Description

TAST is a diversified operator of quick-service/quick-casual restaurant concepts, trading at 8.5x conservatively-estimated normalized cash earnings. This is an attractive valuation for a surprisingly steady and resilient business. After IPOing near the peak of the market in December of 2006, TAST's stock price cratered amid the credit crisis. The company has since largely been forgotten by Wall Street, with limited analyst coverage and almost no hedge fund ownership.

TAST operates three concepts. It is most commonly known for being the largest Burger King ("BK") franchisee in the nation, with 312 restaurants located primarily in upstate New York and Ohio. However, Burger King actually accounts for less than 50% of the company's total revenue, and only ~45% of overall EBITDA (before corporate expense). TAST's other two brands, Pollo Tropical and Taco Cabana, account for the remainder. Pollo Tropical is a Caribbean-themed, chicken-based concept with nearly 100% of its locations in Florida (91 in total), while Taco Cabana is a Tex-Mex concept with nearly 100% of its locations in Texas (156 in total). While the majority of VIC members have likely never heard of either chain, each is a mainstay within its local geographies. This is evidenced by tremendous productivity on a per-store basis - the average Pollo Tropical generates nearly 2mm in sales per year, and the average Taco Cabana generates 1.7mm in sales per year. As a point of reference, the average Chipotle does about 1.8mm annually, the average El Pollo Loco about 1.7mm, and Baja Fresh and Qdoba about 1.1mm and 1mm, respectively. Profitability is also comparable: Pollo Tropical's three-year average EBITDA margin is 15%, compared to 14.1% for El Pollo Loco and 15.5% for Chipotle. Taco Cabana comes in slightly lower at 12.2%.

Collectively, TAST's three concepts have delivered very consistent results over time. On a company-wide basis, here's how sales, gross profit, EBITDA, and ROIC have trended (all figures in millions):

Total Company - Sales

2001: 656

2002: 657

2003: 645

2004: 698

2005: 707

2006: 751

2007: 789

2008: 816

2009: 816

Total Company - Gross Profit

2001: 156

2002: 159

2003: 149

2004: 161

2005: 160

2006: 174

2007: 172

2008: 165

2009: 172

Total Company - EBITDA

2001: 91

2002: 94

2003: 84

2004: 93

2005: 91

2006: 96

2007: 88

2008: 81

2009: 89

Total Company - ROIC (ex-intangibles)

2004: 9.4% 

2005: 12.3%

2006: 17.1%

2007: 17.7%

2008: 17.5%

2009: 14.7%

On a concept-by-concept basis, the breakdown is as follows:

Pollo Tropical - Sales

2001: 98

2002: 102

2003: 110

2004: 125

2005: 137

2006: 154

2007: 168

2008: 175

2009: 178

Pollo Tropical - EBITDA

2001: 22

2002: 22

2003: 23

2004: 28

2005: 29

2006: 28

2007: 29

2008: 23

2009: 26

***

Taco Cabana - Sales

2001: 178

2002: 175

2003: 181

2004: 203

2005: 210

2006: 228

2007: 239

2008: 250

2009: 254

Taco Cabana - EBITDA

2001: 26

2002: 28

2003: 24

2004: 30

2005: 32

2006: 33

2007: 30

2008: 29

2009: 31

***

Burger King - Sales

2001: 381

2002: 380

2003: 353

2004: 370

2005: 360

2006: 369

2007: 382

2008: 392

2009: 384

Burger King - EBITDA (Includes Corporate Expense)

2001: 43

2002: 44

2003: 37

2004: 37

2005: 32

2006: 34

2007: 31

2008: 31

2009: 33

***

Before delving into some of the current issues surrounding each of the above brands, a brief history of the company is in order:

In 1986, TAST was exclusively a Burger King franchisee. The management at that time took the company private in an MBO in conjunction with a couple of venture funds. Ten years later, two private equity outfits, Bahrain International Bank ("BIB") and Madison Dearborn, purchased a majority stake from the original MBO investors. The management from the 1986 transaction actually stayed on through the sale, retaining an equity stake alongside the new majority owners.

It was at this point that TAST began expanding away from BK - in 1998 Pollo Tropical was acquired for 90mm. In 2000 Taco Cabana was acquired for 150mm. Both companies were actually publicly-traded, so it's possible to go back and dig up their historical financials from the mid-90s. What you'll find are two very steady brands that have expanded their reach over time.

