Description

Diversified Restaurant Holdings

Diversified Restaurant Holdings (SAUC) is a self help, deleveraging story.  SAUC was written up in the past, but the thesis has changed with spinoff of Bagger Dave’s.  The thesis isn’t all that complicated, SAUC was a successful franchisor of Buffalo Wild Wings (BWLD) and figured that since they did that pretty well they’d go ahead and start their own concept, Bagger Dave’s.  The Bagger was a $&#!show.  It consumed time, attention, and resources.  It was never profitable, it was actually a yuge drag on earnings.  Recently SAUC put the Bagger in a garbage barge, set it on fire and sent it adrift.  So now Diversified Restaurant Holdings is not diversified at all, it is 100% BWLD and that's not so bad.  What’s left is a company with an upside down cap structure, but a pretty low cost one, with a management team that can focus and BWLD franchises that we think can cashflow well enough to reduce the debt burden from 5x to 3x.  We think investors can make money on this as a more focused team can both improve their financial results and reduce leverage.  This is almost a publicly traded LBO in that way.  Management owns nearly 50% and the recently promoted CEO has been making open market purchases, so they obviously have good skin in the game and are signalling confidence on a go forward basis.

The Business

SAUC the largest franchisor of Buffalo Wild Wings.  We don’t love the restaurant business and we would typically prefer to be the franchisor rather than the franchisee, but we think in this situation the economics for shareholders make sense.  BWW is a fairly good concept and differentiated in the marketplace.  It has been through a bit of a rough patch, comp wise (SAUC comps appear to be roughly in line with the parent), and has activist Marcato involved pushing for more franchising and various operational improvements.   

SAUC has 64 BWLDs, which puts them at 11% of all franchisees.  The former CEO/Current Chair won BWLD's franchisor of the year award in 2015, SAUC's COO won it in 2014.  It is safe to say they’re in the good graces of the parent as franchisors.  With Marcato pushing more franchising, that could create more opportunities for the top franchisor in the system.  They are contracted to open another 13 through 2020 in their territory and we think they can support that on the backend due to de-leveraging priorities (management has stated it’s goal to get to 3x EBITDA).  They don't do such a bad job with the franchises they have, with restaurant level EBITDA margins pushing 20%, slightly higher than corporate.  They target a revenue/unit of $3m.  They're below that now, my estimate is about $2.6m, but there's reason to believe they could get closer to the target. They recently, mid 2015, acquired 18 locations in the St Louis area that were apparently under managed, many of the locations could do a lot more revenue and they represent a lever to pull to get the per unit numbers closer to the target.

The Financials & Valuation

The financials with the Bagger are a mess.  We need to tease out what the economics are ex-Bagger.  This is best done by looking at the restaurant level economics and subtracting corp o/h, interest expenses, etc.  The company won't be a meaning cash tax payer for the next few years due to carryforwards.  By bagging the Bagger, they probably do about $22m in EBITDA in 2016 (they guided for 33-35m at BWLD minus 12m of corp o/h).  This was a recent number so it's probably pretty firm.  They think they save $1-2m in overhead costs from the spin going forward, so we have maybe $23-24m as a starting point for 2017.  Improving the St Louis locations could get them closer to $24m in 2017 and to $26m in 2018.  

Starting with EBITDA of $24m we have interest costs of $5.5m and MCX of $6.5m or so.  Most of that capex is the Stadia refresh BWLD corporate is pushing, I will point out Marcato was saying they could do refreshes that are less expensive, so if they get their way maybe MCX is little lower (I don't have a view on that and haven't assumed that happens).  As it stands now, this leaves $12m for growth capex and deleveraging.  They probably don't do a unit in 2017 and only do 1 unit in 2018 at a little over $2m, leaving $12m for debt in 2017.  In 2018, they probably get to $26m in ebitda, have interest costs of $5m, MCX of $6.5m, leaving $14.5m for new units and debt.  Note they have a fairly sizeable NOL (21m federal and 17.6m state as of YE 2015, and they've added to that YTD) and tax credits that will save them in taxes so this is a decent cash flow estimate for the period.   

It currently has about $43m or so in market cap, $120m in net debt,~$21m in EBITDA and a 7.7x multiple.  The multiple on the stand alone business isn’t crazy, and we won’t argue for a higher one, so all else constant all FCF used to pay down debt should accrue to the equity.  Also, every $1m in ebitda also accrues to the equity at a rate of $7m.  It’s credible to believe that with their store commitments, and cost saves from the Bagger spin, that 2018 EBITDA could be in the $26m range.  So as we look out to YE 2018, we have a company that can credibly have take leverage down to $95m and ebitda up a few million dollars.  Holding the multiple constant that means equity is roughly $100m or ~130% higher than today, who knows if they start to execute and deliver they may get some margin expansion and help on the multiple, each turn would be worth north of $20m to the equity.  Carroll's trades about a turn higher and has lower EBITDA margins, though it is considerably less levered and much larger.  I also think if they get improvement in the StL locations EBITDA margins could tick up, but I'm not counting on it.  I think there are a few levers that could see better upside.  See the model below:

Risks

There are a few, the first being the business itself being some sensitive to the tastes of fickle consumers, though wings, beer, and sports aren’t fads.  To their target demographic it might even be described as something of a religion. The second is the relative debt burden today is high, even if the cost of maintaining it is low.  The third is this is the management team that thought up and introduced the Bagger, though I would say that their publicly stated goals and debt load now keep them from doing anything too dumb.  Fourth, spin timelines that they need to Bagger to stay afloat for 2 years before sinking or they could be on the hook for the liabilities, but my understanding is that the leases are the main obligation and locations are pretty good and the terms not so bad that someone wouldn't be interested in them.  

Catalyst

deleveraging

clean post-spin financials

operating improvements in stl portfolio