Description

ARKR runs large restaurants and food courts in landmark locations in Las Vegas, NYC, and Washington DC. It was recommended here in 8/02 by Roark304, who has since regularly contributed excellent (and stylishly written) follow up reports. In his most recent one, covering ARKR’s Dec. Q1, he said that the interest here in the ARKR story was slim. Probably true, but it shouldn’t be. ARKR may actually be a more attractive investment for most small cap investors now than it was two years ago, even though the stock price has approximately doubled, because of substantially lower risk, and clear catalysts for upward price action over the next year. In fact, by the end of this summer, if the stock is still where it is now or lower, ARKR’s strong cash flow will have brought the EV back down almost to where it was when Roark304 first recommended it.

Compare the ARKR of 8/02 to the ARKR of today. Then, it was heavily in debt, and business stunk in all its markets. The only thing that had allowed ARKR to survive the aftermath of 9/11 was the willingness of employees, suppliers, and landlords to temporarily take much less than they were owed. But costs had already been slashed as much as possible, and any further downturn could well have been fatal.

Now, ARKR is within one quarter of paying off all debt. Management indicated that by later this year it is inclined start buying back stock or paying dividends. Business is booming in its Las Vegas properties, with good reason to expect very strong growth for some time to come. ARKR has been closing and selling most of its smaller neighborhood type restaurants in NYC (Lutece, announced last week, for example), that were losing money and/or lacked the potential of its large operations. Even with various small one shot negative provisions, ARKR should still clear $1.50 in EPS this year, on sales of around $120M, and something close to $2 looks plausible for next. If ARKR can get a 15 P/E on that, the stock has another double in it.

Background: ARKR has evolved over its 20 year life from being a collection of small mid-priced to upscale restaurants, all with separate names, chefs, etc., mostly in NYC, to being one of the leading operators of very large scale food operations in landmark locations. For example, in the NY-NY Hotel & Casino in Las Vegas, ARKR runs three large restaurants (America, Gallagher’s Steakhouse, and Gonzalez y Gonzalez), eight different concepts in the food court, room service, banqueting facilities, and the employee cafeteria. Similarly, it runs four restaurants in the Venetian Hotel in Las Vegas, plus the food court there. In Washington DC it has primarily large properties: Sequoia, America, and Thunder Grill. In NYC there is a mix of large operations, like Bryant Park, The Grill Room at the World Financial Center, and some properties at the South Street Seaport, and a number of legacy neighborhood restaurants, which are mostly being closed or sold.

In the last seven years ARKR invested large amounts of its capital on specific expansion projects. The first one it did, the NY-NY operation in Las Vegas, has been a complete success. A second, its operations at The Venetian, have only recently started earning decent returns, due to unexpected changes in construction that reduced the promised traffic flow. Two other projects in which ARKR invested lots of borrowed money, one in Las Vegas and one in Michigan, were failures and resulted in big write-offs.

Management insists that it will never put large amounts of capital at risk again. It is in the process of opening food courts in new hotel/casinos in Tampa and Hollywood, FL, and these were financed with outside capital. That reduces the return somewhat, but if the promising early results continue, they will both be quite lucrative, on sales probably running at an $8M annual rate. ARKR is negotiating on several other large scale operations, in Atlantic City, Las Vegas, and elsewhere, and none will require a significant up front investment on ARKR’s part.

The company’s strong reputation for handling complex operations serving thousands of high quality meals per day, has put it in a position where it is increasingly invited by developers to negotiate on new projects, rather than have to competitively bid against others. ARKR’s value added is in its ability to plan and operate the facilities successfully, not its ability to provide capital. It will make small (well under $1M) investments for tweaks, such as changing brand names of some food court operations, or expansion of existing restaurants, but is firmly against ever again placing large amounts of its capital at risk.