In late 2006, BIB and Madison Dearborn agreed to sell a portion of their stake (retaining 30% of shares outstanding) in the TAST IPO. Interestingly enough, management did not sell. Today, the architects of the original 1986 buyout, CEO Alan Vituli and COO Daniel Accordino, still own in excess of 11% of the equity, worth more than 14mm (not inconsequential relative to their combined salaries). Vituli has been with TAST for 24 years and Accordino for 38.

BIB and Madison Dearborn sold the remaining 30% of their stake in July of 2009 to Jefferies Capital Partners, a middle-market PE firm, in a negotiated transaction for $5.75 per share. The stock was trading at 6 and change at the time. Management, again, did not sell.

In speaking with the various parties involved, it is my impression that Madison Dearborn sold out not necessarily because of an imminent concern with the business, but because a.) they had already made a good return; b.) the initial stake was purchased more than 10 years prior as part of their first and second funds (they are on to fund number six now)...and these funds ultimately need to return capital to LPs.

It is also my impression that Jeffries got a very good price (and likely conducted serious due diligence before purchasing). The Jeffries investment was led by Brian Friedman and Nicholas Daraviras, both of whom graduated from Wharton and have a wealth of experience in the restaurant business. The two now sit on the TAST board. In total, management and Jefferies own 42%+ of the stock. This significant insider ownership, as well as the fact that Jefferies' cost basis is not too far from today's price (especially taking into account a liquidity discount), gives me comfort that minority shareholders' interests here are well aligned.   

Current Issues

Of the three brands, the longest tenured - Burger King - is treated internally as the cash cow. Management made the decision many years ago not to grow this segment any further, as the other two concepts offered superior returns on incremental capital. In fact, over the last decade, management has closed ~47 BK franchisees (out of 359 at the peak in '01), while still largely maintaining the segment's overall levels of sales and profitability.

Unlike BK, Pollo Tropical has grown from 60 locations in 2003 to 91 in 2009. Revenues have increased commensurately, from 110.2mm to 177.8mm. However, profitability has stagnated - EBITDA was 27.9mm in 2004 vs. 26.2mm last year. There are several explanations for this. First, Pollo is basically 100% Florida-based. 2007-2009 was not exactly the ideal economic timeframe for restaurateurs in that state. Whereas in 2004 Pollo only spent about 2mm on advertising, they've had to spend nearly 5mm in 2009. Second, Pollo converted a bunch of capital leases to operating leases over the last several years, which, while having no economic effect, resulted in increased rent expense and hence a 3mm hit to EBITDA. Third, new stores take time to mature. Fourth, there have been some pressures on commodity costs.

The same general issues apply to Taco Cabana. This concept has also grown its unit count by some 30-odd stores, from 126 in 2004 to 156 in 2009. Sales grew commensurately from 202.9mm to 254mm. However, EBITDA has remained fixed at 30-33mm.

There are a couple of ways to interpret these data points. The pessimist would contend that the growth in store count has been value-destroying because immediate system-wide profitability has not improved. The optimist would argue that the expected increase in profitability is simply latent, masked by terrible economic conditions and accounting machinations; Pollo Tropical in particular may have significant embedded operating leverage as the Floridian economy recovers. The optimist might also note that, for a restaurant brand with such huge exposure to Florida, even maintaining profitability through the downturn was an impressive feat. It's worth highlighting that comps for Pollo are actually up 3% in the first quarter of 2010, after being slightly negative for the last two years (-1.0% in 2008 and -1.3% in 2009). Comps before 2008 were consistently positive.

The good thing is that you don't have to believe the optimistic case for TAST to be cheap. The valuation is low enough such that even if reported net income were to fall 30-40% in 2010, the stock would be trading at a low-teens multiple of earnings.

Calculating Normalized Earnings

What are normalized earnings? I would contend that 2009 serves as a fair base year to examine. Margins were slightly below mid-cycle levels (6.9% EBIT margin versus a ten-year average margin of 7.4%), comps were negative for all three brands, and employment conditions were poor. In 2009, TAST reported net income of 21.8mm. This compares with a market cap of 170mm, resulting in a multiple of 7.8x. However, the real multiple is a bit higher because earnings need to be adjusted for two non-recurring items. First, TAST has been amortizing an annual deferred gain of 2.15mm on unearned purchase discounts (related to a soda deal done way back in 2000). This gain will not repeat next year. Second, fiscal 2009 contained an extra week, which boosted pre-tax earnings by 2.9mm. Adjusted and tax-affected for these two items, recurring earnings should be closer to 18mm. On this basis, TAST is trading at a multiple of 9.4x.

