All posts by Roger Lipton

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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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – TRADE, IMMIGRATION, MUELLER, YADA, YADA, DEFICITS EXPLODE

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SEMI-MONTHLY FISCAL/MONETARY UPDATE – TRADE, IMMIGRATION, MUELLER, YADA, YADA, DEFICITS EXPLODE

There is lots of economic/political/social news day to day, but we believe the underlying fiscal/monetary problems will soon dwarf the currently discussed issues. In this country alone, billions of dollars per day (in deficit spending) are being created out of thin air.   It’s been said that “money is the source of all evil”. That may be true, but a currency of some sort is necessary to exchange goods and services to make social progress. Since we are in the midst of the largest monetary experiment in the history of the planet, and we don’t believe it will end well, unfortunately, we continue to monitor developments.

While there was quite a bit of intra-month volatility in the capital markets in November, the changes were minimal over the entire month. The precious metal markets were much quieter, but there was one notable down day, November 23rd, the reason not quite clear, with mining stocks down 3-4% which was not recovered by month end.  In any event, the gold mining industry, represented by GDXJ (the small to mid-cap miners) and the three prominent funds, Tocqueville, Oppenheimer and Van Eck were down about 2.7%.

Every indication is that the long-term financial issues overhanging the worldwide economy are becoming more intense every day, any one of which could ignite the monetary embers:

(1) The US Treasury must raise over $100B every week, to finance the growing deficit and refinance the maturing debt, and the Federal Reserve is no longer a buyer but a seller of securities. The “bid to cover” ratio for two-year US Treasuries has been coming down in recent months, and last month was the lowest since December 2008, the peak of the financial crisis.

(2) Major foreign purchasers of our debt, including China, Japan & Russia have backed off or eliminated entirely their purchases of US Treasury securities, to some extent replacing that portion of their foreign reserves with gold. As a corollary, the US trade balance that President Trump is so desperate to improve, would reduce the US dollars in foreign hands, which would in turn reduce the demand for our debt, contribute to higher interest rates, slow our economy, and trigger greater stimulus.

(3) Only six to nine months ago, reporters were talking about “worldwide synchronized growth” with no sign of inflation, truly a “goldilocks” situation. Just two weeks ago, headlines in the Wall Street Journal said “GLOBAL ECONOMIC SLOWDOWN DEEPENS”, “INFLATION TICKS HIGHER…”, “INTERNATIONAL FIRMS IN US SEE AUTO TARIFFS AS A THREAT”. As a corollary, Japan and Germany reported GDP contraction in Q3, Chinese growth continues to slow. So much for Goldilocks.

(4) The US current deficit, is exploding, will clearly be over $1 trillion in FY ending 9/30/19, with the total debt going up by more like $1.5T including borrowing from the Social Security Fund. There is no chance of less government spending, especially the next two years with the two houses of Congress split. According to the Wall Street Journal, the US will spend more on interest in 2020 than it spends on Medicaid, more in 2023 than it spends on national defense, and more in 2025 than it spends on all non defense discretionary programs combined. THIS IS SERIOUS, AND IT IS IMMINENT. The relevance of the deficits and debt is that the higher the debt load, the chance of the economy breaking out with productive expansion is reduced.

(5) The long-term suppression of interest rates has serious unintended consequences. Among them is the “misallocation of resources” as investors large and small “reach for yield”.  The current news flow is starting to reflect it. The Wall Street Journal two weeks ago had the headline DEMAND FOR RISKIER DEBT LETS COMPANIES SHIFT ASSETS.  The text ….” Investors are literally giving away the store to squeeze out meager returns from picked over market for corporate debt. Demand for riskier bonds and loans has been so intense that companies…are able to move valuable assets beyond the reach of creditors. Investors continue to make it easier for them to do so by agreeing to terms …that offer fewer and fewer protections.” The financial community has a very short memory. Ten years ago, the phrase was “covenant light”, and mortgage companies were making NINJA loans to homeowners with No Income No Job, and No Assets. Who said, “history doesn’t repeat, but it rhymes”? Just this morning, this was described in the Wall Street Journal in relation to sub-prime Auto Loans.

(6) Don’t take it from me. I’m just a veteran restaurant analyst. What could I know? However, within the last few months: Richard Fisher, former Dallas Fed Chair said: “…interest expense and healthcare expenditures will soon be more than 50% of revenues. At some point you have to pay the piper…We (the Fed) have been suppressing the yield curve. it’s a ticking time bomb”.

Ludwig von Mises, the legendary Austrian economist long ago taught us: “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come soon as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

(7) Just last week Goldman Sachs came around (finally) to the view that markets offer an extremely attractive entry point for longs in goldWe see diversification value in adding gold to portfolios.” Goldman is (finally) forecasting a slowing US economy….at this stage of the business cycle, gold may be particularly appealing as a portfolio diversifier given that long-term bonds may be hurt if U.S inflation surprises to the upside … If U.S. growth slows down next year, as expected, gold would benefit from higher demand for defensive assets.”

