In 2014, the investment firm Fidelity National Financial (NYSE:FNF) decided to separate some of businesses it took over during the crisis of 2008, in order to focus on its core activities in the insurance industry. As part of that notion, it separated Remy International (NASDAQ:REMY) via a spin-off, which has already been acquired by BorgWarner; in September, it separated via a spin-off as well the restaurant chain of J. Alexander's Holdings (NYSE:JAX), and the company soon intends to separate the American Blue Ribbon Holding.
J. Alexander's operates three brands of exclusive restaurants: J. Alexander's, Stoney River Steakhouse and Grill and Redlands Grill, a new brand which about half the chain's restaurants are expected to turn into. Currently, the company operates 41 such restaurants in 14 states throughout the US, primarily on the East Coast and a few branches in the center of the country.
J. Alexander's intends to rely on the concept of a restaurant chain that is not a chain (naming it "Unchained"); i.e., any one of the restaurants in this non-chain brings its own uniqueness, both in atmosphere and menu - a boutique restaurant chain of sorts (Why is it good to be "non-chain"?). The food in the restaurant chain is considered to be of high quality; for evidence, note the fact that 95% of the dishes are prepared from scratch in-house, and are served fresh to guests. Unfortunately, I did not have a chance to visit any of the restaurants of the chain, but looking at the pictures of the various branches, it seems this concept is able to produce restaurants with a luxurious look-and-feel, and, according to the numbers in the reports, guests are filling the restaurants and are generating profitability for the company. It's probably not just because of the quality of the food, but also due to the fact that the price level in most branches fits the pocket of most guests. The average check per person (including alcoholic beverages) in the third quarter of 2015 was $30.63 in the J. Alexander's restaurants and $45.89 at Stoney River.
Additional general information about the company can be found in an updated presentation which it released here.
Financial condition and growth potential
J. Alexander's is based on an unleveraged balance sheet, which includes $12.8 million of cash and short-term investments, against $21.7 million of debt (all data is from the third-quarter report of 2015). However, I don't I like the fact that the company's current assets ($17.6 million) is slightly lower than its current liabilities ($19.7 million). On the other hand, a current ratio of less than 1 is a typical occurrence among companies in the industry, and in addition, J. Alexander's has a stable cash flow, as will be shown below (a low debt-to-EBITDA ratio of 0.3), so there is no particularly high credit risk.
The main issue of the company is its intent to aggressively expand in the coming years - something that was less of a priority prior to the separation. In fact, in the past 7 years, it opened only 8 new restaurants, all in the last two years. Still, it managed to produce an average annual growth of 7.8% in revenue from 2009 to 2014 due to an impressive growth in the number of diners (although the bulk of the growth recorded was, as stated, in the last two years). Compared to other chains, some of which have decreased in size in recent years, J. Alexander's is on a high revenue growth rate of similar restaurants (Same-Store Growth), which implies wise and efficient management of the chain's branches.
Obviously, the growth was supported by the recovery of the US economy in general and private consumption in particular, which contributed to the improvement in the restaurant business. According to NRA (National Restaurant Association) data, sales in the restaurant industry grew steadily in the last six years and reached $709 billion in 2015, a nominal growing of 3.8% compared to 2014. Continued positive US data is expected to provide further tailwind to the activities of the industry in the upcoming years. Along with the company's expansion plan, which I will immediately detail, it is possible to be optimistic about the continued growth.
Starting on 2016, after the completion of the separation from the parent company, J. Alexander's plans to grow not only by increasing the traffic at restaurants, but also through the opening of new restaurants. The target set by the company's management is opening 4-5 new restaurants each year starting in 2016. To implement this in practice, the company is regularly exploring attractive locations, when currently it has a watch list of around 30 different locations in various stages of testing and development. According to management, statistically, a new restaurant will not open in most locations at the end due to a variety of reasons, and in light of this, the strategy of examining multiple sites simultaneously seems smart. According to the latest presentation published by the company, it already has three new restaurants in line - a new Stoney River restaurant in Memphis that is expected to open in the first quarter of 2016, and two J. Alexander's restaurants in Lexington, KY and Raleigh, NC.
Every one of the chain's restaurant yields an averaged revenue of about $5 million a year, so each new restaurant that is opened will increase revenues by approximately 2.4% (JAX had revenues of $212 million in the last 12 months). In a likely scenario, the company will open up to 2 new restaurants each year, so along with a few percent increase of traffic to existing restaurants, it is possible to estimate an average annual growth rate of approximately 5-7% in the coming years.
