¦ MRT trades at about 4x normalized EBIT or about 50% of replacement cost
¦ MRT is unlikely to violate debt covenants; even so, a violation would cause minimal impairment for equity holders
Morton's Restaurant Group (MRT) owns 77 high-end steakhouses under the "Morton's" brand. These restaurants are generally located in metropolitan locations, with all but five in the United States. Approximately 35% of the company's sales are from prime beef and 30% are from alcoholic beverages. Eighty-eight percent of sales are from dinner guests and 19% are from private dining. The average check is about $98, and about 80% of sales are believed to be business related. Morton's also owns the Trevi Italian concept in Caesars Palace Las Vegas.
Before you go any further, just know that this is not the sexist idea ever posted on VIC -- so if you like Bill Ackman-esque pitches that involve the creation of multiple LLC's and require several law firms to understand than this is probably not for you. However, if you like buying simple, well run business at (very) cheap prices, than keep reading...
Key Investment Factor 1: Very cheap on normalized earnings
Morton's (as is the case with most restaurants) is best thought of as operating in a perfectly competitive industry where free entry and exit cause midcycle excess returns on capital to approximate 0%. Thus, the normalized earnings power value of these businesses should about equal the replacement cost of the assets. Investment opportunities arise when these businesses trade at a substantial discount to normalized earnings power value/replacement cost (Greenwald's Value Investing chapter 3 offers a good discussion of this concept).
Such is the case with MRT, as shown in figure 1 below. The normalized cash flow to the firm is about $25mm/yr, which would imply a return of about 9% on MRT's replacement cost of ≈$265mm ($2.5mm per restaurant x 77 units + historical cost for the company's owned real estate and Italian concepts of $21mm + a conservative estimate of $50mm for the company's brand and intangible assets). At a 9% cost of capital, this implies 100% upside for the firm value, or over 250% upside for the equity.
Figure 1: Normalized Earnings of Current Asset Base
Cost of sales
Marketing and promotional expense
Restaurant level profit
General & administrative
Depreciation & amortization
Reported proforma operating income
+ D&A + other non-cash charges (ex stock comp)
- Maintenance capital
= Cash operating income
Normalized NOPAT (34% tax rate)
Perpetuity value (9% cost of capital)
- Debt & other net liabilities (assumes $10mm paydown in 4Q)
= Equity value
Implied Value Per Share
Other key valuation assumptions include:
1) Normalized average unit volumes of $4.15mm - Previous midcycle level of about $4.1mm + modest 2% annual inflation adjustment - 10% to reflect unusual strength of the previous cycle.
2) Normalized operating cost per unit of $2.1mm - Based on conversations with industry participants and historical relationship between incremental sales and labor.
3) Annual maintenance capex of $50k/unit - Based on conversations with management and industry participants.
Of course, it is not enough to assume that Morton's should earn its replacement cost by divine right (indeed many restaurant chains are permanently worth far less than replacement cost). Failure to earn the replacement cost in a perfectly competitive industry is inevitably the result of three factors, none of which I believe applies to MRT:
Declining Businesses - Several restaurants have suffered long-term secular decline as their concepts fail to meet changing consumer preferences (Buffets, Sizzler, Golden Corral, etc., are recent examples). Morton's, however, remains a highly relevant concept, and there is no reason to believe that this will change any time soon. My conversations with people in the industry lead me to believe that the decrease in traffic over the last couple of years is due to cyclical, not structural, factors and that the general attitude toward corporate entertainment spending has not materially changed.
Oversupply - I don't think there is reason to believe that any current oversupply situation for prime steakhouses is materially higher than would normally be expected in a recession. Over the last several years, MRT's restaurants did not perform worse than expected under the economic conditions, nor did the sales relationship with macro variables such as airline travel or hotel occupancy materially change, as would be expected in an oversupply scenario.
Incompetent or Poorly Incentivized Management - Not an issue here.
Key Investment Factor 2: Don't fear the debt
Morton's has about $70mm of debt outstanding under a revolving credit facility. The most restrictive covenant is a 5.25:1 leverage ratio. Frustratingly, MRT does not give examples of how this leverage ratio is calculated or even disclose exactly where the ratio stands. However, looking at the credit agreement, I believe that it is possible to get close to deriving the calculation. Accordingly, I believe that there would need to be continued negative comps in the mid-to-high single digits for 2010 in order for MRT to violate its leverage covenant. Such continued negative sales performance is clearly not impossible; however,the continued negative comps required to trip a covenant are unlikely. Even if a covenant violation does occur, it is unlikely to be overly harmful to equity holders,for the following reasons:
Continued credit amendments/rent concessions are the most likely outcome - MRT's credit facility is held mostly by Wells Fargo, J.P. Morgan and RBC. In the event of a technical default, it is highly unlikely that these banks would go through the hassle or expense of pushing MRT into bankruptcy, seeing as the debt is most likely marked close to par on their books. Even if business does not improve over 2009, MRT could still repay at least $15mm of debt per year ($2.5mm of net income + $15mm of D&A and other noncash charges + $2mm of stock comp - $4mm in maintenance capex). Thus, these holders would likely prefer to amend the credit facility as they have already done once. Furthermore, MRT could likely to continue to negotiate rent concessions in order to meet the required leverage ratio. Industry contacts I've spoken with believe that MRT has significant leverage in rent negotiations and should be able to continue to lower its rent expense.
MRT could easily raise capital to repay debt - Several consumer companies in risk of technical default (WFMI, RUTH, etc.) have raised capital in the form of equity or preferred stock. I know for a fact that there would be competition among investors for this deal. Such a deal would likely cause minimal harm to equity holders.