Unfortunately, though Jay Powell, and other Central Bankers, might wish to persist in their collective attempt to contract credit, the politicians around the world can be expected to continue to kick the can down the road. Their unstated reality is “whatever happens will happen, but “not on my watch.” Politicians, economists, and capital market strategists, will soon be screaming “DO SOMETHING” and the Central Bankers will accommodate. Jay Powell gave us the first indication of that with his comments last week. Steven Mnuchin, Treasury Secretary, confirmed that just this morning, saying Powell is trying to position the Fed to stimulate when necessary.

Roger Lipton

 

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PRICE WAR in FAST FOOD – BURGER KING TO PROVIDE, FREE, FLAME GRILLED DOG BONE!!

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PRICE WAR in FAST FOOD – BURGER KING OFFERING  FREE, FLAME GRILLED, DOG BONE !!

The latest “initiatives” in the fast food space include (1) all you can eat fries at Wendy’s for $1.00 (2) $0.89 pancakes at Burger King (3) $1.00 coffee at McDonald’s in Canada (4) 10 nuggets for $1.00 at Burger King.

And just this morning:

“Burger King is launching the DOGPPER, the first flame grilled bone, for your best friend. This dog-friendly alternative to the WHOPPER sandwich is a bone shaped treat with flame grilled beef taste for the dogs of these generous owners. The DOGPPER is available for free exclusively through DoorDash when you order a WHOPPER sandwich* . Plus, new customers can get a zero delivery fee with your $10+ order at DoorDash….use promo code DOGPPER from November 28 through December 4th.**”

“*Offer valid for one Dogpper dog bone on qualifying purchase of the WHOPPER + Dogpper combo. Not for human consumption. Offer valid while supplies last at participating locations. Not valid for pickup r dine-in. Limit one per person. Fees, taxes, and gratuity apply. All deliveries ubject to availability. Must have or create a valid DoorDash account with a valid form of accceplted payment on file. No cash value. Non-transferable. See full terms and conditions at dasherhelp.doordash.com/offer-terms-conditions.”

“**$0 Delivery Fee Terms: Offer valid through 12/4/18. Valid only on orders with a minimum subtotal greater than $10. Valid for new customers only. Valid at participating locations. Limit one per person. Other fees (including service fee), taxes, and gratuity still apply. All deliveries subject to availability. Must have or create a valid DoorDash account with a valid form of accepted payment on file. No cash value. Non-transferable. Use promo code DOGPPER to redeem. See full terms and conditions at dasherhelp.doordash.com/offer-terms-conditions.”

OUR TAKE

(1) As described above, ONE DOLLAR has become the promotional price point, and by combining two current offerings  you can get three pancakes and ten chicken nuggets for $1.89 at Burger King. This traffic building strategy is unlikely to build the average ticket and equally unlikely to improve the dollar profitability at franchised locations.

(2) The dollar driven sales “initiatives” are no doubt part of the reason that large franchised groups at Jack in The Box, Tim Horton’s, McDonald’s, and others are publicly expressing their dissatisfaction. Since franchisees are normally reluctant to go public with criticism of their franchisor, and knowing how challenging their business has become, we can surmise that many other franchise systems are suffering in a similar fashion.

(3) Burger King’s business is not “going to the dogs” exactly, but this admittedly creative approach is a demonstration of the desperation within the  QSR segment to build traffic. It might even work, for a while. Got to say: I really love the commercial. Who could argue with Willie Nelson singing “You Were Always On My Mind” and appealing dog shots?  We don’t know how extensively it will be advertised, but will likely create trial.  We assume that DoorDash will be paid, even if a reduced fee has been negotiated for this short promotional period, so the margin for the operator will be compromised. The success of the program, if pursued further,  in terms of profit for franchisees will be determined down the road. The most significant question for us:

Is this a long term edge for Burger King? Is this new approach valid strategically, and is it competitively defensible? How far can Willie Nelson, and cute animals take you? Is this how BK intends to differentiate their commodity? How much is that edible “biscuit” shaped like a bone worth? Maybe $0.50 and customers are unlikely to order $10-$15 worth of food with tax and tip to get a snack for the pooch, which can be accessed in the pantry about six feet away. Even if it Helps in the short term, it seems to us that competitors can react, and will, in short order. Burger King has no doubt tested the appeal of their flame grilled product, but my dog is not too discriminating, and would likely appreciate a Ronald McDonald offering just as much. (McDonald’s could roll out George Strait singing “Write This Down”, cute puppies, and a baby or two.) Seriously though,  Burger King would have to become “the pet food authority in QSR” to build market share, which seems to us to be a bit of a reach. Color us skeptical.

Roger Lipton

 

 

 

 

 

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DEL FRISCO’S RESTAURANT GROUP (DFRG) – NEW WRITE-UP -company at crossroads

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CONCLUSION:

 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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