Description

The casual dining industry is facing a major shakeout as guest counts are down sharply and high food prices are squeezing margins.  Historically, quick-service chains and ultra-high-end restaurants have fared okay during economic slowdowns while everyone in the middle gets squeezed, with low-end casual dining spots suffering the most pain.  The market knows this and has pummeled casual dining companies such as Denny’s (down 35% YTD), Steak n Shake (down 38% YTD), Ruby Tuesday (down 31% YTD) and Ihop/Applebees (down 37% YTD).  My best idea from this wreckage is a chain of Texas cafeterias called Luby’s that I’d like to tell you about.

 

Luby’s is one of the few public restaurant companies out there that owns its own real-estate and has no debt.  It operates 121 restaurants, owning the ground and buildings for 94 sites.  The company has invested a tremendous amount of money updating its store base (remodels, kitchen overhauls, POS overhauls, etc) in recent years (an average of about $375k per restaurant over the period from 2005 to 2007).  Luby’s is also cheap, trading at 5.5x FY 2007 EBITDA minus maintenance capex.  The company is well-run by successful Texas restaurateurs Chris and Harris Pappas (who have recently been buying shares) and best of all, the actual product is very very good.  Luby’s sells surprisingly good food at low prices and we expect them to open new restaurants and gain share from competitors over time.      

 

https://www.lubys.com/07menuCombosnew.asp

 

Company Background

 

Luby’s was founded in 1947 in San Antonio, Texas and is currently based in Houston.  The food is served in a cafeteria-style manner, with premade entrees and side dishes displayed for the customer to see.  Luby’s shares traded as high as $25 in the late 1990s, but margins shrank and the debt load caught up with them.  By the early 2000s, the company was faced with $125mm of long term debt, declining earnings and a stock price under $1.

 

In March 2001, successful restaurateurs Chris and Harris Pappas swooped in with $10mm of convertible debt financing and assumed the roles of CEO and COO of Luby’s.  The Pappas brothers toiled for two years with little success. They tried some special promotions with some new all-you-can eat concepts and they also revamped the menu with more updated and upscale food offerings.  By 2003, the debt problem was critical and Luby’s embarked on a major effort to reduce debt by closing underperforming stores and selling real estate.  Luby’s closed about 50 underperforming stores in 2003 and another 21 sites in the following three years.

 

In late 2003, Luby’s embarked on an aggressive advertising campaign, “Luby’s Tastes Like Texas, Feels like Home.”  The ad campaign started paying off in early FY 2004 when same-store sales turned positive and stayed very strong for three straight years.  It took a long time for the Pappas brothers to strike gold, but everything seemed to come together after the restructuring in 2003.  The ad campaign brought new customers in (and old customers back) to try the new food offerings.  The biggest change in the menu was the addition of targeted “value meals” with one entrée, two sides and a choice of bread.   

 

Good Management

 

One thing that gives me great comfort with this investment is the track record of the Pappas brothers.  Chris and Harris Pappas are genuine operators, having found success launching their own casual dining concepts (across various genres from Mexican to Cajun) as well as running franchised QSR restaurants and even high-end steakhouses.  Luby’s is their attempt to rejuvenate the southern cafeteria, once a very popular regional concept. 

 

The restaurant industry, particularly in the casual dining segment, is very competitive and littered with many failures.  Yet successful chains can be massively profitable and can invest capital with high rates of return for long periods of time if their concept resonates with the consumer.  Success as a casual dining operator requires a focus on your core business, your core food offerings and what separates them from the offerings of your competition.  As Chris Pappas explains, once you have isolated your competitive edge, you need to stay focused on it with a passion, but you must innovate and improve your product so it can maintain its edge over time. 

 

I believe that Luby’s has a nice little niche in the competitive landscape between quick service, casual dining, and prepared foods departments at upscale grocery stores like HEB.  Customers are getting more sophisticated about what they eat and how healthy their food is, and I think that Luby’s can benefit from this transition over time.  Industry research shows that Luby’s has more repeat customers than other casual dining chains, so the average Luby’s customer has a lot of loyalty and goes for many repeat trips. 

 

The Pappas brothers’ long-term successes across genres speaks to their ability to manage restaurant operations, develop good menus, choose good real estate, build good store-level teams and drive guest counts over long periods of time.  Their work with Luby’s is particularly impressive.  In the late 1990s, Luby’s cafeterias served room-temperature Aramark-esque meals (like ground beef patties with canned peas and instant mashed potatoes) to an elderly customer base.  (Texas politicians still talk about carrying the “Luby’s vote.”)  The Pappas brothers replaced the large vats of defrosted vegetables with a state-of-the-art food delivery system driven by touch-screen computers that show recipes and guide the timing for producing each batch of fresh food.                       

 

Growth Opportunities

 

Now that the Luby’s turnaround is complete, debt has been eliminated and unprofitable sites have been shuttered, the Pappas brothers are looking to expand the chain with a newly designed Luby’s restaurant.  There are photos of the new Luby’s prototype in Cypress (a Houston suburb) here: 

 

https://www.lubys.com/WhatsNew.asp

 

After years of contracting, Luby’s has an opportunity to expand into the newer suburbs it has missed out on for years.  The company retains its good brand name and the first new prototype, which opened last year, is generating revenues at a $3.25mm annual pace (well above the system average of $2.5mm). 

