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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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RED ROBIN (RRGB) reports Q1 – STOCK DOWN CLOSE TO 15% – IS IT THAT BAD?

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RED ROBIN (RRGB) reports Q1 – STOCK DOWN CLOSE TO 15% – IS IT THAT BAD?

Conclusion:

The stock has reacted so violently not so much because the results were disappointing but because management couldn’t provide comforting guidance going forward. Management refrained from describing the sequential progress (or lack thereof) in the year to date. While, during the conference call, management said “…still expect to deliver on our year end earnings targets”…analysts have obviously thought that an “adjustment” to expectations is more realistic. The upgrading of the Red Robin dining experience continues to be a work in progress, and money managers now consider RRGB to be a “show me” situation. At about 7x the current EBITDA run rate, RRGB could become a takeover candidate in an easy money environment (think Buffalo Wild Wings) but private equity firms also like predictability, and the stock could sell materially lower before the potential becomes adequately compelling. BWLD had the franchising (and re-franchising) component which is not nearly so prominent here. BWLD’s balance sheet was also far less leveraged than that of RRGB.

The best overview of the situation is likely provided by management, as described on the conference call:

  • The January administrative reset was described as “consistent with our pivot away from being a unit growth driven organization to one focused on value, affordability, and improved four wall economics”.
  • “The first quarter of 2018 demonstrated the continued evolution of RRGB’s business model that was largely dependent on sales to a business model that has multiple ways to deliver sustained earnings performance and return on investment… built on every day value, affordability, long term profitability and prudent investment of capital.

The Q1 report:

Before getting into the details of the report, this commentary is meant to not only describe the developments at Red Robin but provide our readers with feedback relative to operating trends (and challenges) that are broadly affecting the industry. This full service burger segment, most directly including Applebee’s and Chili’s, but also affecting chains above and below the price and service points, is one of the most competitive. Potential problems become vividly demonstrated. It’s like skiing a “double black” trail. Weaknesses in technique quickly become obvious. Management here is doing their collective best, but it’s hard to run up an escalator going the other way. So much for the metaphors.

The quarter was only mildly disappointing in terms of sales and traffic. Comp revenues were down 0.9% with comp guest counts up 0.1%, once again outperforming peer group trends. There was a 1.0% decrease in average check, comprised of a 2.0% decrease in menu mix, offset by a 1.0% increase in pricing. Importantly, off premise channels were up almost 40% YTY so dine-in traffic was down about 3%. “Adjusted” earnings per diluted share were $0.69 compared to $0.89, but GAAP EPS was $0.34 vs. $0.89. Income from operations was $7,019k vs $17,458k, after a charge of $6,287k in Q1’18 for “home office reset and establishment of a litigation reserve for employment-related claims”.

The operating details include restaurant EBITDA at 20.0%, down about 130 bp YTY. Cost of sales was up 90 bp to 23.8% (higher Tavern mix, higher cost of Steak Fries and ground beef, lower nonalcoholic beverage sales). Restaurant labor was better by 70 bp to 34.5%, due to hourly labor productivity, partially offset by higher manager salaries and bonus). Other operating expenses were up 70 bp to 13.3% as a result of increased technology expense, to-go and catering supplies and third party delivery costs, partially offset by lower repair and maintenance. Occupancy costs increased 40 bp to 8.4% due to higher property taxes and insurance costs. D&A was up 20 bp to 6.9%. G&A improved by 50bp to 6.8% due to the home offset reset. Importantly, the January reset was described as “consistent with out pivot away from being a unit growth driven organization to one focused on value, affordability, and improved four wall economics”.

Within the conference call dialogue were the following bullet points:

(1) Off premise dining, including curbside pickup, third party delivery, and catering, all of which have sales potential, have their own sets of operating challenges and margin implications. There may or may not be cannibalization of dine-in business, but if you don’t do it, your competitors will.

(2) There continues to be a huge battle to provide “value” to the guest in terms of quantity and quality of food (and of course the service). It is hard to improve operating margins when your most popular platform is at $6.99, including the challenge of attracting well qualified servers when tips are so modest at a low price point.

(3) It is desirable to control the off premise business yourself, for the purpose of gathering customer information as well protecting the brand and  profit margin, but third party delivery services are a necessary fact of life for the time being. 70% of RRGB locations have third party delivery.

