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Investment thesis

Restaurant stocks have been going through a very tough earnings season. Of the six restaurant groups to have reported so far, five have reported earnings misses. As a result, there has been significant share price weakness following earnings at companies such as Ruby Tuesday (NYSE:RT), Darden Restaurants (NYSE:DRI) and Domino's Pizza (NYSE:DPZ).

Ignite Restaurant Group (NASDAQ:IRG) is on deck to report earnings and all signs point to a significant earnings miss. The shares have traded flat for 2 months and could see a decline of around 30%. Given the abundance of data points coming from all angles, this should not come as a surprise to anyone. A large sale by the backing private equity fund could also contribute to further pressure.

Background

Back in August, I made an earnings call just ahead of the reporting date for Francesca's Holdings (NASDAQ:FRAN). I predicted that the clothing retailer would report weak same-store sales and that discounting would continue to pressure margins. My share price target called for a quick 30% drop. Within days, Francesca's reported their results and they were exactly as predicted. Discounting had accelerated and margins had come under pressure. The shares quickly dropped by 30% to around $17.00.

In fact, these predictions were fairly easy to make. Most of Francesca's competitors had already reported difficult results and their share prices had tumbled. Many of these competitors even operate in the same malls as Francesca's such that they suffered from the same weak traffic. I also made it a point to visit in person and call numerous Francesca's stores over a period of many weeks so that I had a solid idea about the discounting practices in place during the quarter. My article made all of this clear.

In short, no one should have been surprised by Francesca's poor results. But the analysts were clearly surprised. They maintained their targets at over $30.00, only lowering them after the big miss. Clearly this helps no one. For some reason, they saw no need to conduct store visits and interviews to support their targets. Likewise, we can see that many investors were also surprised. These investors have just begun filing class action lawsuits against management for not revealing the discounting practices, which I described in my article before the miss was reported.

Looking at the restaurant space, we can see a very similar phenomenon unfolding. It is now easy to see that the biggest loser in the near term is going to be Ignite Restaurant Group, which is likely to decline by at least 30% following earnings next week. The company is suffering from 3 years of continuously declining sales at its recently acquired Macaroni Grill. These declines are now accelerating rather than reversing. Majority shareholder JH Whitney currently owns 68% of Ignite. However, a registration statement filed in July now covers the sale of these shares. The timing for such a sale looks very good for Whitney. But it will certainly put heavy pressure on the share price.

According to its latest 10-Q, Ignite is now down to just $1 million in cash. Current liabilities are $106 million vs. current assets of just $40 million. The company now has long-term debt of $93 million plus another $13 million due within 12 months. For all of 2013 and 2012, cash from investing activities has more than consumed all cash generated by the business as the company tries to expand its way into profitability. However, the company has been losing money in two of the past three quarters. In the one profitable quarter, net income was just $2 million on $118 million in sales.

The company still suffers from multiple weaknesses in internal controls, which resulted in the restatement of several years of financial results. Following a plunge in the stock, there are still shareholder lawsuits outstanding. For these reasons, Ignite is among the weakest and most vulnerable of all of the restaurant groups.

As I did with Francesca's, I recently called and visited numerous Macaroni Grills across two states. Interviews with staff there consistently revealed the existence of significant discounting along with fairly slow traffic over the past 6-10 weeks. The results of these interviews are just one of the reasons that I expect revenues to be flat to down with significant pressure on margins resulting in a noticeable net loss.

A second reason is that we can already see that most of Ignite's close competitors have been pummeled by poor results. The significant and persistent slowdown in the casual dining space should now be widely known. This was identical to the disappointing results reported by competitors in advance of Francesca's. Yet many investors ignored these obvious signs and only sold after the disappointment and plunge.

Ruby Tuesday is down by 25% in the past few weeks following difficult results and a poor outlook for its turnaround strategy. Darden Restaurants also took a hit of 10-15% following its weak earnings. Darden operates a number of casual dining chains including Red Lobster and Olive Garden.

