Since my initiation piece on J. Alexander's (NYSE:JAX) ("J. Alexander's", "JAX" or the "Company"), shares have declined slightly from ~$11 to ~$9. Despite the decline, the Company remains an attractive investment, in my view.
Reasons for the opportunity: underfollowed spin-off, uncertainty regarding public-company transition, limited daily liquidity, lack of management participation in investment conferences, near-term earnings pressure
On March 9, J. Alexander's released its fiscal 2015 results. Management continues to execute strongly and financials were within my expectations, validating my bullish thesis. Investors likely continued selling off JAX due to spin-off dynamics (though certainly less likely as time goes on), uncertainty with respect to the Company's public-company transition, skepticism regarding its store growth story going forward, among other issues. In my view, these concerns are largely unwarranted.
Infrastructure-building is expected to depress near-term earnings and is likely another factor weighing on shares. The Company's 2016 guidance further substantiates this assertion. However, due to certain non-recurring costs, 2016 earnings should jump substantially as these costs fall off. Stated simply, 2016 net income guidance appears significantly underestimated.
J. Alexander's has a well-supported, low-risk, multi-year growth story ahead of the Company that should result in high single-digit top-line growth and 20%+ earnings growth as operating leverage begins to ramp significantly beginning in 2017.
Applying a very conservative 25x earnings multiple (with 20%+ earnings growth, a higher multiple certainly isn't out of the question - moreover, store growth could accelerate - driving high double-digit sales growth and much greater earnings growth, if the Company levers its balance sheet), shares should trade at ~$16.50 today - based on ~$11 million in 2017 net income on ~14 million shares outstanding, implying ~75% upside potential from current levels. These estimates could prove even more conservative given that they neither factor in the effect of the Company levering its balance sheet, something which is highly likely, in my view, nor the potential expansion of EBITDA margins - any one of which (likely both) could result in the stock being multiples of its current price.
By virtue of possessing minimal debt, proven concepts, a seasoned management team, close ties to its former parent FNFV, as well as a prominent activist fund, the probability of permanent capital loss is significantly limited, in my view.
Shares seem cheap largely due to non-fundamental reasons
It appears to me that shares of J. Alexander's are cheap due to mostly non-economic reasons. Despite being a public company for a few months and counting, the Company still remains very much under-the-radar, given its lack of participation in small-cap investment conferences to date (this is set to change). Uncertainty regarding its public company transition is overblown, given that management's projected public company costs appear quite reasonable for a business of its size.
Other issues include its limited average daily liquidity of <$1 million worth of shares - likely permitting only small individual investors to build positions, the aforementioned near-term earnings pressure and continued limited analyst coverage.
JAX is not a complicated story. In my view, the main reason for the current mispricing is simply because not many people are looking. This is unsurprising, given that the Company has yet to court investors. Shares should re-rate substantially as the Company gets its growth story out to Wall Street in coming days as management makes its very first public appearance at an investment conference.
4Q results indicate continued strong execution, 2016 mgmt net income guidance seems significantly understated
In the fourth quarter of 2015, execution at J. Alexander's remained strong. At J. Alexander's/Redlands Grill, average weekly same-store sales were up 1.4%, although when one excludes the extra week in 4Q, the metric declined 0.2%. Importantly, this was not due to missteps in execution on the Company's part.
Both the Company and peers reported a softness in 4Q, citing that consumers are increasingly staying home for the holiday season to do their online shopping. Moreover, average guest checks rose ~2.3%, indicating high earnings quality; in light of softness in guest traffic, some restaurants may engage in promotions to drive traffic and prop up SSS, JAX is not one of them.
J. Alexander's/Redlands Grill even managed to increase menu prices by ~1.7%. Given declining guest traffic and the average guest check number, this illustrates the loyalty of J. Alexander's/Redlands Grill's customer base. Stoney River had a much better 4Q, with average weekly SSS rising ~4.7%, even up against the declining guest headwind discussed earlier.
