Description

Can I interest you in a no-growth assortment of eclectic, disconnected restaurants with dropping comps, consecutive unprofitable years and the liquidity of a Marty Barrett rookie card? Please, read on.

Overview

Ark Restaurants is a melange of 26 restaurants and 19 fast food “concepts,” (it was 20, but they sold the “fast food is an allegory for modern industrial life” concept to KKR), nearly all of which have different names and styles, located New York, Las Vegas and Washington D.C. Founded in 1983 by current management as a New York neighborhood-style restaurant operation, Ark has grown into an idiosyncratic group of boxes focused instead on large, destination-type locations.

Strategic Change

Ark is a masked improvement story. After years of running the reasonable if difficult business of owning a series of mostly unrelated restaurants, Ark hit upon the idea (beginning around five years ago) of expanding into what it calls the destination business, which focuses on larger locations whose customer are attracted more by their host than the restaurants themselves. To that end, Ark has become the biggest non-casino food and beverage operator in Las Vegas, where it essentially runs the restaurants and food services and NYNY with another large footprint at the Venetian, and has developed a good enough reputation to get landlords to provide nonrefundable construction allowances to entice them into a destination.

In its more traditional business Ark owns a host of successful, mid and high end New York restaurants (12 in total) with generally reliable customer flows and long term operating leases at almost uniformly attractive prices. The most famous is probably Lutece, but they also own a few other well known names, including America and Bryant Park. It owns another four in D.C. including a the huge Sequoia (1000 seats) and another America. Its most lucrative ground for recent expansion, though, has been in Las Vegas, where Ark management has established a firm reputation for running destination type sites, which in Vegas means for the most part in hotels. To that end, they have several successful higher end restaurants in both New York, New York and the Venetian. They also have a small presence at Caesar’s, a semi-disaster at Dessert Pasasage in the Aladdin (more on that later). In addition, they operate the food courts (the aforementioned concepts) in NY, NY, Venetian and Dessert Passage.

The important thing here is to bifurcate the operations. On the one hand you have the traditional, Lutece type neighborhood restaurants, which are conventional reputation and location based eateries, and on the other you have a series of food solutions, where Ark basically comes in and provides a complete or at least substantial dining answer to a large destination, be it New York, New York or in Union Station. In the former, the quality of the actual restaurants and the ability of management to secure, hire for, locate and run new, profitable concepts is the central determinate of economic success, while in the later, management’s reputation in quickly building large scale multi-faceted restaurants to fit a destination along with the attractiveness of the particular destination in question or what will govern results.


Management

Ark is run primarily by Michael Weinstein and Bob Towers, both of whom were there at inception in 1983. Weinstein holds just south of 30% of the equity. Weinstein’s isn’t building a franchise, he’s building restaurants. Here’s a snappy quote from a couple of years ago:

"I don't know how to build brand equity and don't want to,"

When you’re in the restaurant business and not building brand equity, then you’re going to have hits and misses, which certainly applies to Ark. They’ve tried many concepts over the years that haven’t panned out, the great majority of which being attempts at infiltrating suburbia, but their overall success rate has been fairly good, and they are extremely ruthless at quickly cutting out an operation that isn’t generating positive store level operating cash flows. Another recent example of a failed project came via the destination strategy in Vegas, where Aladdin’s struggles (and bankruptcy) killed the profitability of the restaurants Ark had inside. Since Ark simply will not except negative store operating flows and Trizec (landlord) refused to subsidize their losses, Ark ended the project entirely and wrote the entire thing down to zero for a tax loss.

Financial Results

In the end, this is simply a cheap stock with a difficult but not horrible business. Until 9/11, the restaurants were producing very moderate but stable annual comp increases in the very low single digits (2.6%, 3.10%, 0%, 3.6%, 1.7% in the 4 years and eight months leading up to 9/11). The business got absolutely crushed in the wake of 9/11, with one restaurant (The Grill Room) taking direct damage (it’s still closed, will reopen in December) and the rest finding themselves at the heart of the fallout: destination tourist areas reliant on business and consumer travel and discretionary spending. Interestingly, it’s the DC restaurants that have taken the biggest hit, comp’ing in the high negative double digits since 9/11, while Vegas has actually returned to form. When 9/11 hit, Ark, which was already carrying too much leverage, went from reliably cash flow positive to immediately losing literally $1 million a week and was in significant danger of going splat. Management made severe cutbacks and got enormous cooperation from both landlords (who are generally very happy with Ark as a tenant, at least according to my anecdotal inquiries) and their lenders and managed to stay afloat in the brutal fall of 2001.

