. The most recent openings were in Boston (Q3’18), Atlanta (Q3’18) which was the first “smaller prototype”, and San Diego in Q4’18.  Century City, CA is expected to open in Q1’19. Leases have also been signed for Santa Clara, CA and Pittsburgh, PA.

Del Frisco’s Grille

Del Frisco’s Grille was developed in 2011 to take advantage of the positioning of the Del Frisco brand and to provide greater potential for expansion due to its smaller size, lower building costs, and more diverse menu. The Grille is an upscale casual concept with a refreshing modern menu. It appeals broadly to both business and casual diners borrowing from the Del Frisco’s heritage offering the same high-quality steaks and top selling menu items. In addition, the Grille’s menu offers many new creative twists on American comfort classics including regional flavors. Once again, the ambiance appeals to a wide range of customers seeking a less formal atmosphere for their dining occasions. The Bar at the Grille is the centerpiece focused for a great night out. Currently, there are 22 Grilles. The Grille’s average size range from 6,500 to 8,000 square feet with seating capacity for 200 people. Annual AUV in 2017 was $4.9 million with an average check of $46. Two new locations are expected to open in Q4’18, in Philadelphia and Fort Lauderdale. A new Grille requires a capital expenditure of $3.5-4.5M.

Barcelona Wine Bar

Barcelona Wine Bar is the largest Spanish restaurant concept in the U.S. with 15 locations as of Q3’18 and two under development. The stores are about 4,000 square feet with 120-150 seats, now with a targeted cost of $2.8-3.2M. Primarily a dinner concept, they serve an ever-changing selection of Tapas as well as specialties from Spain and the Mediterranean, also featuring award-winning Spanish and South American wines. 40% of sales are from alcoholic beverages with an average check around $30. The estimated market potential is between 50 to 100 locations. The AUV in calendar 2017 was about $4M, approximately 1,000/sq.ft. and the EBITDA at the store level was 23.5%. Stores opened prior to 2016 averaged $4.4M. with EBITDA of 24%. A new location is expected to open in Charlotte, NC in Q4 and in Raleigh, NC in Q1’19.

bartaco

Bartaco has 18 locations and 3 under development. The stores are also about 4,000 square feet, seating 120-150 patrons. This concept has more balanced dayparts than Barcelona, with 40% at lunch, 60% at dinner, with 40% alcoholic beverages. The targeted investment per store is $2-3M. The estimated market potential for bartaco is between 200 and 300. The AUV for all stores in calendar 2017 was about $5.0M, over $1,000/sq.ft., with an EBITDA at the store level of 27.4%. Excluding two recent closures, the remaining restaurants opened in 2016 or earlier averaged $5.4M with store level EBITDA of 29%. The most recent new restaurant was in North Hills, NC, with Q4 openings expected in Fort Point, MA and Dallas, TX. An additional unit is expected to open in Madison, WI in Q1’19.

LONG-TERM BUSINESS STRATEGY

Del Frisco’s growth strategy and outlook are comprised of the following primary drivers, initially established in 2014 when Norman Abdallah became CEO. Significantly, the below long term objectives are now augmented by balancing growth opportunities among the four concepts, at the same time reducing the newly acquired long term debt. We consider the objectives as outlined below relatively “standard” or “generic” within any well run restaurant company, so it will be up to Abdallah and company to “differentiate their commodities” in a still unforgiving environment. With that backdrop, management at DFRG is planning to:

  • Pursue disciplined restaurant growth – there are significant opportunities to grow all their concepts in both existing and new markets. All opportunities are subject to Del Frisco’s growth strategy which includes accepting only those sites that they believe can meet their sales objectives per site.
  • Grow existing revenue – continue to pursue opportunities to increase check, pursue targeted local marketing efforts and evaluate operational initiatives including growth in private dining.

Q3’18 LEADS TO OUR NEW MODEL: STORE LEVEL EBITDA REDUCED BY RECURRING CORPORATE EXPENSES

The third quarter report was dominated by all kinds of non-recurring items, relating to the acquisition of Barteca, disposition of Sullivan’s, and a handful of store closures. Comps were “mixed”, better at the newly acquired concepts than Double Eagle and the Grille, but non-recurring factors (weather, YTY comparisons at bartaco in Port Chester which was closed for a few days in late October’17 after a hepatitis A “incident”, cannibalization at Double Eagle in Boston, closures for remodels, etc.). On the positive side, management pointed out that Q4 has started out stronger. On balance, the explanations were reasonably comforting, giving this observer the feeling that business was far from “crumbling”, especially considering the indication from management that Q4 has started out stronger.