Looking at fiscal 2015 as a whole, the Company continued extending its SSS growth track record, with the metric up ~3.7% and ~6% over the year for J. Alexander's/Redlands Grill and Stoney River, respectively. Even excluding the impact of the 53rd week, the aforementioned metrics were ~3.4% and ~5.3% - still one of the better performances in the space. In addition, despite fighting an uphill battle with higher beef prices, restaurant operating margins still showed expansion, growing to ~14.7%, up from ~13.9% in 2014, indicating a continued cost-conscious culture.
Off the back of a strong 2015, management is guiding low single-digit SSS growth - conservative given its fiscal 2015 performance and net income of ~$6 million at the mid-point. In my view, net income is significantly underestimated.
The Company was spun off from FNFV last year. As a result, it incurred a material amount of transaction fees - expenses that are clearly one-off. This amount was ~$7.2 million in 2015. Adding back this one-time expense and adjusting for the tax rate differential (JAX had a ~20% tax rate in 2015, management is guiding ~30% in 2016), adj. 2015 earnings would have clocked in at ~$10 million, as compared to the reported ~$5.3 million.
Assuming the $224 million in 2016 sales, the mid-point of guidance - as discussed above, this is conservative given that its projection is based on low single-digit SSS growth - incremental sales at ~10% net income margin (in line with 2015 after adjusting for non-recurring costs), per management: incremental public company costs of ~$750 thousand and incremental SG&A associated with the Black Knight Advisory Services agreement of ~$550 thousand, 2016 net income should amount to ~$9.4 million, as seen in the earnings bridge below.
Source: Company filings, author's calculations
As discussed in my previous article, 2015 adj. net income is unlikely to fall off a cliff. Reason being: restaurant operating expenses have been decreasing steadily per my prior commentary, transaction and integration expenses are one-off, G&A declined despite the inclusion of non-cash comp expenses as a result of a profit interest plan implemented during the year, increased incentive accruals, salaries, payroll processing fees, employee relocation and other largely one-off items, and finally, one location was closed for a north of one month for remodeling.
Note that new unit openings for this fiscal year is heavily weighted to the back-end (management guided to 4Q openings), implying that it will only contribute to the top-line starting in 2017. Hence, my above calculations do not give credit to sales or net income contribution from new stores.
Multi-year high single-digit/high-teens top-line/earnings growth is not only well-supported, but is relatively low-risk
Management intends to open 4-5 stores going forward. Off the 2016 store base (same as 2015, given openings are in the late fourth quarter) of 41 locations, this suggests ~10% sales growth assuming flat comps (conservative, reasons: see supra).
In my view, execution risk is substantially limited as management is exploiting proven restaurant concepts (20+ quarters of high-quality SSS growth, driven largely by higher average guest checks), not running with an unproven one.
Moreover, over the past few years, management has inculcated employees and general managers with a cost-conscious culture that is highly focused on employing best practices and continuous training. The explanation requires a bit of background.
J. Alexander's was initially acquired by FNFV in 2012. Back then, the Company had been facing several quarters of declining same-store sales. FNFV, having tremendous experience in the casual-dining business (evident by its numerous stakes in other casual-dining companies, including the industry-leading Del Frisco's), saw an opportunity to reinvigorate SSS growth and improve margins by implementing best practices.
These include giving significant autonomy to general managers, minimizing bureaucracy by decentralizing operations, restoring service levels, re-designing menus to suit local tastes, expanding the wine program to drive high-margin alcohol sales and realizing scale efficiencies in purchasing and inbound logistics through a dense network of stores.
Collectively, this resulted in ~$14 million in incremental sales over a single year (2013-2014), as compared to ~$18 million in incremental sales over three years (2009-2012, a horrendous performance, considering that said period coincided with a strong economic recovery) previously. Restaurant-level margins also improved 170bps over the '13/'14 period. A small note: I did not discuss 2012-2013 results as it was skewed heavily by the Stoney River integration.
