Short DFRG: A Broken Growth Story

$10 Price Target

I will try to keep this brief with minimal background as the business isn’t complicated. Del Frisco’s operates  up-scale steak chains under three banners (Double Eagle, Grille and Sullivan’s). Since its IPO in 2012, it has been marketed as a unit expansion growth story. Despite continued poor performance and unfulfilled expectations, the Street is still trying to sell this story. In the few years as a public company, DFRG has changed strategy multiple times. Opening and closing locations is an expensive endeavor and the lack of operating success augurs poorly for future expansion efforts. This is a broken growth story that will continue to disappoint in near-term (comps) and over long-term (because unit expansion in a highly saturated market will ultimately yield poor returns). Mgmt. uses “adjusted/non-GAAP” earnings” liberally and yet still misses these managed expectations. To boot, the company recently disclosed a material weakness in financial controls and had to delay their 10-K due to a routine sale-leaseback transaction. This short is predicated on a continuance of poor operating performance (comps) which are not reflected in DFRG’s valuation. The past several quarters have seen poor results, but after an initial decline following earnings, the stock seems to drift higher on hope for improvement.

My base case target is $10 which equates to 15.0x the low-end of management’s ADJ 2018 EPS guidance. Since I am arguing that DFRG will likely miss estimates (or “adjust” the downside out as they have done in the past), could alternatively look at valuation as a higher multiple on lower earnings, e.g., 20.0x 2018E GAAP EPS of $0.50. Either way implied downside is roughly 40% from current levels. I believe upside is limited to ~20%, getting to an attractive 2x skew to the downside.    

Company Overview

DFRG operates 53 high-end restaurants under the following banners: Del Frisco’s Double Eagle Steakhouse (“Double Eagle”), Del Frisco’s Grille (“Grille”), and Sullivan’s Steakhouse (“Sullivan’s”). DFRG’s model is 100% operated.

Del Frisco’s Double Eagle Steakhouse:

-Currently 13 Double Eagle steakhouses in nine states and the District of Columbia

-Range in size from 11,000 to 24,000 square feet

-Development cost (ex. LL TI and equipment financing): $7 to $9 million

-Annual AUVs: $13.6 million

-Average check: $116

-Restaurant level margin: 26.5% (28.1% in 2016)

Del Frisco’s Grille:

-Grille was developed in 2011 to provide greater potential for expansion

-Smaller size, lower build out cost and more diverse menu

-Currently operate 24 Grilles in 12 states and the District of Columbia

-Range in size from 6,500 to 8,000 square feet

-Development cost (ex. LL TI and equipment financing): $3.5 to $4.5 million

-Annual AUVs: $4.9 million

-Average check: $46

-Restaurant level margin: 13.2% (14.8% in 2016)

Sullivan’s Steakhouse:

-Sullivan’s was created in the mid-1990’s as a complementary concept (more accessible price point)

-Currently operate 16 Sullivan’s steakhouses in 13 states

-Restaurants range in size from 7,000 to 11,000 square feet

-Development cost (ex. LL TI and equipment financing): $3.5 to $4.5 million

-Annual AUVs: $3.8 million

-Average check: $65

-Restaurant level margin: 15.7% (15.7% in 2016)

Sullivan’s comps have recently been in a free fall, exacerbated by the elimination of lunch at certain locations. Overall, it is important to note that comps at Double Eagle have been strongest. In 2017, Double Eagle was flat, Grille was -1.6% and Sullivan’s was -6.1%. For 4Q, Double Eagle was +1.2%, Grille was +0.9% and Sullivan’s was -10.8%. In 4Q, negative traffic was offset by higher check at Double Eagle and Grille.

Due to the poor performance at Sullivan’s, DFRG recently announced it is seeking strategic alternatives including the possible sale of the chain. This follows previous comments from mgmt. on franchising the concept. I view the possibility of a sale of Sullivan’s at attractive terms extremely unlikely given the lack of brand identity, poor economic model and recent comps.