Our following discussion is focused on “continuing operations”, made up of store level cash flow (EBITDA), then followed, below the store operating line, with marketing expense, pre-opening expense, G&A expenses, and interest, to get to pretax cash flow, then subtract depreciation to get to pretax GAAP earnings. Admittedly, the model could be more precise. For example, there will be no more Grilles built in the near future, which is the lowest margin concept, so the higher margin segments will provide a bigger percentage of future revenues. However, the following model should give us an adequately useful picture of what the next two to three years might look like.

Total revenues for Q3’18 were $105,304,000, broken down as follows: Double Eagle, 36.2%: Barcelona, 16.3%, bartaco, 21.%: and Grille, 25.9%.  Store level EBITDA was 15.5%, 22.8%, 27.8% and 9.0%, respectively, $18,588,000 or 17.6% across all four brands. Applying realistic store level margins and corporate costs to calendar ’19 estimated revenues should give us an idea of the cash flow and earnings power next year and beyond.

The consensus Street estimate, according to Bloomberg, for calendar ’19 revenues is $531.3M. In terms of store level margins, we will try to lean to the optimistic side, making the assumption that a steakhouse management no longer distracted by Sullivan’s can improve margins at Double Eagle and the Grille. At the same time, we will assume that Barcelona and bartaco, already operating at industry high store levels of EBITDA, can maintain their performance, even improving slightly, since there have been two closures.

Double Eagle had store level EBITDA of 15.5% in Q3’18, down from 22.8%. For nine months Double Eagle had store level EBITDA of 22.4%, down from 25.2%. In calendar ’17, Double Eagle had store level EBITDA of 26.5%, down from 28.1% in ’16. Going forward, in ’19 and, if not ’19, by ’20, we will make the assumption that store level margins can get back to 25.0%.

The Del Frisco’s Grill had store level EBITDA of 9.0% in Q3’18, down from 9.3%. for nine months the Grille had store level EBITDA of 12.2%, down from 12.9%. In calendar ’17, the Grille had store level EBITDA of 13.2%, down from 14.8% in ’16.  Going forward in ’19 and if not ’19, by ’20, we will make the assumption that store level margins can get back to 14%.

For the Barteca concepts, Barcelona Wine Bar and bartaco, while Q3’18 showed an improvement, we are hard pressed to assume that the already high margins can improve by much under new publicly held ownership, and the risk of margin contraction is always present. While it is true that a few closures can improve margins at the remaining fleet, it is also possible that certain new locations might not meet expectations. We will therefore make the adequately optimistic assumption that calendar ’17 store level of 23.5% and 27.4%, can be improved by a point to 24.5% and 28.4%.

Applying those store level margins to $531M for ’19, broken down (revenue wise) between concepts according to Q3’18 percentages, would provide $120M of store level EBITDA, or 22.5% overall relative to revenues. From 22.5% store level EBITDA, we will model the following expenses. Nine months in calendar ’18 show 2.0% for marketing, 2.4% for pre-opening: we will model G&A at a “leveraged” 10%, considering that it ran 11.2% for Q3 and 10.9% for nine months. That leaves us (22.5-2.0-2.4-10) 8.1% to cover interest and depreciation, before taxes. Interest expense for Q3’, after deducting a non-recurring loss of $18.3M relating to financing,  was $6.1M.  Annualizing that to 24.4M annually would be 4.6% of ’19 revenues. (The effective interest rate on the debt is a about 9.3%, LIBOR plus 600 bp).  That leaves 8.1% less 4.6%, or 3.5% of pretax cash flow, or $18.6M, which is corporate EBITDA. Since D&A runs about 6%, GAAP result would show an operating loss. Basically, this is consistent with consensus expectations, which shows an $0.11 loss in calendar ’19, as shown in the table above.

MANAGEMENT GUIDANCE – CALENDAR ‘18

Excluding Sullivan’s and the Barteca concepts prior to ownership (the first six months of ’19), management is looking for comp sales of (1.5) to 0.5%, restaurant level EBITDA of 19.5% to 20.5%. On the same basis, EBITDA was 17.6% in Q3 and 19.4% for nine months, so this guidance assumes a slight positive influence from the seasonally strong Q4. G&A (recurring) will be $39-42M for the year, which would be 9.5-10.1% of consensus sales estimates, beginning to show the G&A leverage from the Barteca acquisition. Pre-opening expenses will be $10-11M or 2.5% of sales, slightly above what we model going forward. Capex, after tenant allowances will be $75-80M and “adjusted EBITDA” will be $34-$38M (8.2-9.2%). This number for adjusted corporate EBITDA turns out to be very close to the 8.1% in our model in for ’19, presented in the preceding paragraph. A footnote on the Q3 release, relative to their estimate of “adjusted EBITDA for ‘18” says “A reconciliation of the differences between the non-GAAP expectations and GAAP measures for adjusted EBITDA and restaurant level EBITDA generally is not available without unreasonable effort due to the potentially high variability, complexity and low visibility……the variability of the excluded items may have a significant, and potentially unpredictable, impact on our future GAAP results.”  FWIW, we can’t recall this kind of caveat elsewhere.