I emphasize the capital investment issue because ARKR generates substantial free cash flow relative to its stock price. Keeping an existing restaurant in good shape requires current maintenance expenses, rather than substantial new capital investment. Depreciation is running at about $1.25 per share, and maintenance cap ex under $0.30 per share. The tax rate, although reported at about 35%, is more like 25% in terms of actual cash paid, due to previous write-offs.

Las Vegas operations now represent over 50% of ARKR’s total sales, with same store sales up 12.4% in the most recent quarter. Recent expansions at the Las Vegas Convention Center, The Venetian and Mandalay Bay have raised the city's available exhibit space to more than 5.2 million square feet, which is allowing the city to take on many new meetings. Las Vegas is now the most popular site for conventions and shows, and since they are planned several years in advance, strong growth in visitors for the next few years is highly likely. Helping ARKR in particular has been the recent expansion in the number of guest rooms at The Venetian without a comparable increase in restaurant space, as well as a 90 seat expansion of its popular Gallagher’s Steak House operation in the NY-NY Hotel & Casino.

After sharp declines in connection with 9/11 and the weak economy, ARKR’s operations in DC and NYC are now comp’ing flat, but there is good reason to expect positive comps as the year goes along. The sharp decline in the US dollar in the last year has made the US a bargain destination for foreign travelers, and NYC and DC (and Vegas) are all in popular tourist cities. Another factor is that several of ARKR’s NYC and DC restaurants have significant outdoor space, such as Bryant Park with 180 indoor seats and 820 outdoor ones. Revenues are obviously quite dependent on the weather, and last summer was unusually inclement, especially towards the end of weeks when people tend to go out to eat more. One of the only nice Thursday nights in NYC all last summer was the one in which the blackout hit, closing the restaurants for that reason. A return to just mediocre weather would be a big plus. The somewhat improved NYC economy might help too. Eliminating the poor performing restaurants will eliminate their negative EBITDA from the picture.

This is a very, very thin stock. Of the 3.24M shares outstanding, management and directors own almost half. Recently the CEO exercised an option at $10 and bought 60,000 additional shares, not quite an open market purchase, but close enough in price. Some days the bid-asked spread gets quite wide. There are some options held by a number of employees that are getting close to expiration, so perhaps some shares will come into the market from that source.

Risks and Issues:

Given its long record of successful operations, its strong cash flow, and its low valuation, I am generally quite comfortable with my fairly large position in the stock. There is only one potential disaster scenario for the stock, which is another major terrorist attack like 9/11 involving Las Vegas, NYC or DC. ARKR has terrorism insurance that would cover its business losses up to $25M in such an event, so the company would probably survive, but it wouldn’t be pretty. Similarly, a major economic crash and depression would not be good for business. Yes, every company would be affected, but I would rather own McDonald’s than ARKR in that event. The odds of these things happening may be very small, but they are greater than zero, so bear that in mind.

Shorter term, there is some chance of negative comparisons, or at least a lot of confusion, in the current quarter. In addition to various write downs and ups in connection with restaurant closings and sales, there are some other potential one shot items. For example, ARKR lost a labor arbitration going back to 1997, and has been waiting for some calculations of liability before writing off its expense. The state of Nevada has claimed that one of ARKR’s operations there is subject to a certain entertainment tax, which the company had not been accruing. If ARKR loses that dispute, that would mean a several hundred thousand dollar hit for back taxes at some point. I have little doubt that actual operations will be up every quarter this year, but that may not be obvious in the headline numbers.

And as a general caveat, I’ll add the obvious, which is that debt is not the only fixed obligation a restaurant chain may have; leases are very significant. This business has operating leverage down as well as up.

Catalyst

1. Double digit sales growth in ARKR’s Las Vegas restaurants, and a decent recovery from depressed levels in NYC and DC, should produce strong earnings growth this year and next.

2. Elimination of all debt, and the buildup of cash, combined with its single digit P/E, should induce a higher valuation.

3. The company’s strong commitment to not use much of its own capital for expansion will allow a stock buyback and/or dividends to start later this year.