Valuation

View P/E as the most relevant valuation metric because the significant depreciation and other real expenses over time required to operate the business should not be ignored. DFRG leases all of its locations and the build-outs can be expensive.

At the midpoint of mgmt.’s 2018 ADJ EPS guidance ($0.71), the stock is trading at 22.5x. On DFRG’s heavily adjusted 2017 EPS of $0.75 (basically ex. anything bad), stock is at 21.3x. So expensive even if you give them credit for all the add-backs. On a more realistic accounting where expenses incurred as a normal part of the business are actually run through the income statement, 2017 EPS shakes out around $0.53, implying a multiple of 30.3x on 2017 EPS. Note that this assessment adds back the asset impairments, accelerated depreciation and eliminates the benefit from change in gift card breakage estimates. Since they impaired a significant amount of assets, 2018 earnings are aided by $2 million (~$0.10 per share) in lower depreciation expense in addition to the lower tax rate. DFRG’s 2018 ADJ EPS guidance assumes an effective tax rate of just 10%-15%. Consensus EPS for 2018 is $0.68, increasing to $0.93 for 2019, implying a big jump in the out-year. DFRG is currently trading at 17.2x 2019 EPS (these broker estimates give mgmt. credit for the multiple add-backs). I view 2019 consensus as extremely optimistic and expect it to come down as the year progresses. One broker has 2019 EPS jumping to $1.00 from $0.70 in 2018 on outlandish revenue growth expectations of 20% (and a 12.5% tax rate). This same analyst expected 2018 EPS of $1.13 a year ago (now expecting $0.70). As a rule of thumb, each 1% change in SSS equates to ~$0.06 in annual EPS.     

On an EBITDA and EBIT basis, valuation also screens expensive with room for downside on both estimates and multiple. I am using broker estimates (likely optimistic) for EBITDA of $37 million for 2018 (a decline from 2017 EBITDA of $47 million which benefits from the same add-backs as EPS). 2019E EBITDA is $47 million. EV/EBITDA is 9.5x on 2018, and 7.4x on 2019 estimates.

Take-outs in the industry have historically been executed at multiples of 5.0x-12.0x. So there is a risk that a PE firm takes a risk by overpaying for DFRG and betting on a turnaround. However, even at an extremely aggressive 10.0x multiple, implied stock price is only $17. For reference, 2018E EBITDA of $37 million is lower than the company’s 2012 EBITDA of $39 million. The company’s expansion has not panned out.

In terms of EBIT, 2018/2019 estimates are $16 million and $21 million, representing a decline from 2017 EBIT of $23 million. EBIT/EV is 4.6% on 2018 and 6.0% on 2019 estimates.

Closest comp (Ruth’s) trades at an 18.3x/17.9x P/E for 2018 and 2019, with wider peers at 19.4x/17.3x. Ruth’s Hospitality Group (Ruth’s Chris) trades at 11.7x/11.4x EV/EBITDA for 2018/2019, with wider peers at 9.8x/9.4x. DFRG deserves to trade at a material discount to RUTH. Ruth’s has leading brand recognition, is ~3x the size of DFRG, has a much better track record and also franchises half of its locations (significantly higher multiple earnings stream).

Note that all of these estimates assume the Sullivan’s locations remain for the entire year. If a sale were to occur, there would likely be a material decline in earnings (would take a lot of time to redeploy the proceeds). Margins would also take a hit due to G&A deleverage.

Fundamental Drivers

Comps are the most important metric for DFRG. Traffic trends have been poor and higher check has offsetting some of that impact. This will not continue. For the company as a whole, comps have been negative for the past three years (-2.0%, -0.8% and -0.6% in 2017, 2016 and 2015, respectively). Comps grew 1.9% in 2014 and 1.3% in 2013. Recently, the negative comps have been driven by declining traffic partially offset by higher pricing. Not exactly exciting growth. Meanwhile, average sales per comparable restaurant have declined every year since 2014. The metric declined 8.3% in 2017. While the unit count has grown from 40 at YE 2013 to 53 at YE 2014 (comp. unit base from 30 at YE 2013 to 46 at YE 2017), revenue growth continues to decline (+11.0% in 2014, +9.9% in 2015, +6.0% in 2016, +2.6% in 2017). Again, not exactly a compelling growth story.