Shares of BJ's Restaurants (NASDAQ:BJRI) are down by nearly 30% since its last earnings date. Shares of Del Frisco's (NASDAQ:DFRG) are down by nearly 20%. Shares of Brinker International (NYSE:EAT) are down by more than 12% since August.

Even Dominos Pizza recently skidded when it missed earnings. Dominos is at the low-end of the price spectrum such that it is usually expected to be more resistant to sector wide slowdowns than many other competitors.

The only competitor to have done well this season has been Wall Street darling Chipotle Mexican Grill (NYSE:CMG). Chipotle continues to be a very strong stock that seems capable of doing no wrong.

In short, the environment for casual dining stocks has been consistently bad for most direct competitors. It should be noted that the majority of these competitors can often be found within close proximity near the same shopping malls and office complexes. As a result, their sales performances tend to be highly correlated.

Shares of Ignite have been basically flat over the past two months. However, volume has been low. This has been the case despite the fact that the problems at Ignite will have a noticeably greater impact than those of its competitors.

In its last quarterly earnings announcement, Ignite disclosed a loss of $2.5 million. Revenues had jumped to $228 million, but these were driven mostly by its recent acquisition of Romano's Macaroni Grill in April for $61 million.

By looking deeper, we can see that growth for Ignite's core business (which excludes the Macaroni acquisition) has basically stagnated. The revenues for Ignite have historically been dominated by its Joe's Crab Shack chain. In its most recent quarter, revenue from Joe's increased just 0.7%. Revenue from its Brick House Tavern chain did increase by an impressive 6%. However, given that Brick House now contributes less than 5% of revenue to Ignite (only 16 stores out of over 300), this increase does not move the needle much at all.

In order to combat the revenue stagnation at Joe's, management plans to open up to seven new Joe's locations during all of 2013. But obviously these new revenues will come with a fairly substantial startup cost and ramp up time so it will take some time before results are felt. It will also take time to evaluate the real cost-benefit of those new, incremental revenues.

The biggest disappointment this last quarter came from the Macaroni acquisition. Romano's Macaroni Grill has been struggling for years, reporting sequential declines in each year going back to 2010. The struggles appear to be getting more severe and more expensive.

On its earnings call, management made some troubling revelations:

During the due diligence phase of our acquisition and right up to the February 6, signing of the letter of intent, Macaroni Grill's comp sales were right around in negative 5%; from February through April 9, when we closed on the business, comp sales deteriorated to a negative 11.5%. While there was no secret to us that Macaroni Grill sales had been challenged for an extended period of time, the pace of deterioration in the first quarter was significantly greater than we had anticipated, and we felt that we needed to act very quickly.

Management noted that it completed a $2 million media buy to attempt to boost sales. This did help to slow the decline moderately. But in the end, Macaroni Grill sales still decreased by 7.4% vs. the prior year. And it should be noted that even this dubious victory still cost management $2 million, which went straight to the bottom line.

These observations reveal two significant problems that are going to drive the earnings miss and share price decline at Ignite.

The Macaroni Grill now dominates the equation for Ignite. As of June 30th, there were 186 Macaroni Grills, 134 Joe's Crab Shacks and just 16 Brick House Taverns.

The decision to substantially lever up to acquire the declining Macaroni Grill is a questionable one. Revenue from the chain was already in decline in each of the past 3 years. It has already declined by nearly 30% in that time. This was prior to the declines in 2013, which now appear to be accelerating.

In 2012, Macaroni lost $6 million on $390 million in sales. Sales are already on track to decline a further 25% from that level this year, following a 10% decline the previous year. Nothing seems to be able to slow the decline.

Management seems to indicate that the problems at Macaroni were larger and more expensive than they had expected. They have also admitted that they were "overconfident" in their ability to make a rapid turnaround of the chain. In effect, we have already been warned of what to expect from management.

The Macaroni restaurants were being staffed very lightly to deal with ongoing declines in business. But new management hopes to ramp up business, and therefore chose to increase headcount by 1,700 jobs. Management noted that:

At any rate a significant investment was made and clearly more than we have planned.

