- Ruby Tuesday has been through a rough last couple of years marred by ill-executed strategic decisions.
- Recent earnings report indicates that the company could be moving in the right direction.
- Cautious analysis calls for the company to be about 14-31% undervalued.
Ruby Tuesday (NYSE:RT) reported their Q4 earnings two weeks ago and the market responded poorly (shares were down 15% on the day after the earnings press release) considering the company's revenue was only 3% less than last year and earnings cracked positive territory for the first time all year. Despite the negative sentiment some analysts believe that the company has finally turned the corner on a rough patch that had seen the stock price plummet from a high of $33 in 2004 to a low of $0.95 five years later that had extended into FY'14. Has the company indeed started a new chapter of profitability? I would like to look at how the company got to where it is financially at this moment as well as discuss what this earnings report could mean for the future success of the company. Afterwards I will examine some strategies that investors should expect Ruby Tuesday's management to explore in expanding their brand as well as increasing bottom-line profitability. Lastly I provide a DCF analysis that should offer an accurate price range that represents the company's value.
How the Company Got Here: A Brief History of Ruby Tuesday
The company was founded in 1972 by Sandy Beall as an investment to open up a restaurant that would be adjacent to the University of Tennessee campus. The company grew and the chain was sold to Morrison Inc. in 1982. The company would become renamed Morrison Restaurants Inc. and eventually Ruby Tuesday Inc. In 2007 the company underwent changes to its menu to introduce more upscale items and initiated remodeling efforts to modernize each restaurant right as the economy began to sour. These moves alienated old customers and failed to bring in new customers as the bar-and-grill segment as a whole fell harder than any other segment in the restaurant industry. The company flirted with bankruptcy in 2009 before a surprisingly good quarter allowed it to issue additional stock and pay down debt, remaining afloat.
In 2011 the company experimented with new concept restaurants, converting underperforming restaurants and developing new properties into different concepts such as an internally developed seafood concept, an Asian concept, a barbeque concept, and an upscale café concept, with limited success. (In FY'13 the company closed all of those concepts, deciding to focus on its core Ruby Tuesday brand, but has continued expanding and franchising its fast casual Mexican-style Lime Fresh concept restaurants.) In 2012 founder Sandy Beall retired and current CEO JJ Buettgen took his place, introducing a strategy that would shift back to focusing on improving the quality and scope of the Ruby Tuesday menu as well as the customer experience. In October 2013 activist investor and chairman of the company Matthew Drapkin abruptly resigned from the board, punctuating an especially troubling time for the company that saw its same-store sales growth decrease by 11.4% in Q1.
In January 2014 the company announced a plan to close 30 locations in midst of a report that same-store declines improved slightly to 7.8% in Q2. In Q3 the company announced that same-store declines had been just 1.9%, beating analysts' expectations by 100 bps. Additionally, losses per share were just $0.12 after having averaged $0.48 the previous three quarters, and the company announced that it was meeting its goals of cutting costs by $13 million a year from the cost of goods sold and SG&A expenses. (The stock rose 11% after the company's press release.)
In the company's most recent earnings report management reported that same-store sales growth climbed 0.4% at company-owned stores and 4.9% at franchised stores as earnings per share climbed to $0.03 (excluding items) and revenue outperformed expectations to once again eclipse over $300 million for the quarter. In addition, the company was able to pay down $40 million in debt, lowering its debt level to $259 million. Company management hailed its results as proof that the company was moving towards profitability once again. CEO JJ Buettgen attributed the year's overall success to the company's ability to effectively introduce over 40 new items, improve the customer experience, and establish advertising campaigns that communicated the company's fresh and family-friendly personality. Guidance called for same-store sales to grow between 0-2% for FY'15 with improved operating margins.
