Famous Dave's: A Busted Brand Facing Topline Headwinds And A Rise In Fixed Expenses

| About: Famous Dave's (DAVE)

Summary

DAVE is a classic value trap.

The company has very poor economics.

Famous Dave is suffering increasingly higher fixed costs.

Top management has been a revolving door.

There's still downside from what appears like a cheap price.

Famous Dave's Of America (NASDAQ:DAVE) is a company with very poor economics, facing headwinds in their topline. The company's fixed costs continue to rise and comparable same store sales continue to fall. Moreover, in the most recent years, the CEO position has been a revolving door to say the least. When looking at the valuation metrics, DAVE appears to be a value stock with potential for a turnaround. However, we think that DAVE is the classic value trap with further downside.

Summary

DAVE was incorporated in Minnesota on March 14th, 1994. As of September 27th, 2015, there were 179 restaurants in operation, in 33 states, the Commonwealth of Puerto Rico, and Canada. Included are 44 company owned restaurants and 135 franchise operated restaurants.

DAVE is known for its hickory smoked and off the girl meats and meals. The majority of the restaurants are full table service styled diners. Overall, DAVE is your typical backyard BBQ smokehouse restaurant.

Tripped Covenants and Potential for Working Capital Windfalls

Recently, DAVE tripped two covenants on its credit facility with Wells Fargo. The covenants it's tripped were the Adjusted Leverage Ratio and the Consolidated Cash Flow Ratio. Fargo allowed the company to enter a forbearance period soon after the trip.

On December 11th, 2015, DAVE amended their credit facility with Fargo, which in reality was much less attractive than the first facility. In this facility, the maturity changed to December 31st, 2018, from May 8th, 2020. Secondly, they reduced the term loan maximum to $12mm, from $30mm. Finally, the company now has a revolving credit loan commitment of $3mm with a $2mm letter of credit sublimit. Finally, these reductions on the term loan require DAVE to make an aggregate payment of $5,140,000 on their First Amendment Effective Date.

Currently, DAVE has borrowed all $12mm of the term loan and $1,145,000 in outstanding letters of credit that are undrawn. Right now, DAVE has $3.4mm in cash and $1.85mm available under a revolving credit facility. Consequently, DAVE will need to pay $150,000/month with an applicable margin at 3.25% for Eurodollar Rate Loans, 1.75% for Base Rate Loans and 0.50% for Commitment Fees.

There are a few key takeaways from this new credit facility that investors should be aware of. First, the company has very little money they can borrow from the future to use today. Unless the company can secure another credit facility with another financial intermediary, they will have very little cash to work with going forward.

Secondly, the company's fixed costs have risen since this new facility was established. In the former facility, interest rates were 2.64% (in the mrq). Now interest rates are starting off at 3.25% with an additional $150,000 that needs to be paid each month. DAVE already had a high fixed cost of operating due to its business model. With higher interest rates, payments each month, and less money it can borrow, the stock has gotten much more risky.

If sales continue to decline, there are two things DAVE can do to try to 'restructure'. First, they could try to establish another credit facility. The problem with this is that if done, fixed costs will continue to rise, putting more of an overall risk on the security as a whole. A second thing DAVE could do is issue equity. If sales continue to decline, issuing equity to bring fast cash to the balance sheet could work. However, rampant dilution is never a good thing. At the current price DAVE is selling at, there would in fact be an outstanding amount of dilution.

We believe that if sales continue to fall, there is potential to be working capital windfalls. If the former transpires, there is high potential for rampant dilution or further rickety credit facilities.

Declining Sales

In the past few years, sales were steady, then started to follow a downward trend…

TTM

2014

2013

2012

2011

2010

Revenues

136

149

155

155

155

148

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In millions

In 2013, the company used a heavy discounting strategy in order to drive sales. However, after the removal of the heavy discounting strategy, sales started to fall. Moreover, in Q3, revenues fell 17.6%, which was mainly driven by comparable store decreases (fell 9.8%) and the closure of nine company owned restaurants.

What is troubling and may indicate signs of corporate governance follies is that management does not explain why revenues have been falling in the most recent quarter, only that they have fallen. The reason for the falling revenues is from; bad menu changes, decreases in average check sizes, and changes in the portion sizes. In fact, the SEC actually sent out a notice to DAVE for not addressing why revenues have been falling.

First Nine Months of 2015

2014

2013

2012

Food and Beverage Costs

30.6%

29.5%

30.3%

31.3%

Labor and Benefit Costs

33.6%

32.5%

32.4%

32.6%

Operating Expenses

28.6%

27.5%

25.6%

26.9%

Restaurant Level Cash Flow Margins

7.2%

10.5%

11.7%

9.2%

Click to enlarge

In the face of revenues falling, costs continue to rise as well. Food and beverage costs are up from an anticipated increase in contracted food. Labor and benefit costs are up from sales de-leverage, a rise in management labor costs and operational inefficiencies from the transition of new labor management and a new payroll system. Finally, operating expenses as a whole are up from an increase in repairs and maintenance and the costs/timing of advertising spending.

When looking at the average weekly net sales, almost all segments have fallen in the most recent years…

Click to enlarge

Source: 2014 Annual Report

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Source: 3Q15 Report

The issue that we have all drives back to fixed costs. Restaurants are horrible business models. Fixed costs are high, competition is plentiful, margins are weak and customer preference can change rapidly. DAVE's new strategy going forward is to follow the path of being more or less, "asset light" by moving towards a franchise business model. What is troublesome is that company owned store sales are falling and revenues at their franchises are falling as well.

