Red Robin (RRGB) posted yet another disappointing quarter, with comps down 3.4% y/y leading to a total revenue decline of 3.6% y/y to $290 million. It would be easy to look at any finance website and notice that shares are down about 50% YTD and conclude it may be a time to buy. However, I believe the company’s heavy reliance on off-premise as well as heavy promotional offerings to drive traffic in combination with structurally higher labor costs have only brought the stock down from heavily overvalued to roughly fairly valued. I see no immediate signs of a recovery, and as a result, I think investors would be wise to avoid the company.
Comps – Falling In Spite of Value Prop
Red Robin has focused intensely on providing a “value” price point, with offerings from $6.99 to $8.99 for burgers, endless sides, and endless beverages. For a few years this helped the company drive traffic, but customers have realized that this is not simply a promotion, but rather regular operating behavior for Red Robin. As a result, traffic fell 1.5% y/y in the quarter, driving total comps down 3.4%. Q3’17’s comp was down just 0.1%, so the 2-year stack is just -3.5%. This is not a great number by any means, and the trend is accelerating versus Q2, where the stack was -3%.
In addition to promotional behavior, Red Robin had been relying too heavily on off-premise dining to drive comps. As I noted following the last earnings report, off-premise sounds great, in theory. In reality, it adds operational complexity and cannibalizes highly profitable beverage sales. During Q3, off-premise rose to 10.1% of gross food & beverage sales versus 7.6% in the prior-year quarter. Clearly, top-line from this business remains healthy, though I question what profitability it generates.
Management admitted that declining levels of service was negatively impacting sales. On the earnings call, management referenced high weekend waits and slow table turns as causing customers to walk away. I believe the complexity of pushing through off-premise orders as well as likely tighter labor requirements are the primary causes. In fact, management noted a willingness to add labor hours if needed to help capture peak traffic. However, I wonder if the company may simply need to intentionally slow off-premise growth, especially if kitchen throughput is robust. The company could do this via higher service fees or higher minimum orders quantities, and perhaps it would have a positive impact overall on profitability.
As we move through the P&L, we can see that the weak comps are the primary culprit for declining profitability. Cost of sales and labor were both flat as a percentage of sales, but other operating expenses, which are typically fixed, were up 120 basis points y/y to 15% of sales, and occupancy cost was up 60 basis points y/y to 9.2% of sales. In total, restaurant operating costs were up 170 basis points y/y to 83.2%.
In order to compensate for a declining restaurant operating margin, Red Robin cut marketing spending, and ended up reducing SG&A by 130 basis points y/y to 9.8% of sales. Overall, operating margin fell 70 basis points y/y to 0.6% of sales, so Red Robin remained profitable, though only marginally.
From a cash flow perspective, Red Robin has performed adequately YTD in 2018. Free cash flow of $39 million is down from $60 million, but it nevertheless remains healthy. I expect capital expenditures to remain lower going forward, especially as the company works to refranchise 100 existing locations. Refranchising is precisely why it is too hard to get overly bearish at current levels.
In addition to reduced capital spending, management bought back a very modest amount of stock to offset dilution from equity-based compensation. I think buybacks could become more material if the company engages in refranchising, but at the moment, it does not appear to be a focus of the management team.
For the full year, management again cut guidance, reducing EPS expectations to $1.60-1.80 from $1.80-2.00, as the company does not see momentum heading into Q4.
Stay Away from Shares
Although shares are down around 50%, there is no reason to initiate a position at current levels. Management seems to grasp some of the problems, but I do not like Red Robin’s overly promotional position and reliance on off-premise growth to drive sales. Additionally, the company is not in a position to meaningfully grow its restaurant count, so the company is relegated to driving comps at existing stores to drive earnings growth.
As I noted previously, the company can reduce capital intensity via refranchising efforts, and Red Robin has a track record of driving above average traffic growth in casual dining, so I can see a world where the company returns to low single-digit comp growth. However, even in such an event, shares look about fairly valued. Even at current levels, shares are trading near a double-digit EV/FCF multiple. It would take a share price under $20 for me to consider a position.
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.