Thirty years of investment analysis experience teaches you many things. One thing it teaches you is to always question the sustainability of above average margins. Too many investors today rely too heavily on screens and spreadsheet data to make investment decisions and ignore how those figures are actually derived and how a company actually operates.
This article will analyze the operating margins of the Del Frisco Double Eagle Steak House division of Del Frisco's Restaurant Group (DFRG) and illustrate how one unit in New York City significantly distorts the division's operating margins.
For some brief background, Del Frisco's Restaurant Group operates 34 restaurants under the Del Frisco's, Sullivan's and Del Frisco Grille concepts. On a trailing twelve month basis the company generated $223 million in revenue and $42.6 million in EBTIDA. The long-term model is for 8-10% unit growth, 3-4% per annum increases in comparable store sales ad 18-20% long-term EPS growth. As the table below shows, Del Frisco's has the highest operating margins of U.S. based, publicly traded, full service dining concepts. The purpose of this article is to break down why this is so.
|Buffalo Wild (BWLD)||Darden (DRI)||Texas Roadhouse (TXRH)||Brinker Int. (EAT)||Cheesecake Factory (CAKE)|
If a long-term investor is really to "think like an owner" and not a day trader, then is important for him to understand how a business really operates and understand how every line item in the financials is derived and its investment implications. Below are the costs of goods sold and other operating expenses of several well know casual dining chains.
What immediately jumps out to an investor is the 39.4% total operating costs of DFRG compared to an average of 54.6% of the group. For the prudent analyst, this 1500 bps disparity warrants further attention to help understand why it exists. Notice that Del Frisco's has very similar food costs to its direct competitors, Ruth's and Morton's. This would be expected since they all sell the highest quality beef and have similar alcohol to food mix. Also notice the fairly tight range in other operating costs as a percentage of sales as the five other companies in the table.
Food Costs and Other Operating Costs
|FY11||Del Frisco's Division||Ruth's Hospitality||Morton's||Cheesecake Factory||Brio Bravo (BBRG)||BJ's Restaurant|
|Cost of Goods||30.8%||31%||30.4%||25.5%||26.6%||24.6%|
|Other Op. Exp.||39.4%||51.8%||54.4%||56.6%||55.3%||55.0%|
The impact of the New York restaurant on margins is significant.
So what is the "secret sauce" that gives DFRG such a huge advantage on operating costs? The answer is its New York City restaurant. The financial disclosure in SEC filings and presentations is excellent and gives the investor enough information to breakout the approximate revenue and expenses of the New York unit relative to the other 8 units in the division at the end of 2011.
Below is a table that estimates the sales and costs of the non-New York City units and the New York unit. In the risk section of the S-1, DFRG states that the New York restaurant accounted for 18% of total company sales. One assumption I made was that the food costs were relatively similar. I also assumed that the operating costs for the non-New York units were similar to the other steak house and higher end casual restaurant chains listed above.
The operating expenses for the New York unit were plugged in to get the numbers to foot with the totals. While these numbers may not be 100% accurate and are not endorsed by company management, I believe they are relatively close to accurate and good enough for this analysis. When broken out, the tremendous profitability of the New York restaurant jumps out at the investor.
In fact, the New York unit appears to be more profitable than the other eight restaurants combined! As a check on our assumptions, it should be noted that the company's Sullivan's concept food costs of 30.4% of sales and operating costs of 48.2% of sales. There are several implications from this analysis.
The first implication is that the company's industry leading margins are, in part, the result of one extraordinarily profitable restaurant in New York City. When this restaurant is excluded, the operating margins of the company are more in line with the group. This is not to say that the company is intentionally misleading investors and analysts as to its true operating margins or potential. To the contrary, the company has provided detailed information that allows an investor to figure out this on their own. But it is still important to understand why the company is so profitable today.
The second implication is that as the company adds new Del Frisco Double Eagle Steak House units, they will ultimately be dilutive to the division margins as their operating margins will most likely approximate the non-New York units profitability of 14-16% operating margins and $9 million in unit sales. As a simple illustration, I doubled the number of non-New York units and increased the New York unit's sales by 10% and kept the other margins relatively flat. Here is what the operating margin of the division would look like at this point. The operating margin declines by nearly 600bps in this example.
% of Sales
% of Sales
% of Sales
Year to date, operating costs have declined by almost 200 bps in this division as the company achieves operating leverage on very strong same store sales. The point of this analysis is to show that investors should not be complacent about this improvement and extrapolate the margins and trends significantly into the future. At some point, the "mix shift" will begin to impact the aggregate division margins. When this happens, it should not come as a "surprise" to investors and should be expected as the normal maturation of the company's store base. It is not a sign of worsening conditions or a great "bear case" point. It just, it what it is.
A final implication is that, until the company builds more units, change in same store sales of the New York restaurant will have an outsized impact on the divisions' same store sales calculation than any of the other 8 stores by a factor of about 3.5 to 1. This is something investors should consider when assigning any valuation metrics to the company.
The bottom line is that Del Frisco's Restaurant Group is a well-run restaurant chain with above average margins and above average unit growth prospects. However, these above average margins are derived, in part, by one restaurant in New York City that produces almost $38 million in revenue (4X the average) and these operating margins will most likely decline as the company expands into other areas of the country. Investors need to understand the company and its prospects in this detail in order to make reasonable assumptions about the company's future earnings power. Company management has given investors a significant amount of financial disclosure in the SEC filings, which is somewhat unusual for a small cap company that is a recent IPO, and should be applauded.
I believe the long-term prospects are bright for the company. At current valuations of 15X forward EPS and 8X EV/EBITDA, the company seems fairly valued assuming consistent performance. Of course, if investors react negatively to "new news" that current long term operating margins are "unsustainable" at some point in the future, readers of this article will not be surprised at all.