As discussed in prior sections, this strong performance is continuing (despite higher commodity costs) even after JAX was spun-off from FNFV, suggesting that management continues to retain the principles imparted to them by FNFV. Moreover, management has a combined 186 years of experience spread across 9 officers (averaging ~20 per officer) while middle management has had tenures ranging from 6-10 years. In addition, given the Company's 41 general managers (presumably 1 per location), this suggests that the Company has the bandwidth to run additional stores (i.e. a general manager running multiple stores).
Additionally, Black Knight Advisory Services (which JAX has a consulting agreement with) is owned by FNFV management. As part of the agreement, Black Knight was issued non-voting Class B units which is essentially a profit-sharing plan, significantly aligning the interests of both parties, and making it highly likely that FNFV would ensure that the winning culture is maintained.
What's more, FNFV currently owns a significant stake in Del Frisco's - whose Double Eagle Steak House concept sports store-level EBITDA margins approaching 30%. In my view, J. Alexander's close ties and aligned interests with FNFV could lead to a sharing of best practices across their restaurant holdings, which could substantially boost JAX's EBITDA margins.
While it seems optimistic to expect JAX's margins to expand to the same as Del Frisco's (as Double Eagle Steak House's high margins are partly driven by higher average checks), expectations for expansion to a low-20s EBITDA margin from its current ~18% seems reasonable. These numbers seem even more achievable if one considers that incremental EBITDA margins have been in the ballpark of 30%.
Recent new store openings have also been extremely well-executed. Per management (emphasis mine):
Our newest Stoney River has been extremely well-received within the Germantown community and has significantly exceeded both our current system weekly sales average as well as our targeted weekly sales average of $85,000 once a restaurant reaches maturity"
Source: Company 8-K
The above management commentary suggests that the Company's projections for ~$4.4 million in AUV for new Stoney Rivers could prove conservative and also supports my assertion that assuming flat comps is inherently a conservative assumption.
Due to the reasons cited above, execution risk is substantially minimized, in my view.
With ~$13 million cash on hand, operations generating ~$20 million (adjusted for non-recurring costs and incremental public company and SG&A costs) per annum and growing, and with build-out costs ranging from $3.5 million-$5 million, J. Alexander's can effectively self-fund its 4-5 store growth target (this target would likely increase as the store base grows and produces cash), eliminating any need for tapping the capital markets.
The market appears to be unfairly discounting the presence of a significant activist shareholder
However, it is highly likely that J. Alexander's will lever up its balance sheet to significantly accelerate store growth, in my view. This is because Eminence Capital, an activist hedge fund, recently acquired an ~8.4% ownership stake in the Company, which should increase over the next few years as J. Alexander's buys back shares (see infra).
In my view, given the recent share price performance, the market appears to be unfairly discounting the presence of Eminence Capital who has a track record of pushing for the maximization of shareholder value (WSJ has some decent coverage on the fund's activist campaigns).
Such a significant ownership stake could give the hedge fund sufficient clout to influence management and egg them on to utilize its balance sheet more efficiently. Furthermore, interest rates remain at record-lows, which may also tempt management to take advantage of this window before it closes.
Assuming J. Alexander's levers to a conservative 2x net debt/EBITDA, this would result in an additional ~$46 million of cash (~$26 million in 2015 EBITDA, current net debt of ~$6 million) which would be good for 9 new stores on $5 million build-out costs (the high-end of mgmt estimates).
Off of the 2016 store base of 41, this could add ~20% sales growth (conservatively assuming flat comps) which will be incremental to the ~10% top-line growth implied by current store opening targets (4-5). With ~10% incremental net income margins on 30%+ top-line growth, earnings will undoubtedly explode.
Valuation: cheap as-is, extraordinary bargain pro forma for debt raise
Notwithstanding the probable utilization of the balance sheet going forward, high single-digit top-line growth driving ~20% earnings growth seems very plausible.