But here is the biggest problem. In order to maintain any type of longer-term profitability, Ignite simply must effect a successful turnaround of Macaroni. But turnarounds take lots of time and lots of money before the results are felt or known. It is almost a certainty that the next 2-3 quarters (including this one) are going to be dominated by substantial turnaround expenses from Macaroni. If the turnaround works, we will then likely see results in mid 2014. But until that time there will be lots of pain in advance of the hoped for gain. It also remains to be seen if the surge in expenditures for a few quarters will end up creating a sustained boost to the results of the chain once deep discounting comes to an end.

Management has already committed itself to substantial fixed costs by adding these 1,700 new jobs. Many of the hires would not have been in place for the full length of last quarter. As a result, the expensive effect of these hires on net income will not be fully felt until this quarter. Management will also continue to spend heavily on media buys and the advertising budget. But as we saw last quarter, even spending $2 million did not end up increasing sales. It only slowed the rate of decline.

Perhaps the largest negative impact will come from the discounting of customer bills that is necessary in order to attempt to lure customers into the stores. We can see from their website that there are multiple promotions ongoing, which promise discounts to customers. Sales of alcohol are a leading profit driver for these chains. But Macaroni is now offering half-priced wine priced at just $2.75 to attract customers. Visitors are offered $5 off for signing up for the mailing list. Group parties who pre-book get 15% off. Each time I ate at Macaroni Grill, the staff gave me discount coupons to come back again and get more taken off of my bill. It is clear that Macaroni Grill is trying to increase absolute traffic by cutting prices wherever possible.

According to the wait staff I spoke with, a new line of bigger promotions will be rolled out this weekend. Those who wish to gauge the impact of future discounts should check on Ignite's website once these promotions are announced over the weekend.

But we can see from past promotions that these discounts have previously failed to boost sales. Coupon histories can still be found online which show that during late 2012 and early 2013 Macaroni Grill was providing half-priced food and "buy one get one free" offers. These offers were made at precisely the time that sales for Macaroni Grill were showing their largest declines.

These offers are a devil's bargain for restaurants. They often end up losing money on them, but they feel that they have no other choice if they want to stimulate the nominal level of sales and traffic.

During the most recent quarter, the Macaroni Grill returned to "buy one get one free" promotions. "Happy hour" with loss leading specials now lasts as long as 5 hours. This leaves very few prime time hours during which to offset those losses.

What we will almost certainly see at earnings is that the heavy spending and discounting will help to move the needle on revenues, but it will come at an enormous cost to margins and will contribute to a large net loss.

Given the accelerated discounting, it is almost guaranteed that the net loss in the current quarter will greatly exceed the $2.5 million from last quarter. In fact, the loss could even significantly exceed the $8 million loss reported in December of 2012.

Heavy discounting to stimulate declining traffic was exactly what we saw in the retail space with Francesca's, which led to its recent 30% plunge. The malaise is also identical to what we saw with the turnaround strategy at Ruby Tuesday. By now, the short-term results of this type of strategy should be predictable. Investors will be forced to tolerate near-term losses in the hopes that a rebound will happen in several quarters. But in fact, most investors will tolerate no such thing. They will tend to sell their shares now and re-evaluate once the results of the turnaround strategy become better understood in a few quarters.

Part of the problem in the restaurant industry is that these discounts have been absolutely pervasive this year. When every restaurant out there is offering deep discounts, it does little to help the business of any one of them. Instead, it just means that deep discounts are needed just to lure customers away from the other deep discounting restaurants. For those who are interested, here is just one of dozens of coupon lists where consumers can get deep discounts on meals from Applebee's, PF Changs, Sonic, Cheesecake Factory, Olive Garden, Outback, Chili's and on and on.

The conclusion is that many restaurants are now being forced to issue coupons and discounts. If they do not, customers will simply go to other chains, which have large discounts. And when one restaurant stops discounting, consumers will just switch to the others that do. In the current environment, no one should be paying anything close to full price for meals in casual dining chains.