Roger Lipton

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RED ROBIN GOURMET BURGERS

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RRGB: Recent Developments  and Conclusion  (As of Q3’17)

Per Q3’17 Corporate Release

http://investors.redrobin.com/phoenix.zhtml?c=131715&p=irol-newsArticle&ID=2314672

Per Q3’17 Conference Call

https://edge.media-server.com/m6/p/wjpoao8g

Operating results, though encouraging from a number of standpoints, were not impressive on the surface. The lower results were more a function of operating expenses than a shortfall in sales. Comps and traffic were basically flat, with a 1.6% decrease in menu mix offsetting a 1.5% price increase. Hurricanes Harvey and Irma affected sales by about 40 bp. For the fifth consecutive quarter RRGB gained market share within the casual dining industry, by 400 bp, but of course you can’t pay the rent with “market share” gains. (I’m “unfiltered”, don’t forget!) Restaurant operating “profit margin”, which I always point out is really restaurant EBITDA, was down 120 bp to 17.4%. Labor was up 50 bp, cost of sales was up 20 bp, “other” expenses were up 40 bp, and occupancy costs were up 10 bp. One of the positive aspects was the 41% YTY gain in off-premise sales, up to a still modest 7.6% but a help to be sure. Curbside delivery is available at 50% of the locations, expected to max out in the low 60s due to lease restrictions. Third party delivery was available in close to 50% of the locations, using up to three providers, and accounting for 110 bp of the 7.6% total. This area is still being refined, with self-delivery being evaluated in the hope of improving margins.

RRGB is coping with higher labor costs through their Maestro service model, now fully rolled out. This is expected to reduce labor hours by 5% in Q4 and beyond, though labor in ’17 as a whole will be up by 50 bp. Higher ground beef costs affected Q3, and it is expected that the higher cost of Steak Fries will affect Q4 as well, bringing cost of sales for ’17 as a whole slighter higher YTY. Selling expenses were up 50 bp to 3.4% in Q3, as a function of the timing of national media.

Guidance for Q4 was lowered materially. EPS should be in the range of $0.45-0.60, against a previous Street estimate of $1.01. Due to the Q3 shortfall of $.08 per share, the full ’17 year is expected to be $2.16 to $2.31, versus a Street estimate of $2.80. Comp sales are expected to be flat to up 0.5% for the full ’17 year, which would imply a flattish fourth quarter, perhaps up just slightly (against -4.3% LY). The Company pointed out, again, that EPS results are very substantially levered to comp sales (and margins). A one percent change in traffic can affect EPS by $0.40 annualized. Only 10 bp in operating margins can drive EPS up (or down) by $0.10 per share.

Overall, blocking and tackling, meal by meal, guest by guest, in an effort to gain market share in a difficult consumer environment, continues. In the supplemental material provided with the Q3 report, the company describes “our unique differentiating strengths” as: (1) Craveable, customizable burgers (2) Reputation for service and speed that meets the needs of Guests and (3) Best-in-class value perception with Bottomless promise, ‘affordable abundance’” Couldn’t have said it better. This management team is highly qualified, the balance sheet is strong enough to prevent financial jeopardy, and tangible progress is being made. The point at which the reported results turn for the better remains to be seen. As we have said many times over the last couple of years, sluggish sales combined with rising costs (labor, commodities, rents, etc.) are not a good combination. As somebody once said: “This too shall pass.” If I knew WHEN? I would tell you.

RRGB: Company Overview (Q3’17 -10Q) (2016 10-K) (ICR Slides 1.10.17) (Analyst Day Slides 5.23.17)

 Source of Revenues  Red Robin Gourmet Burgers, Inc. is a casual dining restaurant chain, s of  Q3’17 operating and franchising 565 restaurants (479 company, 86 franchised) with system-wide revenues of $1.5 billion in 39 US states and 2 Canadian provinces as of 17Q3.

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

Operational Model & Unit Level Economics  Of $1.36B T12M revenues to 17Q3, nearly all (98.8%) is generated by the company stores, while the balance consists of royalties and fees. Contrary to the current refranchising trend in the industry, RRGB is going the other way.  It has acquired 50 franchised units since 2014, including 13 in 2016., and for several years the company has not actively sought to expand franchising.  As discussed below in Strategy, the company is seeking to renew franchisee growth.

