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.”
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 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.
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