LONGER TERM MANAGEMENT GUIDANCE

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 from 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. 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.

SHAREHOLDER RETURN

On October 14, 2014, Del Frisco’s Board of Directors approved a stock repurchase program authorizing them to repurchase up to $25 million of their common stock over the next three years. On February 15, 2017, the Board of Directors increased the authorized capacity under their existing stock repurchase program to $50 million of their common stock from that date forward and is not part of the defined term. Under this program, management was authorized to purchase outstanding common stock in the open market from time to time at its discretion, subject to share price, market conditions and other factors. The common stock repurchase program did not obligate the Board to repurchase any dollar amount or number of shares. The Company fully utilized the availability under the repurchase program in November 2017. Over the life of the program, the Board of Directors repurchased 3,630,390 shares of their common stock at an aggregate cost of approximately $57.8 million and an average price per share of $15.93 under this program.

There is no dividend. It seems reasonable to expect that stock buybacks will not be a feature of the next few years, with free cash flow utilized for new units and debt service.

The stock, DFRG, went from the low teens in 2012 to a high close to $30/share in mid 2014, declined to the mid teens in mid 2015, remained in a trading range from the low teens to the high teens until mid 2018 when it purchased Barteca. It has gone down steadily, about 50%, since then.

CONCLUSION: PROVIDED AT BEGINNING OF THIS ARTICLE

 

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NOBLE ROMAN’S UPDATED WRITE-UP

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THE COMPANY

Noble Roman’s, Inc. (NROM) is forty six 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 plus D.C., Puerto Rico, the Bahamas, Italy, the Dominican Republic 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 $600,000 (including about $50,000 of pre-opening expenses). The targeted average annual volume has been $1.35M (26k/wk.) with a first year store level EBITDA of 22%. Cost of Goods combined with Labor (including fringe benefits) is expected to average no more than 50% of sales. These parameters provide an immediate 50% cash on cash return, allowing for a two year cash payback. The first four locations are collectively meeting, and sometimes (Westfield) individually exceeding all these targeted parameters 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 (the first of which is approaching its second anniversary) 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 there has so far been no effort at delivery, introduction of a mobile app or many other typical operating and marketing initiatives. 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. 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 inicate 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 incremental profits and cash flow to NROM at even the earliest stage. 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 has recently been signed, 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, and should open by February, 2019.

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 has generated steady growth in the last 18-24 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 down slightly YTY in Q1’18, up about the same in Q2, also flat for nine months. Though revenues have been flat for nine months, and openings and closings as described in the quarterly filings are lumped in with grocery store numbers, management indicates to us that non-traditional openings are increasing slightly quarter to quarter, from seven in Q1 to 8 in Q2 to 10 in Q3. Since signings have been going well in ’18, as reflected by “franchise fees and commissions in Q3” which increased from $58,000 in Q3’17 to $119,000 in Q3’18, an increase in royalty revenues can be expected in the future. It should be noted that while 13 non-traditional locations closed in the latest nine months, they were older low volume units and will not cost much in missed royalty income. 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 just over 2,000 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 2000+ 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.  With two other far more profitable and promising areas for corporate growth, NROM management is concentrating efforts elsewhere. Royalties and fees from grocery store distribution was $1.8M in calendar 2017, down from $2.1M in ’16. In the first nine months of ’18, grocery fees were down a more modest 12.5% to $1,151k from 1,316k, though seasonally slow Q3 was down 27%. While this division’s income 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.

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 2010, 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 will have benefited from about $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 $20M of pretax earnings. In the nine month report, the Company indicated its plan to extend the maturity date of the 10% convertible (at $0.50) bond, (with warrants at $1.00/share attached), which has $2M still outstanding, three years until 2023.

Q3’18 CONTINUES TO DEMONSTRATE EXPANSION OF CORPORATE EARNINGS AND CASH FLOW POWER

Operating results over the years, including the last few, have been burdened with lots of unattractive moving parts. While the apparent EBITDA has been about $3M annually in each of the last several years, the actual free cash flow was inhibited due to expenses necessary to wind up the aborted Take ‘N Bake operation, exorbitant interest charges, and legal expenses associated with license fee collection. However, since late ’17, without Take N’ Bake and the exorbitant interest charges, the EBITDA more closely resembles free cash flow. While recent reported results have still been complicated by writeoffs of old receivables and associated legal expenses, as well as non-cash changes in the value of derivatives, a $3.7M change in calendar ’17 in  the value of the deferred tax asset, EBITDA (Operating Income plus D&A plus non-cash writeoffs plus interest) in the trailing twelve months ending 9/30/18 was over $3M. Since legal fees should come down now that the two active lawsuits were settled, the “run rate” of annual EBITDA by 12/31/18 could be over $3.5M.