Due to the high fixed costs of restaurants as a whole, G&A at DAVE will most likely rise as revenues fall on a percentage basis. These are choppy waters and investors should tread lightly. If revenues continue to fall going forward, fixed costs will continue to eat into margins.

Poor Business Model — Opportunity Cost Too High

With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact. Warren Buffett

To us, it appears that DAVE has a revolving door for executive management. Currently Adam Wright, the founder of Blue Clay Capital Management took the reins of the CEO. That's right, an activist investor, with no formal experience running a restaurant is now the CEO.

What can Wright bring to the table that the former CEO's could not have? Since 2007, there have been a string of CEO's who tried to turn DAVE around since David Goronkin left. First there was John Gilbert, who took Christopher O'Donnell place, later to leave only 18 months after taking the job as CEO. Then Ed Rensi took control (a former McDonald's executive) who left only a year after becoming the CEO.

Now we have Wright on the stand whose career experience has nothing to do with running a restaurant (besides sitting on the board of directors for DAVE since 2013). We question what can Wright do that others, who have experience running restaurants could not do?

Currently, DAVE is selling for an EV/EBITDA and EV/Revenue of 6.38x and 0.39x, respectively. The low multiples suggest that DAVE is a value stock. However, we disagree and believe that DAVE is the classic value trap. First, revenues are falling, operating costs are rising and risks have increased from higher fixed costs expenses. There has been no suggestion that sales are prone to turnaround, at least in the near-term.

A second suggestion that DAVE is a classic value trap is due to the reduction in overall store count. Reducing store count may free up some cash, however, it will continue to dampen the topline. If comparable store sales continue to fall, investors should expect more store closures and additional topline headwinds. As long as there is downward pressure on comparable store sales, dipping your toes in this choppy equity is risky business.

On a TTM basis, DAVE has very real potential to get cheaper. An EV/EBITDA ratio of 6.38x, is a little rich for us. With declining sales, shrinking margins and higher fixed costs, we believe that this multiple has a significant amount of potential to continue to get cheaper. From an opportunity cost standpoint, investing in DAVE has high opportunity costs compared to other companies an investor can buy. For an example, we can think of a few companies off the top our or heads with EV/EBITDA multiples less than DAVE's, who have double digit top and bottom line growth and have much higher margins. Investing in DAVE is an opportunity cost in it of itself due to the much cheaper, and much higher quality companies out there.

Currently the TTM revenues are sitting at $135.91mm. From 2014-TTM, revenues have fallen 8.72%. We believe that revenues will continue to fall going forward. In our model, we will assume that revenues will fall 8% in case one and 5% in case two, from the TTM. Currently the company's EBITDA margin is 6%. Because of the high fixed costs associated with DAVE, we will assume the EBITDA margins in case one and two will fall to 5.50% and 5.75%, respectively. For conservative purposes, in case one the multiple will fall to 6.25x, yet in case two it will stay at 6.48x.

Case One

Case Two

Revenues

125.04

129.11

EBITDA Margin

5.50

5.75

EBITDA

6.87

7.42

Multiple

6.25

6.48

EV

42.94

48.08

+Cash

2.02

2.02

-Debt

13.38

13.38

Total Equity

31.57

36.72

Shares Outstanding

6.97

6.97

Estimated Equity Per Share

4.53

5.26

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In millions

In our model above, we are assuming very conservative topline windfalls. If there is a big hit to the topline in 2016, DAVE could drop a lot further than our cases above. Thus far, there has been no suggestions that a turnaround is transpiring, at least on a sales basis.

Investors who are long DAVE may think that the tail risk of investing in DAVE is low due to the already steep price decline thus far. From our experience, believing that the tail risk in any equity is low to nil is ignorance at its best. Equity investing is full of black swans that can swoop down and ruin a thesis. With DAVE's case, we believe that there is significant tail risk for investors. From a poker perspective, buying DAVE right now is like betting heavy on a 2-7 off-suit.

The Changes

Since Wright took over, he has made a few key changes that could help the company.

  1. Returned the ionic items such as corn bread muffins and sauces.
  2. Brought in new uniforms.
  3. Trying to improve guest experience and ramp up employee training.
  4. Working on rebuilding the old culture by bringing back the founder.
  5. Started a happy hour and testing a lunch value special.
  6. Also brought in limited time items such as beef short ribs and fried chicken.

These are steps in the right direction and the company did say that customer satisfaction is up 8.3%. However, despite an increase in customer satisfaction, sales have not increased. Turnarounds can be very profitable if successful. They can also be very damaging if they do not pull through. We think that the recent turnaround activity is not compelling enough just yet to make a purchase. At ~$4.00/share, or if sales start to improve, we may rethink our thesis. However, with an EV/EBITDA at 6.48x, and declining same store sales, there is potential for much more downside.

Conclusion

DAVE currently has a busted brand and continues to see same store sales faltering. If sales continue to fall, fixed costs will consequently rise due to the poor business model. The company looks like a value stock, but in reality, at least to us, it looks like the classic value trap. DAVE's economics are horrible, competition is rampant and they have a limited cash position. Strictly in our opinion, there are much better equities out there, which are cheaper and have much more attractive economics. To close, we would like to leave you with the following quote from Sonya Parker:

Bad relationships are like a bad investment. No matter how much you put into it, you'll never get anything out of it. Find something that's worth investing in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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