Ark Restaurants - Profits Plunge Amid Decline In Revenue And Margin Contraction

| About: Ark Restaurants (ARKR)

Summary

ARKR reported net income of $1.0 million for its fourth quarter of fiscal year 2016 (F4Q16) compared with $2.0 million in F4Q15.

Revenue decreased 5% due primarily to an extra week in F4Q15, but management also highlighted construction near a key restaurant and customers' response to an increase in menu prices.

Operating margin declined significantly because most expenses either increased or were flat despite the F4Q16 having 13 weeks compared with 14 weeks in F4Q15.

Background

Ark Restaurants Corp. (NASDAQ:ARKR) operates 23 full service restaurants and 19 fast food locations. It is somewhat concentrated in New York (6 restaurants) and Las Vegas (5), but its diversification is fairly good considering its roots in Manhattan and modest market capitalization of less than $100 million. ARKR uses 16 brands for its 21 restaurants. Furthermore, ARKR does not appear to have a comprehensive strategy that identifies its strengths and how to leverage them across all of its restaurants. This deficiency is probably why ARKR has remained in the small capitalization asset class.

Results for Fiscal Fourth Quarter 2016 (F4Q16)

F4Q16

F4Q15

Change

Change %

Revenue

38.5

40.6

-2.0

-5.0

Operating Income

2.1

3.7

-1.6

-43.2

Adjusted EBITDA

2.8

4.6

-1.8

-39.2

Net Income

1.0

2.0

-1.0

-50.9

Operating Margin

5.4%

9.0%

Adjusted EBITDA Margin

7.3%

11.4%

Tax Rate

33.2%

37.1%

Source: sec.gov

ARKR's CEO, Michael Weinstein, described the firm's results for F4Q16 as "dismal" even after adjusting for the extra week in F4Q15. Revenue declined 2%, but most of the firm's operating expenses either increased or were flat relative to the same period in fiscal 2015. Consequently, ARKR's net income for F4Q16 was less than half its profits in F4Q15.

Declining Revenue

The extra week confounds analysis of ARKR's revenue for F4Q16. It's also difficult to reconcile information from ARKR's press release with comments by the firm's CFO Bob Stewart during company's conference call with analysts. The press release described same store sales (SSS) as negative 7%. When an analyst asked what SSS would be after adjusting for the extra week, Stewart initially seemed puzzled by the question before finally estimating 2% to 3%. The analyst's question should have been the first thing Stewart asked his own people when he first saw ARKR's results. SSS is vital statistic for any company that generates significant revenue from retail locations. It measures whether revenue is growing organically.

Stewart's answer seems inconsistent with other information. ARKR's press release states that F4Q16's revenue included $0.9 million from a property acquired after Sept. 30, 2015 and F4Q15's revenue included $1.0 million for two properties closed prior to July 1, 2016. The calculation below suggests SSS was actually positive 2.5% after adjusting revenue for properties not in operation in both quarters and the extra week in F4Q15.

($ millions)

F4Q16

F4Q15

Reported Revenue

38.539

40.581

Revenue from Restaurants Not Operating in Both F4Q16 and F4Q15

0.896

1.015

Comparable Revenue

37.643

39.566

Weeks

13

14

Comparable Revenue per Week

2.896

2.826

Source: sec.gov

Despite the above analysis, ARKR's management was clearly disappointed with sales for F4Q16. Weinstein blamed increases to minimum wage and construction near a key store for the poor performance in F4Q16. ARKR tried to offset the increases to minimum wage with modest price increases, but Weinstein noted that he believed ARKR's customers' price elasticity was very high which means a small increase in price triggers a big decrease in quantity.

Margin Compression

ARKR's profitability declined sharply. As mentioned above, management has been battling higher compensation expenses due to the increase in minimum wage. However, the table below suggests the increase in minimum wage was not the only driver of the 362 basis point plunge in operating margin. Food and beverage was the only declined as a percentage of revenue most likely due to a combination of an increase in ARKR's menu prices and a decrease in agricultural commodities. PowerShares DB Agriculture ETF was 4% lower in F4Q16 than FQ15.

Expense Item / Revenue

F4Q16

F4Q15

Change

Food and Beverage

26.2

27.0

-0.7

Payroll Expenses

32.7

31.4

1.3

Other Expenses

26.2

24.9

1.3

Depreciation and Amortization

3.0

2.7

0.3

Source: sec.gov

Looking Ahead

While results for F4Q16 seem mildly unfavorable, investors should be cautiously optimistic about fiscal 2017. First, management announced that SSS was positive 4% for the first 11 weeks of F1Q17. This strong turnaround supports the assertion that adjusted SSS was actually positive in F4Q16.

ARKR is poised to realize a gain of approximately $3 million in fiscal 2017, but it will lose one of its restaurants as a result. The landlord for Rustic Inn, one of ARKR's restaurants, reached an agreement to sell the property that Rustic Inn leases. ARKR executed its right to purchase the property for $5.2 million and subsequently sold the property to a third party for $8.25 million. ARKR has not provided any guidance on the timing or accounting for this transaction, but it seems likely that it would be a $3 million gain in fiscal 2017. Rustic Inn will vacate the property by April 30, 2017.

Unfortunately, the margin compression experienced in F416 were not a one time event. ARKR's operating margin contracted 121 basis points in fiscal 2016. Payroll expenses represented the largest increase in both dollars and percentage from fiscal 2015. This trend explains management's complaints about the increase in minimum wage.

Valuation

ARKR seems overvalued. Its price of $25.99 equals 23 times its diluted earnings per share of $1.15 for 2016 in the past year. According to Thomson Reuters, U.S. firms are trading at 19 times their earnings for 2016. The table below shows that its price-to-earnings ratio seems inconsistent with ratios for larger restaurant operators when you consider earnings growth.

P/E Multiple

Earnings Growth

ARKR

23

-25%

Brinker International (NYSE:EAT)

14

-4%

Cheesecake Factory (NASDAQ:CAKE)

22

19%

Buffalo Wild Wings (NASDAQ:BWLD)

27

12%

Darden Restaurants (NYSE:DRI)

25

12%

Source: Yahoo Finance and SEC.gov

ARKR's growth prospects are modest as demonstrated by its average annual revenue growth of less than 2% over the past five years. Some investors may believe ARKR deserves a higher multiple because it has a low historical beta of 0.35 according to Yahoo Finance. The low beta would result in a low cost of equity because cost of equity equals risk free rate plus beta times market risk premium. Since the cost of equity is the discount rate for future cash flows, a firm with a lower cost of equity will have a greater valuation than a firm with an average cost of equity.

The low beta argument for a high price-to-earnings ratio for ARKR ignores the purpose of beta which is to measure prospective systemic risk not historical stock market returns. The chart below shows ARKR's operating margins have been fairly volatile, and the volatility has coincided with trends in the U.S. Therefore, it does not seem appropriate to use a low beta to calculate ARKR's cost of equity. Consequently, a price-to-earnings ratio of 19 seems approprate. That translates to a share price of $21.

Operating Margin

Source: sec.gov

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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