That precarious period had two important effects. First, it really shook management, who are by far the biggest shareholders (specifically, Weinstein), who have become determined to delever the business and have eliminated all capital spending and expansion plans for the foreseeable future. Second, it revealed some significant froth in Ark’s operations through the drastic cutbacks, and management believes that it can maintain at least $5 million a year (a huge number) out of the emergency cost savings it instituted last year. Those two effects leave a business with earnings power largely understated by GAAP, because with only maintenance capital spending, Ark’s depreciation schedules substantially overstate its true capital needs. For the first nine months of this year, D&A of $3.6m compares to capital spending of $0.4 million. Management estimates that ongoing maintenance capex is only around $500K to $1 million a year, using the higher figure if you want to include the occasional remodel.

Operating results over the last three years have been marred by the writedown of the Dessert Passage properties and a residual writedown from a failed project in Southfield, Michigan. Excluding those charges, EBITDA over fiscal 1999-2001 has been $9.7m, $10.0m, and $8.4 million. EBITDA for the first nine months of this fiscal year, which includes the difficult Oct-Dec period was $9.2 million, as compared to year-ago $8.2 million. Full-year EBITDA is on track for around $12 million. Its operating cash flow, minimal maintenance requirements and halted expansion has already allowed it to meaningfully reduce debt. Total debt outstanding has dropped from $24m to $18.9 million in the 9 months of FY02, which should be shaved by another $3-$4 million by fiscal year end September. Management has been explicit that it intends to continue to delever and expects to reduce debt levels to the single digit million in the next year.

Valuation

At the end of this fiscal year (September), Ark’s debt will likely be down to approximately $15-$million. At a recent market price of $7.00 a share, it’s equity cap is $22 million, leaving an enterprise value of around $37 million. Against that, Ark is on track to product $11 million in EBITDA after capital expenditures, or 3.4X pre-tax FCFF. The company has approximately $10 million in net (i.e. tax affected) NOLs and credits, which should serve to eliminate $30 million of taxable income. One way to look at this is to tax affect ARK’s $11 million post capex EBITDA at 35% but subtract the estimated PV of the net NOLs from EV. That gets you an EV of around $29 million off of $7.2 million of after-tax FCFF, or an unlevered free cash flow yield of 24.8%, with a potential boost from moderate leverage which is not likely to go to zero.

There is arguably significant upside from that valuation given the horrible comps experienced this year. The company was on track to earn $12-$13 million in EBITDA last year before 9/11, and this year is going to effectively match that despite 9/11 largely because of cost savings and the strength of its core Vegas operations. If management is right that $5+ million of its annualized cutbacks instituted this year are sustainable, than even a modest return in business should provide a significant boost to the bottom line with upside to EBITDA in the $16-17 million area. In particular, it seems unlikely that Ark’s acclaimed DC restaurants will continue to experience the terrible comps that they have, and the Union Station will not be forever, although there has been yet no sign of a pick-up.

Risks

-Many worry that Ark and other individual operators are on the wrong side of a secular trend toward branded franchises in the restaurant business. This threat is arguably blunted somewhat as the chains are much less important in Arks core NYC market and are almost irrelevant in its Vegas destination business.

-Ark has significant exposure to NYNY in Vegas. If NYNY were to woefully under-perform, Ark would suffer a significant loss in business. This is also true to a lesser extent with the Venetian.

-It’s hard to know what the five-year future holds in terms of capital allocation. They have walked the talk for nine months in terms of cutting off the spigot and delevering, and they have repurchased stock in the past and have indicated they would be willing to in the future, but these guys are enterpeneurs and once leverage is sufficiently reduce there is always the threat of unknown expansion.

-This stock is very illiquid, and often doesn’t trade at all, average 3K-4K blocks a day. That said, it’s surprisingly possible accumulate a reasonable (depending on your overall size) with minimal price impact given some patience.

Catalyst

-Comps from here on in, or specifically, from 9/11 on in, will be very favorable. After having SSS drop in the high single digits on average since 9/11, FY03 should provide easier comparisons.

-GAAP EPS will increase. Although ARK will only earn ~$0.92 a share this year, that number will slowly but not insignificantly increase as the net PP&E drain from cap ex greatly exceeding depreciation lowers D&A, and has interests costs are reduced from the substantial delevering.