Red Robin units are generally leased and located on in malls (17.3%) or stand alone (74.3%) or in-line retail & other sites (8.4%).  Store size ranges from 4.5K to 5.8K square feet and in 2016 generated AUV’s of $2,969K and store level EBITDA margins of 20.4%. However, at the May 2017 Analyst Day, the company revealed it had stopped opening stores in malls in 2015 as performance deteriorated due to increasing occupancy costs, the drop in mall traffic and because the locations were not suitable for off-premise programs.  In 2016 mall and off-mall AUV’s were $2,827K and $2,998K, respectively and store-level EBITDA margins were 14.6% and 31.2%, respectively.  The company has been analyzing mall sites to develop an exit strategy or means to improve profitability of existing locations.

Not too many new stores are being built, but as of the end of 2016, a new store required a cash outlay of $2.2M-$2.6M (including pre-opening expense).  At the unit investment midpoint and at the historical off-mall performance levels, we estimate the cash-on-cash return would have been about 26.0%.  Obviously, the returns would be lower today, with lower sales and operating margins. Also in 2016, the company competed remodeling its fleet, an initiative begun in 2012.  The remodels feature new signage, technology, a greater separation of the bar and family areas.  The price tag for the remodels was about $400K, which reportedly generated a sales lift of 3%-5%. If the sales lift is a midpoint 4% of $2.9M, or $116,000, and 50% flows through to store level cash flow, $58,000 incremental cash flow returned 14.5% for a remodeled store.

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

Unfortunately, 15Q3 proved to be the high point of RRGB’s 5 years of progress, which was interrupted by the macro environment afflicting the entire industry, but also exposed operational missteps and oversights masked by the improving financials. Since then comps turned increasingly negative, hurt by declining traffic and average ticket.  These 2 components of comps had previously trended generally positive. Worse, until the last five quarters, the company’s traffic also underperformed its peers, which had been rare in the 5 years of the comeback.  Not surprisingly margins and profitability plunged, leading to turnover at the top.  In June 2016 the CFO resigned and 2 months later, coincident with the 16Q2 announcement, CEO Steven Carley resigned and of Denny Marie Post appointed as his successor.  Ms. Post had joined RRGB in 2011 as SVP and Chief Marketing Officer, was promoted to EVP Chief Concept Officer in 2015 and to President in February 2016. Guy Constant was recruited as CFO and Carin Stutz was promoted to COO.

 No one can accuse Ms. Post of glossing over the dismal state of casual dining.  At RRGB’s May 23rd Analyst day, she flatly predicted it will never return to its former glory when the  restaurants were a good place to eat when guests were doing something else, like shopping or seeing a movie.  Now, take-out, delivery or meals available at the grocery store are more suitable for today’s lifestyles.  Instead, customers are shopping less in the malls or less frequently heading out for a movie in favor of shopping online shopping or streaming entertainment at home.  Against this gloomy outlook she aims to pare Red Robin down to its core equities: Good value for gourmet burgers, bottomless fries and brews, which she feels will always be relevant. The program, as outlined in the 5/17 analyst update, includes:

  • The company will concentrate on core value burger line up rather than LTO’s centered on premium burgers.  It will concentrate on building out established and most productive markets to reap advertising and other efficiencies.  And it will expand off-premise, not only via its current on-line order and pick-up business but also through catering and delivery. In fact, off-premise sales have grown from 5.7% of sales to 7.6% of sales in Q3’17 vs. Q3’16.
  • It aims to increase speed of service and improve guest experience.  These initiatives together with menu simplification and operational streamlining, will drive store-level margin expansion, according to its plan.
  • Store Growth. Management will slow new unit growth to improve ROIC via better siting, lower unit investment costs and operational efficiencies (More detail in Unit-level Economics section).  This includes testing new prototypes (eg specialized production kitchens for infill, new territories and delivery-only).  The company also plans to accelerate the buildout of corporate markets and re-ignite franchisee activity by jointly develop the markets with franchisees.
  • Institute a stronger returns-based capital allocation discipline.