There are two other items worth noting - from the earnings figure above I did not back out impairment losses of 2mm+, which, while largely non-cash, consistently recur year-in and year-out as the company shuffles its stores around. Also, the company amortizes deferred gains from sale-leaseback transactions, which, for accounting purposes, offset current rent expense. I haven't adjusted for these gains simply because there is no economic difference between doing it this way and paying fair market-value rents. Finally, the company records 3mm+ of annual non-cash amortization related to BK franchisees that it acquired a long time ago. This amortization is, for all practical purposes, the same as goodwill amortization, and can be safely added back to determine cash earnings. I have not done so in the numbers above, but if you do, you get to a multiple of ~8.5x.

My calculation of normalized earnings over the last decade, adjusted for items similar to the ones described above (and assuming current interest expense and tax rates), results in the following figures:

2001: 13

2002: 19

2003: 12

2004: 19

2005: 21

2006: 24

2007: 20

2008: 15

2009: 18

These numbers, again, are not adjusted for the 3mm in non-cash amortization.

Risks

The biggest risk to the name is leverage. The company has 292mm of debt compared with roughly 90mm of EBITDA - 3.2x. Moreover, as anyone who's spent time looking at the restaurant business knows, there are a lot of other costs that are fixed, including rent, labor, etc. - so there's operating leverage on top of the financial leverage. However, I am comforted by both the historical steadiness of the cash flows as well as the fact that trailing interest coverage is 4x on an EBITDA basis and nearly 3x on an EBIT basis. The company is also applying FCF to debt pay-down - in 2009 they paid down 30mm (which, remember, compares to an equity market cap of 140mm). Finally, there seems to be a vast disconnect between the TAST bonds and stock. The junior bonds are trading above par and yielding 6.7%, while the stock trades at a multiple that implies distress.

A second risk to the name are the short-term negative comps at Burger King. In 2009, TAST's BK comps were down 2.9% (2008: up 3.5%). In the first two months of 2010, comps were down 8%. Part of this large drop was due to inclement weather in the Northeast (management says weather accounted for maybe ~3% or so), but clearly there were also other factors involved. The sky-high unemployment rate among 16-19 year old men - 27.8% - and 20-24 year old men - 17% - doesn't help, as these folks are the core customer base. Anyway, as a result of the poor comps, 4Q09 operating results were quite weak. Adjusting for the extra week in the fiscal year, EBIT was down 25%.

Comps have recovered somewhat in March to -3%. There's not much more that I can say about this risk; as a value investor with a reasonable time horizon, I try not to obsess over a couple of months of bad numbers for a brand like Burger King. Here are some longer-term figures:

Average Annual BK Sales Per Store (000s)

2001: 1,078

2002: 1,069

2003: 1,003

2004: 1,034

2005: 1,048

2006: 1,114

2007: 1,175

2008: 1,226

2009: 1,206

BK Comps

2001: +1.3%

2002: -1.3%

2003: -7.2%

2004: +2.9%

2005: +1.0%

2006: +4.2%

2007: +4.6%

2008: +3.5%

2009: -2.6%

BK isn't a concept that's going away, and as I've noted before, even if you were to annualize the poor fourth quarter, the stock would still be trading at ~10x cash earnings. In the meantime, comps for both Pollo Tropical and Taco Cabana have both improved.      

A third risk is the continued stagnation in Pollo Tropical and Taco Cabana profitability.

Conclusion

To keep this write-up at a reasonable length, I've left out a lot of restaurant-specific data that's available in the 10K (which, BTW, is packed with information - the business description alone spans nearly 20 pages).

I'll wind up with a basic review of the thesis:

-       You're buying three relatively stable restaurant brands, with strong unit volumes and long histories of consistent profitability - but with some economic headwinds and volatile recent SSS performance.

-       You're paying 8.5x normalized earnings.

-       You're getting a management team with skin in the game in the form of an 11% equity stake, as well as a PE sponsor with experience in the industry. The PE sponsor bought in less than a year ago, at a cost basis not too far from today's price.

-       The stock offers a fair amount of optionality since expectations are low, operating leverage is high and chance of something going right is mispriced.

-       The primary risks are leverage and short-term negative results, as well as continued stagnation in Pollo/Taco profits. I believe that these risks are reasonably accounted for in the valuation.

Catalyst

-       Continued improvement in SSS at Pollo Tropical, recovery of BK SSS.

-       Continued debt reduction, which accretes to the equity.

-       Return to unit growth in 2011.