Even if this seems to be a lower growth rate than the potential (or the management's projections), it will not be a simple task to withstand in light of the immense competition in the industry. J. Alexander's competes with many upscale restaurants such as Del Frisco's Grill, Kona Grill or Seasons 52. Stoney River also competes with a wide range of leading Steak Houses, such as The Capital Grille, Smith & Wollensky, Ruth's Chris Steak House among others. Chains like Chipotle (NYSE:CMG) or Ruth's Hospitality Group (NASDAQ:RUTH) are incredibly successful not only because they have quality food at affordable prices, but mainly because they were able to make themselves known as a strong brand. JAX has a management which certainly knows how to run the current business (the growth and improved profitability in the recent years is evidence of this), but the rate of future growth largely depends on the company's success in strongly branding the chain in the future.
Other than growth, it seems that the company can also improve profitability a little more if it continues to become more efficient. In 2012, the operating profit margin was 5.6%, and in the first nine months of 2015, the profitability improved to 6.6% (6.3% in the corresponding nine months of 2014). JAX's profitability is already better than most similar chains, but there are several chains that manage to achieve even better profitability, so the company has something to aspire to. In my likely scenario, I assume that profitability will gradually improve by 0.5-1% in the next five years.
The "ugly" side of the spin-off
As part of the spin-off, JAX entered into a consulting agreement with Black Knight Advisory Services in exchange for the allocation of 1.77 million type B JAX shares. Payment by shares is not unusual, the question is how many shares are allocated and to whom. The problem here is that Black Knight Advisory Services is managed by many Fidelity executives, including the president and CEO (Lonnie Stout). This does not look good. In addition, the shares are convertible into ordinary JAX shares under a number of criteria that depend on JAX's performance, but above them stands a liquidation value determined to be a total market value of $180 million (share price of around $11.3). The maturity date is far away - in three years - and the current share price is close to this bar, so we can assume these shares will be fully converted into ordinary shares in the coming years. In a maximum conversion, it is a 10% dilution of JAX shares. Quite big of a dilution.
If that's not enough, the consulting firm will also receive a payment equal to 3% of the annual adjusted EBITDA of the company (around $750-800 thousand) for the next seven years. That is more than JAX's management's annual payments!
Distribution of bonuses, including stock options, to company executives for a successful job is one thing, but to reward former executives of the parent company is an exceptional thing. Credit is, of course, due to former managers who led the company to this point, but I'm sure JAX could have found another attractive consulting firm to help it promote its business at a much lower cost, and that would not have hurt shareholders so significantly. In any case, this "gifts" detract at least $1.5-2.5 from the fair value of the stock, according to my calculations.
How much is the stock worth?
JAX had revenues of $212 million in the last 12 months, and my basic scenario predicts a growth of 6% in the next five years (and later on a permanent growth of 1%) and an operating profit margin of 6.5% that will grow by 0.5-1% the next five years. JAX pays almost no tax (about 2% of profit before tax), since it is a Limited Liability Company, and in addition, it has no significant working capital requirements. To maintain the existing restaurants and establish the new ones, it will need CapEx of an annual rate of around $11-13 million a year, most of which will be reduced as depreciation expenses over the years. After consulting fee reduction for Black Knight Advisory Services, the company will have a free cash flow that will grow from $12 million in 2016 to approximately $20 million in 2020. Under the assumption of discount factor of 8%, adding cash & equivalents and deducting total debt, the fair value of the company is around $240 million, or $15.0 per share. Under the assumption of a maximum dilution of 10% in the number of shares for converting B shares to A shares, the fair price will drop to US $13.7, i.e., a margin of safety of 27% over the current price ($10 per share).
In more optimistic scenarios in which the growth rate will be higher than 6%, one can also justify a higher fair price, even $16-17, but the probability of this occurring is lower in light of strong competition in the sector. On the other hand, if the growth will be lower and profits decrease a little, the fair price would be similar to the current price of the stock. The negative trend in the market, along with the recent high instability and the fact that the share is an anonymous spin-off can bring the stock even lower in the short term, so I prefer to wait for a better entry point (say, less than $8), but even at the current price, the stock looks interesting to hold for the coming years for patient investors.
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.