I had first written about casual restaurant chain Ruby Tuesday (RT) a couple of months ago.
As expected, this was a tough year for the company as same-restaurant sales decreased by 9.8% while capital expenditures amounted to $116.92M, expenditures the company couldn't afford without taking on more debt. This aggressive spending mirrors what the company has been doing for many years now, trying to quickly expand throughout the United States as well as reinvent its image.
Being knee-deep in the tougher part of the economic cycle, management won't be able to keep throwing cash at re-imaging initiatives and new restaurant openings anymore. This is even truer now that it has received a warning from its banks that it wasn't respecting the maximum total-debt-to-EBITDAR ratio. The company was forced to revise its debt agreements which now include maximum capital expenditures of $30M per annum, much less than the five-year average of $145.65M.
The fact that things look so gloomy for this heavily indebted restaurant chain that operates in one of the worst sectors at the moment is what makes it worth a second look. As we all know, Wall Street pays much attention to short-term earnings, perhaps too much. For a company like Ruby Tuesday, whose D&A and interest expenses increase at an alarming rate, a decrease in sales can lead to a very important decline in the stock price. This is exactly what happened to RT as it went down from a 2007 high of $30.47 to yesterday's $7.41.
What one has to realize here though is that good earnings are not necessarily correlated with a company's ability to re-invest in the business, give a dividend, repurchase shares, or repay its debt. These actions can often only be made possible by the accumulation of large free cash flows, a number that not many people in the market tend to look at. Whenever free cash flows surpass earnings by a large number is when the astute investor should pay attention. (See Information in Balance Sheets for Future Stock Returns: Evidence from Net Operating Assets.
Even though the short-term outlook for RT's earnings, and sales for that matter, doesn't look so rosy, the large cash flow from operations coming in over the next quarters combined with the compulsorily low capital expenditures should help offset this. The management said during the year-end call that it expects to generate $90-100M in FCF during FY2009. Considering this may be one of the worst years for the economy, which has a strong impact on the consumer discretionary sector, $90M (15% of the total debt), would not be a bad number at all. It would represent 4.3 times today's market cap and 10.9 times today's enterprise value.
If the company were to return to its previous CFO average of $190M while only spending $30M p.a. in a few years, which is not far-fetched now that it owns the most restaurants it ever has and that all of them were renovated, I believe we are looking at a tremendous bargain. The numerator of the EV/FCF ratio would go down considerably as the management repays its debt while the denominator would increase by a large amount.
Once this is reflected in the EPS number as interest expenses and outstanding shares go down, I believe the RT stock could increase by a very large percentage. The margin of safety here can be found in the large cash flows from operations that Ruby Tuesday generates as well as the management's strong alignment with the shareholders' interests. The casual restaurant chain industry can look like a scary one at the moment but I strongly believe that RT offers a very interesting entry point to value investors.
Disclosure: Long RT.