Shares of Ruby Tuesday fell by 16% upon earnings. Stifel Nicholas described the situation for the brand in a research report as follows (readers should note that these comments appear to apply quite precisely to Ignite and other brands as well).

The persistent casual-dining sales slowdown has presented a more-than-challenging environment for an in-turnaround concept such as Ruby Tuesday that seeks to re-introduce consumers to its brand," he said. "We continue to believe that mass-casual family dining names such as Ruby Tuesday will continue to underperform until the casual-dining sales softness that has persisted throughout September shows signs of reversal.

So we now have the observations from above, along with statements from management and then comments from analysts. All of these consistently point to a very challenging environment for the comps and especially for turnaround stories like Ignite.

After viewing these similar assessments, no one has any excuse whatsoever to be surprised at a substantial disappointment from Ignite next week.

One question now is whether or not private equity firm JH Whitney intends to stick around for several more quarters to see if this acquisition can actually be turned around. The recent registration statement was filed in July. This was just a few months after the troubled Macaroni acquisition and just before the recent earnings disappointment was made known to investors. Whitney has two board seats at Ignite, so it should be fairly plugged into the latest developments.

Whitney has already done well with this investment. The firm sold stock in the IPO at $14.00 and also received an $80 million cash dividend payment from Ignite before the IPO.

The acquisition of Macaroni has some interesting details. The target was acquired from Golden Gate Capital for $61 million in cash. Whitney and Golden Gate have some intertwined executive histories and they have also worked together in the past, most notably in taking Herbalife (NYSE:HLF) private and then selling the company for a substantial profit.

The Los Angeles Times notes that

Whitney and San Francisco-based investment firm Golden Gate Capital Inc. acquired Herbalife for $700 million in 2002, putting up $176 million of their own money.

Shortly after the firm went public again in late 2004, it paid Whitney and Golden Gate more than $110 million in dividends, filings show.

After the value of the shares more than doubled in 2005, Whitney sold a large portion of its holdings, raising $233 million.

In the case of Ignite, JH Whitney's rush to get liquidity in the stock means it may have come public a bit before it actually was ready to be an answerable public company.

Ignite still lists 4 material weaknesses in its internal accounting controls. Previous weaknesses resulted in Ignite restating 3 years worth of financial statements just after the company came public. This caused a 25% plunge in the share price and resulted in lawsuits against the company and their underwriter for making material misstatements in the IPO.

It is somewhat surprising that the weaknesses have still not been remedied even 15 months after the IPO. Instead, the company has taken a JOBS Act exemption, which allows it to continue operating with material weaknesses in internal controls. Under normal circumstances, this would be bad enough. But with Ignite trying to integrate a major acquisition of a very challenged and sprawling brand, this is almost a perfect formula for yet another restatement.

Conclusion

Right now is a great time for consumers who wish to eat out cheaply. Restaurants are aggressively competing on price to combat a sector-wide slowdown in traffic. These restaurants have demonstrated that they are more than willing to incur substantial losses in an attempt to maintain traffic. We have already seen earnings disappointments in 5 out of 6 reporting restaurants. Share prices have dropped accordingly. So what turns out to be great for consumers is in fact quite challenging to these restaurant groups.

Ignite is a far weaker restaurant group than most of its peers. The company's balance sheet is very weak with just $1 million in cash and a deep current account deficit. The company has reported losses in two of the past three quarters. Last quarter began to feel the impact of the continued slowdown in the Macaroni Grill. Efforts to stem the decline are already proving to be very expensive but with minimal results. Management clearly has its hands very full in trying to integrate this large acquisition, such that ineffective internal controls have still not been remedied after 15 months.

Ignite and several analysts have already given us a very clear view about what to expect this quarter in terms of the restaurant slowdown and the impact on revenues and earnings. By trying to launch an expensive turnaround during a restaurant slowdown, Ignite is likely to exacerbate these difficulties substantially.

As a result, no one should be even remotely surprised when Ignite reports a much larger loss than last quarter. Shares should be expected to correct by around 30% to around $11-12 following earnings.

Source: Ignite Restaurants: All Signs Point To A Big Earnings Miss