Similar to its competitors, much of the strategy boils down to basic blocking and tackling for which management has set itself measurable objectives and milestones.   As such the company has planned slowed company unit growth (16 new unit in 2017, with 2 units sold through Q3) or about 1% annual growth, which combined with 1%to 2% comps, would drive 2% to 4% top lie growth through 2021, Below the top line the company, earlier this year, was planning on 200-300bps of cumulative margin expansion by 2021.  Of this, labor would contribute 75-100bps (despite inflation), Occupancy & other store level expense savings and leverage would contribute 75-150bps, and G&A savings and leverage 50-75 bps.   As such the company expected EBITDA to reach $200M by 2021. Obviously, these expectations have been scaled back. Free cash flow has continued to be part of the equation here, but, for the moment, will reduce debt, rather than repurchase shares or build new stores. While, the combined effect of the company’s previously stated strategy was to double EPS by 2021, with a 10%-15% CAGR (2-4% revenue, 3-5% margin, 4-6% share repurchases).  New guidance has not been provided, since the general industry and macro-economic trends are so uncertain.

Shareholder Returns   In the last 3 years the return on RRGB has been negligible, having made a round trip, from the mid 40s to over 90 and back again. Longer term, the original IPO was in 2002, at $12.00 per share. The stock had a run to over $60 by late, 2005, declined to about $10 at the market low in 2009, had a great run to over $80 by early 2014, which has been the high point a couple of times in the last three years. I would say that long term shareholders have had more than their share of excitement. There is no dividend.

RRGB: Recent Developments  (As of Q3’17)

Per Q3’17 Corporate Release

http://investors.redrobin.com/phoenix.zhtml?c=131715&p=irol-newsArticle&ID=2314672

Per Q3’17 Conference Call

https://edge.media-server.com/m6/p/wjpoao8g

Operating results, though encouraging from a number of standpoints, were not impressive on the surface. The lower results were more a function of operating expenses than a shortfall in sales. Comps and traffic were basically flat, with a 1.6% decrease in menu mix offsetting a 1.5% price increase. Hurricanes Harvey and Irma affected sales by about 40 bp. For the fifth consecutive quarter RRGB gained market share within the casual dining industry, by 400 bp, but of course you can’t pay the rent with “market share” gains. (I’m “unfiltered”, don’t forget!) Restaurant operating “profit margin”, which I always point out is really restaurant EBITDA, was down 120 bp to 17.4%. Labor was up 50 bp, cost of sales was up 20 bp, “other” expenses were up 40 bp, and occupancy costs were up 10 bp. One of the positive aspects was the 41% YTY gain in off-premise sales, up to a still modest 7.6% but a help to be sure. Curbside delivery is available at 50% of the locations, expected to max out in the low 60s due to lease restrictions. Third party delivery was available in close to 50% of the locations, using up to three providers, and accounting for 110 bp of the 7.6% total. This area is still being refined, with self-delivery being evaluated in the hope of improving margins.

RRGB is coping with higher labor costs through their Maestro service model, now fully rolled out. This is expected to reduce labor hours by 5% in Q4 and beyond, though labor in ’17 as a whole will be up by 50 bp. Higher ground beef costs affected Q3, and it is expected that the higher cost of Steak Fries will affect Q4 as well, bringing cost of sales for ’17 as a whole slighter higher YTY. Selling expenses were up 50 bp to 3.4% in Q3, as a function of the timing of national media.

Guidance for Q4 was lowered materially. EPS should be in the range of $0.45-0.60, against a previous Street estimate of $1.01. Due to the Q3 shortfall of $.08 per share, the full ’17 year is expected to be $2.16 to $2.31, versus a Street estimate of $2.80. Comp sales are expected to be flat to up 0.5% for the full ’17 year, which would imply a flattish fourth quarter, perhaps up just slightly (against -4.3% LY). The Company pointed out, again, that EPS results are very substantially levered to comp sales (and margins). A one percent change in traffic can affect EPS by $0.40 annualized. Only 10 bp in operating margins can drive EPS up (or down) by $0.10 per share.