Third quarter results showed revenues increasing substantially from the addition of NRCPP locations. Up front Franchise Fees and Commissions more than doubled to $119,000 from $58,000 in Q3’17. Royalties and fees from non-traditional locations was flat at $1.2M while fees from grocery stores were down $124,000 to $311,000. The most important line item was the Revenues from Craft Pizza and Pubs, increasing from $457,000 to $1.309M, reflecting the four stores now opened. Equally important was that restaurant expenses of NRCPPs amounted to $1,048,566 or 80.1% of sales, providing store level EBITDA of 19.9%. A year ago, Westfield was the only store opened and had store level EBITDA of 24.0%. The lower margin this year is a function of three relatively immature locations, still reflecting opening inefficiencies. Annualizing the third quarter revenues would indicate an average yearly revenue level just above $1.3M for the four stores now open, but the third quarter is a seasonally slow quarter reflecting typical back to school consumer spending. Also, in spite of some indeterminate amount of cannibalization, the full year should annualize at or above $1.35M. The company stated that they expect the store level margin to improve from the nine month level, as higher seasonal volume combined with operating efficiency from the newest locations kicks in. It seems that the targeted 22% store level EBITDA is achievable, which at $1.35M generates $297,000 and provides a two year cash payback on the $600,000 investment with includes pre-opening expense.

Operating income in Q3 was $714k, in the same range as the last two quarters Adding back $125k of depreciation provides EBITDA of $839k. Below the Operating Income line, interest expense was down sharply to $173k from $601k a year earlier. There was a non-cash adjustment of the valuation of receivables (70% of which was capitalized legal expenses) of $1,296k, relating to two receivables that have been contested in court for over two years. This non-cash item resulted in a GAAP loss after taxes of $562k. This level of earnings and EBITDA is typical of the last four quarters. As indicated above, there seems to be a current annualized level of EBITDA comfortably over $3.0M to build upon.

The Company indicated its plan to open a fifth store in the near future but there is not yet an indication of a lease being signed. We think the probability is high of a new location in early ’19, perhaps another store by late ’19, which would allow for a contribution of at least five store-years for calendar ’19. If we conservatively assume 5 store years for ’19 (versus 4 stores open currently), this would be a total targeted EBITDA addition of $297k on the current run rate from one more store, but it is possible that lower legal expenses and more efficiency from the three newest locations could improve upon that. This ballpark possibility excludes possible benefit (e.g.non-traditional locations) or penalty (e.g.grocery locations) from the other activities. Most important: these numbers do not include any contribution from NRCPP franchising. Ten franchised locations, for example would generate $250-$300,000 up front, and, $675,000 annually of franchise royalties at the targeted volume. There is obviously a long runway for growth here, if operating results do not disappoint.

THE CURRENT BALANCE SHEET AND ENTERPRISE VALUE

There is currently about $7.0M of total debt, and about 21.6M shares currently outstanding. The debt consists of $5.0M bank debt, including the current portion, and $2.0M of convertible debt (at $0.50/share). Between now and late 2019/early 2020, the $2.0M of convertible debt will either turn into 4.0M new shares, be extended in maturity (if bond holders agree), or be refinanced (likely at less than the current 10% interest rate), one of which we believe will be practical, considering the successful development of NRCPP locations.  There are 2.4M warrants, that were attached to the 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, obviously reducing the current $7M of current debt very substantially. We can therefore consider that the total enterprise value of NROM is something like ($0.45/share x 27M shares) plus $2M of remaining debt after cash generated from exercise of all options and warrants, or a total enterprise value of just over $14M.

CONCLUSION

We need not make precise projections in terms of cash flow and earnings, other than presenting the rough parameters above. Our statistical template at the beginning of this descriptive article assumes only a continuation of the four company operated stores that are in place, maintenance of the other two operating segments, 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. The stock is obviously cheap statistically, with an enterprise value of about 4x the current rate of annualized EBITDA. 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. This is especially so, as the company seems to be “cleaned up and just arriving at the party”. 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. Noble Roman’s is an infant compared to some of the more mature participants in the fast casual pizza segment such as Blaze or MOD  but seems equipped to compete effectively.

Roger Lipton

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