On May 13th, 2014, we wrote a Seeking Alpha Pro article entitled "Ignite Restaurant Group: Priced For Perfection But Far From Perfect". Briefly summarizing our original investment thesis, we present the hypothesis that Ignite Restaurant Group (NASDAQ:IRG) is currently operating under constrained capital conditions resulting from the disappointing Romano's Macaroni Grill acquisition. Our writings suggested that management should explore the opportunity to raise capital through the equity markets at the company's relatively full valuation. We felt this solution could provide the financial flexibility to build out its Brick House Tavern + Tap locations, as well as clean up the company's constrained balance sheet.
Since the release of our first article, we continue to maintain a strong conviction toward our investment thesis. On Friday, June 20th, 2014, Darden Restaurants, Inc. (NYSE:DRI) released its Q4 2014 Annual Earnings Summary. Several developments from its quarterly report suggest that Ignite Restaurant Group could be facing similar struggles. When breaking out monthly comparable store sales for both Olive Garden and Red Lobster, the results significantly disappointed investors.
Olive Garden April May
Same-Store Sales -2.6% -3.3%
Restaurant Traffic -3.5% -1.7%
Same-Store Sales -3.6% -4.4%
Restaurant Traffic -8.8% -10.1%
*Source: Darden Restaurants, Inc.
Considering that Olive Garden and Red Lobster are direct competitors to Romano's Macaroni Grill and Joe's Crab Shack in all US markets, we believe these results speak to the current difficulties facing Ignite Restaurant Group. In our original article, we dismissed the proposition that most of the previous sales weakness was directly attributed to a difficult winter weather season, and these current Darden Restaurants, Inc. results reinforces our thesis that there are additional economic issues that deserve further analysis.
The two most significant costs of operating a restaurant are food and labor costs. Nations Restaurant News publishes every month its MillerPulse survey. In a June 16th, 2014 article entitled "Report: Commodity inflation pressures industry to raise prices", the data suggests the restaurant industry is caught between rising commodity prices and weak consumer traffic. Guest traffic has declined for seven straight months. When you further break down the data, casual dining chains reported flat comparable sales and guest traffic declined -2.4% for May.
Casual Dining April May
Comparable Sales 1.5% 0.0%
Traffic -2.3% -2.4%
*Source: MillerPulse Report
The evidence continues to indicate that Ignite Restaurant Group is operating in a very challenging economic environment. The second potential headwind is the implementation of the Affordable Care Act and its effects on the restaurant industry. This element of the hypothesis will take a little bit longer to develop, as companies are required to implement the employer mandate. As a restaurant, the question will be how the employer wants to burden the additional labor costs. Will they eat the cost at the expense of sacrificing margin, or pass the cost onto the consumer with potential backlash of decreased spending? This part of our thesis will take time to develop, and shouldn't be thought about in the present situation.
On May 16th, 2014, Darden Restaurants, Inc. announced the sale of its Red Lobster restaurant to Golden Gate Capital at an amount of $2.1 billion. Ironically, Golden Gate Capital is the same company that sold the Romano's Macaroni Grill to Ignite Restaurant Group. The current debate between investors and Darden Restaurants management is whether the company received a fair valuation for the Red Lobster restaurants. Our prospective is how a private entity would value Ignite Restaurant Group, considering the current acquisition price for the Red Lobster. When you value the Red Lobster transaction, the company was sold at about 9x EBITDA. However, the valuation is misleading, because Golden Gate Capital immediately executed a leaseback arrangement with American Realty Capital Properties of an amount of $1.5 billion for Red Lobster's underlying real estate. Adjusting for the real estate transaction, that would amount to a 5.5x pro forma EBITDA. Accepting the assumption that the Red Lobster deal was significantly undervalued, Ignite Restaurant Group is currently trading at a 25x EBITDA/EV multiple and a 27x forward 2015 PE. When you factor in the company's current financial position, it is a tough argument to justify such a rich valuation.
A simple valuation comparison is not the only issue here. More directly, these actions could significantly weaken Ignite Restaurant Group's competitive position. According to Darden Restaurants, Inc., the company should net $1.6 billion after-tax dollars. Management announced they're going to pay down debt and repurchase stock. Our assumption is that this recapitalization will allow Darden Restaurants, Inc. to focus on growing its younger, more successful brands. For example, in the past year alone, Darden Restaurants, Inc. opened 10 Yard House's, which directly compete against Ignite Restaurant Group's Brick House Tavern + Tap. Even though Ignite Restaurant Group has a very successful brand in its Brick House Tavern + Tap restaurants, its capital constraints prevent it from significantly growing the brand in relation to its overall restaurant count.
The Olive Garden chain is by far the largest brand in Darden Restaurants, Inc.'s portfolio. During the 4th-Quarter Conference Call, President Gene Lee addressed the business plan for fixing the slumping Olive Garden brand.
"Olive Garden provides a strong foundation for the overall Darden business. It's a premier brand in casual dining with average restaurant volumes of 4.4 million and industry leading returns. We are confident that the recently launched brand Renaissance plan is addressing erosion and visit frequency among our core guests. This plan also will enhance our solid position with millennial and multicultural households and is the platform for renewed same restaurant sales growth and margin expansion.
While many of the elements have been underdevelopment during the past year, we're in the early stages of exposing guests to what we call our brand Renaissance plan. Our objective is to make certain that our guests enjoy differentiate experience of todays' Italy where Olive Garden's warm hospitality and superior value bring people together."
When you think about the competitive landscape for both Romano's Macaroni Grill and Olive Garden restaurants, it is easy to observe the weakness in the Italian casual dining space. Since Ignite Restaurant Group acquired Romano's Macaroni Grill in February 2013, the turnaround has been much more challenging than anticipated. Throughout the same time period, Olive Garden has simultaneously experienced similar struggles. Considering the current challenges in this specific marketplace, Darden Restaurants' renewed focus on the Olive Garden brand will only further challenge Romano's Macaroni Grill's turnaround strategy.
The next part of the analysis is the Red Lobster acquisition by Golden Gate Capital. As a deep-pocketed, extremely successful private equity shop, the assumption must be that they have a strategy to turn around the slumping Red Lobster brand. Once again, we feel that Ignite Restaurant Group will rapidly find itself in a similar predicament as it does against Olive Garden, with new capital and efforts coming into a previously weakened but far larger competitor. As foot traffic also continues to diminish in the seafood casual restaurant space, the market space should also get increasingly difficult from a margin perspective, as food costs are also high. This is critical, because Joe's Crab Shack is the most profitable brand for the company, and any further financial strain could present a lethal blow considering how the balance sheet is substantially leveraged.
In conclusion, we continue to believe that Ignite Restaurant Group is currently a deeply troubled company. The latest evidence from Darden Restaurants, Inc. suggests that the casual dining environment continues to present challenges, especially for legacy brands. When you think about the U.S. consumer, especially the lower and middle income classes, our belief is that economic conditions are negatively affecting spending habits. Our belief is that Ignite Restaurant Group will present another difficult quarter, and must make larger changes in the medium term to deal with refreshed competition to face even more challenges in the future.
Disclosure: The author is short IRG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Our existing positions mentioned in this article may change at any time. This article is not a solicitation to participate in any of Volte-Face's strategies or funds. Volte-Face Investments does not accept clients nor is it soliciting readers to buy or sell any equity. This article is provided as an opinion on current information and explanation solely of our own reasoning, none of which is guaranteed.