Overall, blocking and tackling, meal by meal, guest by guest, in an effort to gain market share in a difficult consumer environment, continues. In the supplemental material provided with the Q3 report, the company describes “our unique differentiating strengths” as: (1) Craveable, customizable burgers (2) Reputation for service and speed that meets the needs of Guests and (3) Best-in-class value perception with Bottomless promise, ‘affordable abundance’” Couldn’t have said it better. This management team is highly qualified, the balance sheet is strong enough to prevent financial jeopardy, and tangible progress is being made. The point at which the reported results turn for the better remains to be seen. As we have said many times over the last couple of years, sluggish sales combined with rising costs (labor, commodities, rents, etc.) are not a good combination. As somebody once said: “This too shall pass.” If I knew WHEN? I would tell you.

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SHAKE SHACK (SHAK) – SELLS OFF AFTER EARNINGS REPORT – WHAT’S GOING ON?

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SHAKE SHACK SELLS OFF AFTER EARNINGS REPORT – WHAT’S GOING ON?

We have written many times of our admiration for this company, founded by the legendary Danny Meyer, in terms of the employee culture, operating skills, and their successful management of an extremely aggressive expansion plan. The “cult” of Shake Shack goes far beyond their NYC roots, and openings literally worldwide have supported this notion.

In a nutshell: when a stock is “priced for perfection” ($37) at over 70x calendar 17 earnings and over 60x estimated ’18 earnings, all operating parameters have to be “in gear”, hopefully accelerating, certainly not decelerating. That means: same store sales and traffic, unit growth rate, store level margins, new unit “productivity” of sales and margins.

We don’t have time here to go into all the details of the current results, but in a nutshell: reality is setting in:

Management has continually pointed out that AUVs away from NYC will be closer to $3M annually than the incredible $7M/store within their hometown. It was pointed out that store level EBITDA would be closer to 20% rather than the previous 30% range, at the lower levels. Analysts, and investors heard this, but haven’t wanted to exactly believe this, as  new stores continued, until recently, to open materially above $3M, and average volumes held close to $5M. We will come back to this parameter shortly.

Yesterday, the third quarter report met estimates of earnings, same store sales were down, but a little less than expected, due to menu price increases, traffic was down more, but the expansion rate was increased for next year. Labor costs are up, as expected, especially since SHAK prides themselves on treating employees very well. Overall store level margins are expected to contract further, and G&A expense will not decline as a percent of sales due to the acclerated rate of company store expansion (35-40%) on the base. All of this could be “accepted” by analysts and investors, but here’s the rub:

Each quarter the Company tells us what the weekly AUVs were for domestic company operated stores. This is the way it has gone:

Q3’16    $103,000     Q3’15   $103,000               even

Q4’16     $90,000       Q4’15    $89,000               +1.1%

Q1’17      $86,000      Q1’16    $90,000               -4.5%

Q2’17       $92,000      Q2’16    $102,000            -9.8%

Q3’17       $91,000      Q3’16    $103,000            -11.7%

Clearly, new units are opening “lower”, by our calculation, at about $3.3M. Analysts explored this development on the conference call, and the company confirmed that this range applies, has been predicted all along. The supplemental slides showed that the cash on cash return for a store at $2.8M -$3.2M is 14% in the first year(after $400,000 of pre-opening expense) and 34% thereafter. While more than acceptable, this is a sobering reality compared to the 56% year one cash on cash return for a $5.0M unit, with 79% thereafter. Since the aggressive expansion plan is obviously focused on markets away from NYC, analysts have to assume that the margins will more rapidly approach the lower numbers than they had previously modeled. This is especially true since management was very clear that labor expenses will continue higher, commodities will provide no relief, and corporate G&A will be ratcheted upward to support growth and technology requirements.

In summary: Only the growth rate, of units, is “in gear”, accelerating in fact. Same store sales and traffic are challenged, which is an industry wide issue, store level margins at existing stores won’t improve and will be materially lower at new stores, and G&A won’t be leveraged in the short term. Worst of all, new stores are opening at the previously predicted lower volumes, which removes the possibility of earnings surprises on the upside. A case can also be made that a growth rate, for company stores, of this magnitude, has its own set of dangers, in addition to the more predictable unit level challenges. Investors and analysts have appropriately, in our view,  reacted cautiously to the latest news.

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THE BAR & GRILL BATTLE – EAT, DIN, RRGB, BWLD, RT – “ROLLUP” OPPORTUNITY?

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  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

RRGB STOCK DOWN 6% AFTER EARNINGS REPORT – JUSTIFIED?

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.