 

Another opportunity for Luby’s to grow its sales and profits is its new culinary contract services business.  The Pappas brothers have exported their cafeteria food production systems from Luby’s restaurants to healthcare facilities in Houston such as the Baylor College of Medicine.  Photos of the Baylor operations are viewable at the above link.  This segment of the company landed its first contract in 2007 and has now generated about $7mm in trailing revenues and $800k in segment operating income.  Luby’s is gaining new contracts very quickly for obvious reasons: 1) the Pappas brothers are respected names in the Houston community and have many contacts on hospital boards, 2) cafeteria-style dining is a natural extension of the business Luby’s is mastering at its restaurants and 3) the Luby’s cafeteria product is significantly more appealing than cafeteria food from Aramark and other incumbents in the space. 

 

Perhaps Aramark is a good case study for thinking about the food services industry and how private equity funds have affected the competitive landscape.  Restaurant companies like OSI have leveraged themselves to the gills and sold off all their real-estate, and operators like Aramark have unionized labor and multi-billion dollar debt loads.  Luby’s should have no trouble gaining share from them in local Texas markets. 

 

Ramius Proxy Fight

 

The Luby’s story took a curious turn in mid-2007 when activist investors Ramius Capital filed an angry 13-D stating that the company had $180mm to $218mm of after-tax real estate value (current TEV is about $160mm) and should immediately do a sale-leaseback and pay a special dividend and/or buy back shares.  Ramius also outlined its concerns about conflicts of interest between the Pappas private restaurants and Luby’s, and how management allocates its time between the two ventures.  The stock was at $10 and climbed up to $12 shortly thereafter.   

 

While management valued the flexibility afforded by owned real-estate and no debt, Ramius complained about an over-capitalized balance sheet and launched a proxy-fight when Luby’s rejected the sale-leaseback proposal.  A lengthy and expensive battle ensued that resulted in Ramius’ slate of directors being defeated by shareholders (the Pappas brothers owned about 25% of the shares at the time).  Ramius and its hedge fund brethren blew out of the stock after losing the vote.          

 

Valuation

 

At $6.40 a share, Luby’s market-cap is about $180mm.  With a cash balance of $17mm and no debt, our TEV comes out to around $165mm.  The company also owns $9.5mm in auction-rate notes which I’m not deducting from TEV.  EBITDA last year was about $33.4mm.  This year, Luby’s will probably do about $20mm in EBITDA.  The Pappas brothers have stated that this particular slowdown is in many ways the worst slowdown they’ve ever seen in the industry (they’ve been restaurateurs since the 1950s), and they are committed to giving value to their customers and pricing below its casual dining competitors.  At current levels of profitability, the company is generating cash and its EBITDA minus maintenance capex (which I estimate at $45k per site per year) multiple is about 11x.  Its multiple of 2007 EBITDA minus maintenance capex is under 6x. 

 

Additionally, the company owns 94 restaurants on owned land, as well as an additional 24 restaurants on long-term ground leases.  Recent sales of owned Luby’s restaurants in 2005 and 2006 went off between $900k and $1.3mm.  And sales of Luby’s restaurants on ground leases have gone for as much as $800k.  As Luby’s restaurants have been culled less for real-estate value and more because of underperformance, I assume that the current store base is relatively valuable compared to many past sales.  Some of the owned sites I have visited in San Antonio, such as the restaurant on 1604, are likely worth several million dollars. 

 

So at current market prices, you are getting a company trading at 6x last year’s EBITDA minus capex, 11x times very depressed current EBITDA minus capex.  Additionally, you have growth opportunity through the culinary contracts as well as new store openings.  On top of all of this, Luby’s has no debt and a restaurant base that is mostly owned buildings on owned land.  In the past 2 months, the Pappas brothers have bought 312,000 shares on the open market. 

 

Conclusion

 

One of the more enduring clichés in business literature is the likening of business competition to Darwinian evolution through a process of natural selection.  Viewed through this lens, the business world is a gradually evolving ecosystem where the strong players slowly dominate and weaklings are routinely cast aside.  Scientists now know that nature is not so orderly.  Gene pools are relatively stable over time with a little give and take from regular volatility in weather conditions (which drive food supplies etc).  It takes massive shocks to the system like once-a-century floods or droughts to drive natural selection and dramatically reshape populations.  Rather than a gradual process, evolution happens very quickly and mostly to species facing significant duress.

 

While these times can be fun and exciting for us value investors, they are brutal and unforgiving to restaurant operators and retailers who are competing for their customers’ dollars.  As this process unfolds, we will continue to see a massive shakeout in these industries.  In the end, the best operators with the more convincing value proposition and the most financial flexibility will survive and ultimately prosper.  Luby’s and the Pappas brothers have been around for 50+ years and they will come out of this storm stronger than ever.  I’m happy to be an owner of this business at $160mm.

Catalyst

- author tells everyone he knows that this stock is silly cheap
- everyone he knows says, "yeah, but this is dead money for a long time, brother"
- author says, "what? and you own freakin' Sears? c'mon dude! buy buy buy"
- everyone he knows says, "patience young jedi, we have time. . . and I am short european financials"