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

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

CONCLUSION

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

BACKGROUND

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

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

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

However:

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

 THE FUNDAMENTALS

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

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

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

Some other assumptions in our model are:

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

Base Case

Bullish Case

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

Las Vegas uncertainty: Important leases expire in 17 months

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

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

THE MEADOWLANDS

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

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

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

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

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

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

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

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

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

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

STRONG BALANCE SHEET

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

VERY ATTRACTIVE VALUATION

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

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

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

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

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

CONCLUSION: Provided at the beginning of this article

ARK RESTAURANTS (ARKR) – NO COOKIE CUTTER HERE, BUT THE UNDERLYING VALUE SEEMS VERY SUBSTANTIAL

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ARK RESTAURANTS (ARKR) – NO COOKIE CUTTER HERE, BUT THE CURRENT VALUE AND THE ADDITIONAL POTENTIAL SEEM SUBSTANTIAL

CONCLUSION

Ark Restaurants represents one of the few investment opportunities in the small cap restaurant space for significant appreciation over the next few years. Unlike most restaurant stocks that are trading at valuations that significantly discount their future, Ark’s current valuation gives almost zero credit for the large amount of optionality embedded in their business model and Meadowlands Racetrack investment.

THE REINVENTION OF ARK RESTAURANTS

Ark Restaurants is a unique restaurant company with a 37 year operating history that focuses on large, one-of-a-kind restaurants located in such landmark locations as Bryant Park in NYC and the Sequoia in Washington D.C. The company also operates restaurants in Alabama, Florida, New Jersey and Nevada. The restaurants typically have 200-500 seats (an Olive Garden has about 250 seats) and require specialized management skill to operate efficiently. As of January 2, 2021, ARKR owned and/or operated 18 restaurants and bars, 17 fast food concepts.

In fiscal 2020, as a result of Covid 19 related shutdowns, sales declined 34% and the company lost $7.7M. In 2019 the company generated $7M in free cash flow and paid a $1 per share dividend (the company paid a $1 per share dividend since 2010). As the economy opens back up, the company expects to reach cash flow breakeven by at least Q3, 2021.

The purpose of this report is not to analyze these results, but to highlight several value creating strategies that could drive the stock price significantly higher in the next two or three years. We are going to focus on two specific areas. The first is the company’s strategy of acquiring restaurants and the land (or secure 20+ year leases, possibility with right of first refusal). The second is their 7.45% ownership in the New Meadowlands Racetrack LLC.   We believe these strategies could result in a share price in excess of $30 per share in the new few years.  We believe management’s interest is strongly aligned with outside shareholders due to it 40% ownership of the company. It should also be noted that Michael Weinstein is 77 years old and the average age of the other eight directors is 73 years old, including four 77 years old or older.

Brief Summary of Earnings Power and Liquidity

In 2019 Ark generated $10.6M in cash flow and approximately $7M in free cash flow. The company was using the FCF to make approximately $3M in debt amortization payments and $3.5M in dividend payments. We believe that the cash flow of the company in 2022 could be similar. The company should be able to service its debt without difficulty. While the timing of the resumption of the dividend is unclear, the company will have the flexibility to either reinstate a dividend or accelerate debt pay down.

As of Q1, 2021 (ending 12/31/20) the company had $11M in cash and $41M in debt, of which $15M is PPP loans. The company has applied for $4.1M in forgiveness and anticipates applying for an additional $7-$9M in forgiveness. The company also anticipates receiving $3.4M-$3.8M in tax refunds this year. Excluding the debt associated with the PPP loan that is expected to be forgiven, the company’s net debt position should be closer to $12M-$15M once all the tax refunds are received. The company has stated that it believes it could be cash flow positive within the next 6 months.

How the Acquisition Strategy Creates Significant Value

In response to losing over $6M in EBITDA due to lease expirations over the last 6 years, CEO Michael Weinstein has been replacing this lost cash flow by acquiring properties where they own the building and the land (or have a 20+ year lease).

As a result of wage law changes in New York and Washington D.C. in recent years, the company’s payroll expenses increased by over 300bps so Mr. Weinstein embarked on a diversification strategy to reduce the exposure to these states, increasing activities in Alabama and Florida. Since 2014, the company has spent approximately $34M acquiring restaurants in Florida and Alabama. These acquisitions have increased revenue from these two states to over 40% of restaurant revenue. Not only does this strategy reduced exposure to lease expiration and wage hike risk, but it also increases long-term value by sustainable cash flow improvement.

Acquisition Criteria

The acquisition criteria are straightforward but are designed to improve the chances of long-term value creation. The basics of the criteria are as follows:

One-off, non-branded restaurants to reduce competitive bidding. Acquire restaurant buildings and land for 4-6X cash flow, alternatively with a lease of twenty years or more with a purchase right of first refusal.

