In part one of my analysis of Ruth's Hospitality Group (RUTH), I showed how the company should be able to sustain a free cash flow run-rate of $30-$35 million using conservative assumptions of no growth in same store sales and units nor any improvement in operating margins. In part two, I will show that significant increases in beef prices over the last few years have masked the substantial improvement in the operating expense ratio of the company. The good news is that the company has been able to maintain its high level of customer satisfaction and service levels while producing operating leverage to higher same store sales with relatively flat employee counts. If the company is able to increase same store sales, I expect this trend to continue. However, there will be a point where the increase in customer traffic requires additional staff in order to maintain service levels and customer satisfaction. Monitoring the company's guest satisfaction levels can alert investors as to when this may be necessary. Finally, I will also look at unit growth potential.
Recent Leverage of Operating Costs Is Being Masked By Rising Beef Costs
I always like to look at costs that management can control to get a sense for how well they run their business under various economic conditions. While there are some things management can do to adjust to rising food costs like changing portion sizes, menu mix and reducing waste, generally speaking, I view big changes in protein and dairy costs largely out of the control of management. Therefore, I think it is more informative to look at how management has controlled the "controllable" operating expenses, like labor, over the last few years. Barring an improvement in sales trends, the easiest and shortest route to boost operating margins is to cut costs. However, in a service oriented business, it can be detrimental to the long-term health of the brand if cuts to personnel impact customer satisfaction levels.
Labor is by far the largest and most important component of operating costs, representing 30-40% of operating costs and 25-35% of restaurant sales depending on the type of service. Since RUTH is known for its outstanding service and excellent food, I would expect that RUTH's labor costs are at least 32-35% of total restaurant sales. As the following table shows, after dramatically cutting staff in 2009, RUTH has kept its restaurant staffing levels fairly constant. This has occurred in spite of a 14% increase in guest traffic in the restaurants. Since RUTH continues to be rated the top steakhouse in the country in the Nation's Restaurant News consumer survey, I would conclude that staffing levels have been appropriate to maintain their service and reputation. It should be noted that even though staffing levels are around 13% lower than 2007, total operating expenses per restaurant are flattish and as a percentage of restaurant revenue, they are 500bps higher. Minimum wage hikes, substantially higher employee benefit and energy costs have offset the reduction in staff. In addition, average sales per restaurant are still below peak levels. The acquisition of Mitchell's appears to have permanently increased the level of restaurant operating expenses per store as well. The combination of the acquisition and the large economic slowdown in 2008 and 2009 has distorted the historical run rates of sales and expenses.
Unit Level Table
In $ Millions
It is encouraging that RUTH has been able increase same store sales over the last three years by 14% while maintaining staffing levels and guest satisfaction scores. Operating expenses per unit have grown at half the rate of the same store sales increase over this time period. Management has been able to balance achieving cost cuts with maintaining high quality service. This gives me some comfort that sustained same store sales levels of 3% or more can continue to produce modest 20-40bps a year in operating leverage. Each 10bps of improvement is about $350,000-$400,000 in pre-tax income or the equivalent of about two new franchised restaurants. RUTH does have about 25% of its restaurants in California (6 units) and Florida (9) units. These two states are finally starting to rebound and recent same store sales of 7-9% have been about 50% higher than the company average. Nearly 82% of the system-wide restaurants are comping positively. As the entire chain returns to positive comps, this could help RUTH outperform some of its peers in terms of operating margin improvement. Of course, there is no guarantee same store sales growth can be sustained, but the basic operating model leverage appears to be intact.
While the company has been successful at leveraging increased same store sales into a lower operating expense ratio, the bottom line is that the net operating margin has been flat since 2008 at around 17.2% of restaurant sales. A large increase in beef prices has mostly offset the improvement in other operating expenses. In the next section I will look at the impact of rising beef prices on the company's bottom line.