Cumulatively, since 2013, revenues have grown by 32.7% or $89 million. Over that time frame DFRG has spent over $200 million in capex. Due to the heavy capex requirements from the restaurant build-outs, the company does not generate any free cash flow. And recall that this capex only covers the improvements (very low residual value), not the actual real estate (which is leased). Since 2013, cumulative free cash flow has been less than $10 million. Further, many of these investments have proven ill advised as the company has taken impairment charges of just under $50 million since 2013. A meaningful portion of this amount is from recently opened locations which have since been shut down.

I believe the heady cash-on-cash returns on unit expansion presented by mgmt. are untethered from reality. For example, the company’s brand new (and expensive) Chicago Double Eagle location was recently impaired. DFRG removed the restaurant from the comp base and sunk more money into improvements for a champagne room, shutting down briefly for renovation. Apparently, the problem was that they didn’t spend enough money. On a recent weeknight at 6:30, the massive restaurant floor was empty except for one table and a private room. What would the comp number have been if the poorly performing location was included in the base prior to closing for renovation? Similar renovations have been done at other locations where poor performing restaurants have been removed from the comp base due to short periods of downtime. This is purely conjecture but it feels like there is a possibility that comps have been goosed by mgmt. taking poorly performing locations out of comp base for remodel/redevelopment. The management team clearly understands how the Street game works and what analysts want to see/hear from DFRG. Hence the “growth stock” label and “beating” heavily adjusted earnings expectations.   

I don’t have a strong view on restaurant margins and any potential deterioration is not part of my short thesis. I will note however that DFRG faces headwinds from labor and could also be impacted by rising food costs. I don’t take a stance of food costs because that could swing either way and DFRG’s customer base is more price insensitive than others. Given the revenue trends and store closures, G&A margin pressure from deleverage is also relevant. One thing is clear, mgmt. has proven its inability to control costs. All of these potential negatives would be additive to the thesis.

Capital Structure

At first glance, it appears DFRG has a healthy balance sheet. The company has relatively little debt on its balance sheet (~$25 million as of 12/31/17). However, the company leases all of its locations, so leverage is much higher than advertised. After accounting for the off-balance sheet lease obligations with a gross obligation of $408 million. On a present value basis, this shakes out to roughly $300 million. On a lease-adjusted basis, Debt/EBITDAR is 4.5x for 2017 and 5.2x for 2018 (using broker estimated EBITDA). By next year, these lease obligations will all need to be consolidated onto the balance sheet.    

With the announced unit expansion, capex is expected to approximate $55 million in 2018 and 2019. Operating cash flows have been relatively consistent around $30-$50 million over the past 5 years but will likely not be sufficient to fund this growth. Assuming $45 million in OCF the next two years that represents a funding need of $20 million which would come close to maxing out the current revolver.

The company has a buyback authorization in place for $50 million of share repurchases. Since the IPO, DFRG has repurchased $58 million of stock at an average price of $15.93. Given the need to fund expansion and limited flexibility on the revolver, material buybacks would stretch DFRG thin. Nonetheless, I would not be surprised to see a modest level of buybacks given the track record here which I think has more to do with signaling than capital allocation.

Industry

DFRG operates in a saturated core market (high-end steak chains). The core customer is dining on a corporate expense account. Competition is fierce and the pie is not growing, so it is a zero sum game. Following tax reform, the Street became optimistic on an inflection in comps. This is a meaningful benefit for DFRG, however, it is mitigated by the loss of corporate tax deduction for entertainment expenses. The principal competitors are other upscale steakhouses including local independents and chains such as The Capital Grille, Smith & Wollensky, The Palm, Ruth’s Chris, Morton’s and Fleming’s. I personally believe competition among steak chains will be worse because corporate events are increasingly drifting away from the classic steak closing dinner or team building event. Steak chains are also increasingly out of favor with younger diners who value local and authentic experiences.  