  • Mostly cash purchase (typically owners are 70-90 years old) to reduce buyer pool.
  • Preferably a restaurant with 200-1000 seats with complex operations.
  • Located in areas (i.e coastal locations) that have limited ability for new construction.
  • Opportunity to increase sales and profitability through professional management.

2020 Example: Blue Moon Fish Company, Lauderdale by the Sea, FL. – Voted “Best Waterfront Dining in Fort Lauderdale by Zagat”

In December 2020, Ark acquired the Blue Moon Fish Co. near Fort Lauderdale, FL for $2.8M. The company paid $1.8M in cash and issued a four-year note in the amount of $1M with a 5% coupon. A lease which expires in 2026, has four, five-year extension options.  The rent payments are approximately $360K per year (6% of revenue) and increase approximately 15% as each option is exercised. The restaurant produced approximately $6M in pre-Covid revenue and $1M cash flow. Management believes there is a strong possibility that capacity can be expanded.

2020 Example: JB’s on the Beach, Deerfield Beach, FL

In 2019, the company purchased JB’s on the Beach in Deerfield Beach, FL for $7.04M. In January, 2020, the company exercised its right-of-first refusal to acquire the land, building and parking lot associated with the restaurant for $11M (original offer price was $18M). The original agreement required the company to fund a $3M deposit, but Ark contributed its rights and interest to a new unaffiliated entity which funded the entire $11M. At this point, Ark continues to operate the restaurant and negotiations continue in terms of the real estate development.

2016 Example: Rustic Inn, Jupiter, FL.

No longer in Ark’s portfolio, the company took over the restaurant, then called the CrabHouse, in 2014, for $250k. They then spent $750k for renovations, reopening in January, 2015 as the Rustic Inn. Ark exercised its right of first refusal in October, 2016, for $5.2M, at the same time selling the same property for $8.25M, which generated a net gain of $1.637M, obviously an admirable return on their $1M investment in just a couple of years.

Another Example, with Dramatic Value Created

Another of the four properties currently owned is the Rustic Inn in Dania Beach, FL that was acquired in 2014 for approximately $7.7M.  The acquisition was financed with an original bank loan of $6M, of which $3.7M is remaining. The seller was a 94 year old owner/operator. At the time of purchase the restaurant was generating $1.5M in cash flow. Since the acquisition the restaurant has increased sales 15-20% (through price increases and better management) and increased cash flow pre-Covid to $3.5M.  Among other things, cash flow was increased through the combination of a reduction of 400-500bps in food costs, as well as the operating leverage on sales increase. These improvements effectively reduced the purchase multiple to a little over 2x cash flow.

At this point, Ark has the financial flexibility to leverage the cash flow if they like, with a sale/leaseback. This potential transaction, providing a $1M rent to the purchaser, for example, could generate something like $10M in proceeds, still leaving the Company with $2.5M of annual EBITDA.

THE MEADOWLANDS -RETURN COULD BE VERY SUBSTANTIAL

Background

In 2013, the company made a $4.2M investment in the New Meadowlands Racetrack LLC (NMR). Over time the company has increased its total investment to $5.1M for a 7.4% fully diluted stake. Additionally, in 2014 the company loaned NMR $1.5M by way of a 10 year note. The principal and accrued interest currently totals $1.78M.  The managing partner of NMR is Jeffery Gural, who owns the casino Tioga Downs and a racino at Vernon Downs in New York. Hard Rock International has an equity stake in NMR and a long-term agreement for future development at the Meadowlands.

ARKR has also secured the exclusive right to operate the food and beverage concessions (excluding a new Hard Rock Restaurant that could be built on-site) at the new raceway grandstand and casino. ARKR already has a relationship with the Hard Rock as the operator of food courts for them at two casinos in Florida.

Recent Developments

New Jersey’s mobile sportsbooks produced more than $359 million in revenue in 2020. The Meadowlands has been the primary beneficiary of the legalization of sports betting in the state, with a 52% market share of sports betting in New Jersey in 2020. The Meadowlands partners are FanDuel and Pointsbet, rumored to be in the frontrunner to partner with the world famous Las Vegas Westgate SuperBook. Other advantages of the Meadowlands include the fact that it is only six miles away from New York City and is one of only two active sports books in the country within walking distance of an NFL stadium.

New York lawmakers have recently agreed to legalize mobile sports betting. Lawmakers considered and rejected a budget provision that would have permitted up to three additional casinos in downstate areas, including New York City. Licenses for that area are on hold until 2023. While the Meadowlands could see an initial decline in sports betting (an estimated 20%-30% of NJ revenue comes from New Yorkers), the consensus among industry players is that New Jersey casinos will benefit in the long run.