In light of the recent quarter's positive news has Ruby Tuesday switched from being a distressed stock into a hidden value proposition? The market certainly does not seem to think so. In the 24-hour period from the time that the earnings report was announced the company's stock lost 15% of its value and reached one of its lowest points in two years. But I believe that the market has not been a good arbiter of Ruby Tuesday's intrinsic value in recent times. For instance, at this point last year the company's stock dropped from $9.09 to $7.84 (a 16% drop) after the company missed on both its earnings and revenue targets, and the stock was still 34% higher than it is today despite being in an arguably worse financial position. (Even if one argues that it was in a better position than right now, it certainly was not in a position that was 34% more valuable than today. In fact, within a month of that earnings report one analyst calculated the true worth of the company to be about $1.50 a share.) Analysts have routinely miscalculated the company's worth and growth prospects, such as when they overestimated the company's earnings targets in seven consecutive earnings sessions from Q4'12 through Q2'14. Due to these miscalculations, the company has been punished with post-earnings report "hangovers" of 9% or worse five times in the last ten earnings sessions. Instead of looking at analyst sentiment I believe a much more prudent way to assess the stock's value would be to study the company's financials as well as look for any telltale signs of the stock being undervalued, as well as apply a discounted cash flow analysis to estimate the true value of the stock.
Why This Earnings Report Could be Different
There are signs that the tide has turned for Ruby Tuesday and that it may have positioned itself for a future return to profitability. At a stage such as the one that the company finds itself in the company should have three objectives: improve its top and bottom line margins, pay down debt, and return to consistently positive EPS. In fact, the company's management has essentially voiced these goals in their recent 10-K report:
"Our objective over the next several years is to continue to reduce outstanding debt levels in order to lower our leverage and focus on prudent restaurant development. Our success in the key strategic initiatives outlined should enable us to improve our return on assets and return on equity, and to create additional shareholder value."
Comparing the financial statements from this past quarter to recent quarters it seems that the company is on its way towards reaching these goals. For instance, their gross margin has steadily improved throughout this fiscal year, climbing from 13% to 18.9% in Q4, a higher margin than in Q4'13. (Company guidance in the Q4 earnings release called for margins of 15-16% during FY'15 due to increased payroll costs as the company returns to more normalized incentive compensation levels.) Their operating margin has eclipsed positive territory (just barely) this quarter for the first time since Q4'13, and yearly savings on cost of goods sold and SG&A expenses should further boost that margin in the upcoming fiscal year. EPS has slowly been making progress, breaking into positive territory for the first time in over a year, improving bottom line margins as well. Additionally, as previously noted, the company has made it a top priority to lower its leverage by paying down $35 million in high yield bonds and $20 million in mortgage payments in FY'14.
One area that remains very attractive from a value standpoint is the company's ratios, which are well below industry averages. Its Price/Book ratio is 0.8x compared to the average of 6.9x and its Price/Sales ratio is 0.3x versus 2.2x. What's more is that even with an uptick in the stock price these ratios will remain well below the industry averages for a long time, if not perpetually. For instance, assuming sales reached $1.4 billion (about a 12% gain), the stock price would have to climb more than 9 times its current level to reach the industry average Price/Sales ratio, a feat that the stock has never accomplished. The company's Debt/Equity ratio is half the industry average, 60% versus 120%. (However, Moody's notes that the company does pose a credit risk and that their current earnings levels cannot support their interest payments. Given these circumstances one would expect management to deleverage the balance sheet until earnings improve.)
Concerns Moving Forward
My main concern is whether the company can continue to effectively execute their turnaround strategies and how they would respond to indications that the casual dining sector may continue to lose market share to other sectors. Thus far their strategy to attract customers by revamping the menu and the atmosphere of the restaurants seems to be working-albeit frustratingly slowly. But a one-year sample size is too small to assert that management has successfully turned the company around. The gains that restaurants have seen may have been the result of a temporary uptick in consumer interest across the industry towards the end of Q4. The company and the industry as a whole could very likely continue to be hampered by less and less interest in the casual dining experience, and we do not yet know whether that lack of interest will last for a short period of time or indefinitely. Management is still toying with the right coupon strategy and the right marketing techniques. And any turbulence in the economy could cause investors to flee from the stock, whether that response is justified or not.