The growth story at the IPO was the Grille, now it is Double Eagle. The underlying problem is that not many large cities have a market need for another “ultra” expensive steak house. Only a handful of markets make sense. For reference, the New York City Double Eagle currently represents ~11% of company sales.

Management

There has been significant turnover in the C-suite since the IPO. Currently this a great example of a mgmt. team that spends freely with shareholder’s money. Recent examples include a new operations facility in Texas, a $3 million consulting project (with overhead of ~$30 million shouldn’t mgmt. be able to do this in-house?), poorly conceived unit expansion, almost $1 million in “non-recurring” legal fees and a donation to the Houston food bank of $0.8 million. What’s more important is that mgmt. does not seem to understand the incredibly poor return on these investments. Six restaurants were impaired at year-end 2017, five of which will be closed. DFRG spent a significant amount of time and money on putting together a franchising model for Sullivan’s over the past few years and now it seems to be ditching that plan.  

From the latest proxy, it is clear that the leaders of the company have very little skin in the game. Ownership is low and results mostly from stock options. Mgmt. seems to be paid well regardless of performance. Bonuses are largely tied to achievement of adjusted EPS that excludes anything bad and there is a huge delta between GAAP and ADJ results (see below).

From proxy:

Adjusted earnings per share is a non-GAAP measure calculated as our adjusted net income (loss) divided by the weighted average number of shares of our common stock outstanding. Adjusted net income (loss) represents GAAP net income (loss) plus the sum of GAAP income tax expense (benefit), lease termination and closing costs, consulting project costs, reorganization severance, non-recurring legal expenses, easement clearance, donations, non-recurring restaurant expenses, impairment charges and change in estimate for gift card breakage minus income tax expense (benefit) at an effective tax rate of 23% during 2017.

Although we did not achieve our rigorous financial targets for 2017, and our Named Executive Officers earned no payouts under our cash incentive bonus program, in recognition of the achievement of our Restaurant Support Center annual initiatives for the year, the Committee approved final 2017 annual bonuses for each of our Named Executive Officers as follows…

Another criticism of mgmt. is the material accounting control weakness which resulted in a delayed 10-K for a relatively simple sale-leaseback. This was their first 10-K where they had to meet higher accounting/control standards (JOBS Act). To be clear, I am not suggesting a scandal here, but with the amount of overhead at the company, they shouldn’t have these accounting/control issues.

Every quarter there seems to be a litany of excuses for poor performance (e.g., weather, Super Bowl, etc.).

Recent Performance

After reporting poor trends in the summer of 2017, DFRG experienced a huge run up post-3Q results partly driven by optimism for business spending/tax relief. Based on how the stock removes between earnings, it is clear that sentiment is far from washed out here.

Risks/Considerations

A sale to strategic or PE buyer is a risk here. However, it is offset by the unattractive sales trajectory, saturated market and relatively expensive valuation. In addition, Sullivan’s makes the whole company much less unattractive. At an extremely aggressive 10.0x EV/EBITDA multiple on 2018 estimates, implied stock price is only $17. At low-end of historical range (5.0x), implied stock price is under $8. I view PE more likely to get involved if story continues to deteriorate, so that does add a little cushion to the downside for the stock. Though you also would have to take into account that in this scenario (broken story on lower comps), the franchise is going to have a lot less value and thus a lower multiple.

A successful sale of Sullivan’s is another risk. I deem this unlikely given the comp situation and lack of clear brand value. There would also be a big drag from overhead deleverage.

Lastly, my thesis will miss if DFRG is able to buck the trend and turn the ship around and generate higher comps from improved business spending. In this case, s short-term improvement may be extrapolated by the Street, leading to higher estimates and higher unit growth expectations as well. This risk is mitigated by the reduction in tax benefit from T&E expenses, current valuation and elevated expectations. Street expects comp improvement and numbers already reflect that, so improvement would need to be significant. Recently, mgmt. guided to 0-2% comps in 2018.  

THIS REPORT IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE INVESTMENT ADVICE.