Cost of Goods Sold
No Real Improvement In Commodity Costs Expected In The Near Term
Anyone who buys groceries or invests in restaurant stocks is aware that beef prices have increased substantially in the last 5 years. Since 2007, beef prices have risen over 50%. While there have not been many benefits to RUTH's acquisition of Mitchell's in 2008, one benefit is that the company has able to lower its exposure to beef to 34-38% of Cost of Goods Sold (COGS) because of Mitchell's large fish menu. At approximately 38% of COGS, RUTH's beef costs are higher than Del Frisco's Restaurant Group's (DFRG) 32% of COGS, but lower than Morton's 46% of COGS. Typically the company only hedges 50% of its prime beef consumption or 25% of its total beef consumption, thereby exposing it to large swings in beef prices. For example, in the 2011 annual report, RUTH estimated a 10% change in the price of beef would impact pre-tax earnings by $3.5-4.5M (80-100bps of total revenue). Year to date, beef costs have increased by over 15%.
In the following table, I have shown the trend in COGS, beef as a percentage of COGS and the approximate dollar amount RUTH spends each year on beef. Expenditures on beef have increased 46% since 2009, while the increase in entrées served has been only about 15%. RUTH is spending about $8 million more a year on beef than if beef prices had remained flat. For modeling purposes, I would assume that a 10% increase in beef prices from today's levels would negatively impact pre-tax earnings by $4-$5M, depending on how much the company hedges. To offset those costs, the company would have to raise prices by 1-2% (assuming no decrease in demand as a result of the price increase). For this article, I am assuming the company generates about $370 million in restaurant sales and spends $45 million on beef. Due to the current weak economic conditions, the company has been reluctant to push price too much. But at some point the company will most likely try to offset the cost pressure. Any successful effort to boost margins through price is not in my base case.
Beef % of COGS
Unit Growth Modest, But Sustainable.
RUTH's growth driver for the foreseeable future will continue to be expansion of its franchisee-owned units. Since 2007, RUTH has added 27 franchised units, while company-owned restaurants declined slightly. The ratio of company-owned to franchise-owned units has changed from 61:45 in 2007 to 63:72 currently. The company currently has a strong franchise group with 30 franchisees. The three largest franchisees own 24 (33%) of the 72 units. Franchisees have committed to opening 16 additional units (13 unsigned leases) over the next five years, including opening 3-5 in 2013. This represents the potential for an additional $3 million+ in high margin/low capital expenditure franchise revenue (5% royalty rate X $4 million AUV = $200,000 per unit) at a modest 4% CAGR. While this growth rate about half that of competitor Del Frisco's and chains like Chipotle (CMG), BJ's Restaurants (BJRI) and Buffalo Wild Wings (BWLD), the growth is low risk due to the minimal capital outlays and a disciplined approach.
The company claims that it can eventually double the number of restaurants before it reaches saturation. At the modest pace of opening 3-4 franchisee-owned and 1 company-owned restaurant a year, there is ample room to grow for years.
In part one of my analysis of RUTH, I showed how the company should be able to sustain a free cash flow run-rate of $30-$35 million using conservative assumptions about unit growth, same store sales growth and operating margins. In part two, I showed that significant increases in beef prices over the last few years have masked the substantial improvement in the operating expense ratio of the company. The company's tight control on costs, especially labor, has not impacted the guest experience and shows that there is still operating leverage in the business model.
The company's low capital intensity growth model of franchisees opening 2-4 units a year is a practical, lower risk growth model. Investors do need to monitor how quickly the company can "reload" the unit pipeline. At the beginning of 2012, there were 19 unsigned commitments from franchisees. There are currently only 16. This means the company needs to maintain a run-rate of signing 3-5 new commitments a year to maintain its 4% CAGR. The company does report when new commitments are entered into, so investors should be able to track their progress.
All in all, RUTH does seem to provide the patient, long-term investor the opportunity to purchase a high quality restaurant company at a 12-14% current free cash flow yield and have the potential of modest 3-5% growth in that free cash flow due to unit growth and operating leverage. Any improvement in beef prices would be a delicious dessert, just like their Bread Pudding with Whiskey Sauce!!
Disclosure: I am long RUTH.