Company Policies That Could Change in the Future
I would be interested in seeing how company management addresses franchising opportunities in the future. (At this point only 10% of Ruby Tuesday restaurants are franchised.) There have been two (The Wendy's Company and Burger King Inc.) recent examples of companies reinventing themselves and growing net margins and EPS through aggressive franchising strategies, while a third company (Popeye's) has boosted unit volumes by 25% by franchising out 80% of their units. I am surprised that company management has not been pressed to offer any guidance about this type of strategy moving forward. The standard acquisition price in a franchising deal is about 5x EBITDA, and considering Ruby Tuesday's EBITDA is in the negatives they should be able to find buyers who are looking for attractive deals on the cheap. Franchising could allow the company to cut large expenses off the top line while bringing in steady profit streams, ultimately boosting earnings and allowing them to further stabilize their debt load. At the same time, they could hand off the operating duties to franchisees that historically have been more effective at squeezing profits out of restaurants.
I would also like to see how the company continues to expand the Lime Fresh concept in the future. As of now the company operates or franchises 26 restaurants, mainly in Florida (17 restaurants). The company has had limited success with the concept, and stated in their 10-K report:
"To date, the concept has lagged behind out internal targets as we have been unable to attain targeted pro forma sales or, in certain instances, gain economies on the cost side as a result of unsuccessful real estate site selection on several of our initial locations and other operational issues."
What I wonder is how much of the company's challenges have been the result of operating 66% of their locations in a market where Chipotle has 84 restaurants that dominate market share? One radical approach that management should look into would be expanding this concept into the Midwest markets exclusively as opposed to the East coast and major population centers where Chipotle operates a large majority of its stores. By trying to expand and control market share in smaller Midwestern states (Nevada, Idaho, Wyoming, Colorado, New Mexico, Oklahoma, Kansas, Nebraska, Iowa, Missouri, Arkansas, Louisiana, Mississippi, Alabama, Kentucky, and Tennessee) Lime Fresh could target a market of consumers that have not been as exposed to Chipotle's brand yet (only 16% of Chipotle's 1,600 restaurants are located in those states). Such an approach would be a drastic departure from the management's conservative policies but could open up opportunities to expand a marketable brand in the fastest growing sector in the industry. It should be a policy that management is willing to look into (in addition to dividends and share buybacks) once earnings normalize and they are deciding how to make use of discretionary cash.
Discounted Cash Flow Analysis
It is difficult to try to accurately predict a future price target for Ruby Tuesday, mainly because it is difficult to know how the company will grow in the future. I find it problematic to rely on previous cash flows, revenue, or earnings levels to make growth assumptions because so much has changed on the company's balance sheets in the last few years that have made comparisons or predictions hard to justify. The company has closed and could continue to close underperforming restaurants, has paid down debt using cash reserves, and has forayed into (and closed) several concept restaurants. Management has also chosen not to supply much guidance in terms of expected future EPS levels or what its expansionary plans for Lime Fresh are.
In order to try to evaluate the true value of the stock I attempted to find historical precedents in other companies that had experienced similar turnaround situations and I mimicked those companies' EPS growth patterns for Ruby Tuesday. I created several different simulations forecasting different levels of growth. Those simulations demonstrated that the value of the company's stock could lie anywhere between $5.50 and $10.00 depending on how successful company management is at executing their turnaround strategy. However, the most compelling simulations estimated that the market value of the stock falls somewhere between $6.80 and $7.80 per share, about 14%-31% above current levels and a genuine value stock.
Ruby Tuesday presents an interesting stock that could have plenty of upside should the company's management continue to improve the brand and return the company to profitability. Although there are some reasonable concerns moving forward, both internally and with the industry sector as a whole, I believe that the stock represents a value opportunity due to its rock-bottom ratios and relatively positive outlook for the immediate future.