In fact, Mr. Gural was pleased with how the New York sports betting bill turned out. He was quoted in the Wall Street Journal as saying, “It’s the dumbest thing I’ve ever seen. I consider this a gift to New Jersey and to me at the Meadowlands, and my only regret is that Andrew won’t be around to see this totally fail.” In the past Mr. Gural has been quoted as saying “I think the best hope for The Meadowlands is to get a casino. Once downstate New York gets them, hopefully we would then get them, which would create a lot of revenue. I do think, long term, that we will get a casino.” While the New York lawmakers did put the possibility of three new land-based casinos on hold until 2023, this does not change the long-term attractiveness of the Meadowlands as a land-based casino.  In addition to the large increase in revenue from sports betting, the Meadowlands racetrack has seen a 61% increase in handle over the last 10 years. Mr. Weinstein’s decision to invest in NMR seems to point to a potentially substantial long term payoff to shareholders one way or another.

WAYS TO WIN WITH THE MEADOWLANDS 

Current investment in NMR is profitable

Even without a casino at the racetrack, the NMR partnership is profitable. On the Q4 2019 earnings conference call, Mr. Weinstein stated that ARKR’s share of the cash flow was around $800K.  However, since it is carried on the balance sheet at cost, and not being distributed to the company, it cannot be counted as income. We believe 2020 attributed cash flow could be similar, if not higher, so this imbedded value continues to build.

Important Equity Stake in New Casino Development

The ultimate reward for shareholders would be the approval of a casino at the Meadowlands. As discussed above, the timing of such approval is highly uncertain. However, we do believe that approval will occur in the future. A simple analysis shows the potential value creation that could occur for shareholders once that happens.

Jeff Gural has estimated a Meadowlands casino could generate $800M-$900M in revenue. For reference, in 2016, the Borgata in Atlantic City had revenue of $812M and EBITDA of $212M. MGM sold the Borgata to MGM Growth Properties for $1.175B in consideration.

Example of Hypothetical Meadowlands Casino:

  • Casino cost $1B
  • Debt to equity 60/40 –
  • ARKR prorated share of equity contribution $25-$35M
  • ARKR expenditures for restaurants $55-$65M
  • Funding – many possibilities – returns discuss below are non-leveraged by Ark
  • Company could execute more sale-leasebacks to fund some of the cash
  • Normalized cash flow could also help fund expenditures
  • Outside investors have expressed interest in the project.
  • Per the Q4 2020 conference call:

“And in the last two weeks, I’ve gotten two calls. …….very wealthy groups, one a family office with some $4 billion. And another one…….not involved in the restaurant business but sees the opportunity. And both of them have said that they would like to partner up with us if we saw anything that was attractive. I know one of the group has gaming interest and sort of would like to buy Ark stock, either a convertible preferred or something that converts into Ark stock because they’re not only looking at the capability of us to acquire other restaurants, but they really got their eye on the Meadowlands to own a piece of that through us.”

Potential Value Creation

 We believe that the single most likely scenario is that NMR buys out Ark’s equity interest, with Ark retaining foodservice opportunities at the site. The majority partners may want to takeout its minority partners to simplify the operating structure. It is difficult to project a value, under this scenario, but we believe the payoff to ARKR would be substantial.

 Should the current partnership structure prevail and the Casino get built with Ark remaining a 7.4% equity partner, we suggest that the new Casino could do a minimum of $1B in revenues and generate $200M of EBITDA. Ark’s 7.4% interest in that EBITDA would be worth about $14.8M annually.

Without considering the degree to which Ark could leverage their total gross investment of $90M, inclusive of building the restaurants, one could create a matrix of values with revenues from $1.0 to $1.5B, and multiples of EBITDA between 6x and 10x. A minimum expectation of $1B in revenues, $200M in project EBITDA, and a valuation of 6x, would generate a value for ARK of about $90M, almost exactly matching their gross investment, but without considering the value of operating restaurants.

Possible, based upon the population density in northern New Jersey, is revenues closer to $1.5B and $300M of EBITDA. Ark’s share of project EBITDA would be $22.2M, worth $133M at 6x, net after debt to ARK of $43M or $12.28/share. At a 10x multiple, Ark’s share would be worth $222M, or $37.71/share net after debt.

The range of expectations and values just above are substantial, and exclude the value of Ark’s right to manage the restaurants at the new casino, in which they have invested $50-60M. Assuming those restaurants generated EBTIDA of $10-12M, only a 20% ROI, a 6x multiple on that would be $60-$72M or $17-$20/share.

The range of expectations goes from zero for the project as a whole but $17-20/share for the right to operate the restaurants, to a value as high of $37/share for the project plus the $17-20/share for the restaurants. These are obviously very substantial possibilities, and are provided not as specific projections, but an indication that the long term potential is large relative to the current price of Ark common stock.

CONCLUSION: Provided at the beginning of this article

Prepared by: Roger Lipton and Tim Heitman