Building on the 2016 earnings bridge (essentially management guidance adjusted for one-offs), 2017 net income should clock in at ~$11.2 million, implying ~19% growth - based on 8% top-line growth (assumes 4 store openings - low-end of annual targets, and ~$4.5 million sales per store, compared to average of ~$5.4 million per store, on 2016 sales guidance mid-point, or ~$5.3 million per store on 2015 numbers) off of management's 2016 mid-point sales guidance ($224 million) at 10% incremental net income margins (in-line with historical 2015). Math: 0.08 * 224 * 0.1 = ~$1.792 million, or ~19% of 2016 net income.
Given that I am modeling the low-end of the Company's new store opening targets, significantly lower average sales per store and using current incremental margins, I find it difficult to classify my assumptions as heroic. It is pretty clear (once you adjust for one-off expenses) that the Company's earnings are inflecting due to operating leverage, thereby allowing an 8% top-line growth to translate into ~20% earnings growth.
The board has authorized a share repurchase program in the fourth quarter of 2015 which allows for the buyback of 1.5 million shares over a period of three years. Given the cash flow generation of the business (~$20 million cash from ops), cash on hand (~$13 million), and capital needs (4-5 store openings costing ~$20 million), it seems a reasonable expectation for management to purchase 1 million shares around current prices by year-end 2017, which would add ~7% to EPS growth.
Applying a 25x multiple on 2017 EPS of ~$0.80 suggests a $20 stock price within two years. Discounting that back at a 10% discount rate gets me to a ~$16.50 share price, which implies ~75% upside from current levels.
A 25x multiple seems conservative given 1) the 20%+ earnings growth profile, 2) the fact that my assumptions assume flat comps for new store openings, 3) it does not factor in possible EBITDA margin expansion and 4) it does not account for the likely levering of the balance sheet to significantly accelerate top-line growth - if 3) and 4) materialize, the stock would likely be multiples of the current price by year-end 2017.
Cleaner financials as one-off expenses fall off, which should give market participants confidence in the Company's operating model.
Continued same-store sales growth and expanding margins should calm investors who have concerns on whether the public company transition would take management's eyes off the ball.
Just a few days from now, management will be participating in an investment conference (specifically the TAG conference) for the first time since JAX was spun off. In my view, management is likely trying to get out its impressive growth story in order to drum up bank/investor demand for its eventual debt raise to accelerate growth. As this will be the first investment conference JAX is participating in, shares could see appreciation as small-cap funds get to know the growth story and begin piling in. Due to thin daily trading liquidity, price movements could be pronounced.
Increased analyst coverage - boutique research firms might initiate coverage on the firm hoping to secure debt financing fees. Interestingly, in my prior article, I noted that two analysts currently cover JAX. However, checking the firm's website, it appears that only the analyst from Stephens is currently covering the Company. This could suggest that a debt deal is already underway - analysts usually suspend coverage when raising financing for a client.
Levering of the balance sheet - this would signal that the Company is pre-funding the acceleration of its expansion plans, substantially improving its growth trajectory.
As with any other casual/up-scale diner, JAX is levered to general economic fluctuations. Mitigant: management appears to continue to focus on cost-controls, which should diminish the effects of negative operating leverage if sales decline in a tough environment.
Execution risk associated with expanding the store base. Mitigant: As discussed above, management has tremendous experience in running its restaurants. Moreover, JAX continues to have ties to FNFV, who themselves are exceptional operators. Further, JAX is exploiting a proven concept, not an unproven one, which reduces the risk profile of the expansion, in my view. An activist is also on board. Also, continued same-store sales growth suggest that the model continues to work well.
J. Alexander's exhibits a few attributes that make it a compelling long -1) a small investor following, short-term earnings pressure and non-recurring costs resulting in a bargain valuation, 2) a well-supported, low-risk, multi-year growth story, 3) a clear path to substantial earnings growth going forward and 4) numerous catalysts on the horizon, including one that is just literally days away.
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.
Additional disclosure: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.