Description

Mexican Restaurant Group trades at 5.5xs EV/EDITDA, enjoys the inherently strong margins you would expect from margaritas and burritos, has six consecutive quarters of same-store sales growth, has a nearly recession proof business, has large insider ownership, has aggressively bought back stock close to the current share price and recently announced a $1 mm share buyback. 30% of the stock is owned by an extremely well regarded value manager and CASA board member David Nierenberg who added to his position last week. The only negative to the story is that the stock is thinly traded, so it would be most appropriate for small funds or personal accounts.

We calculate downside risk to be about $1 as the company has aggressively bought stock at those levels, with their most recent buyback done at an average of $8.8. So, we figure there is 10% downside risk, with 70-100% upside (9-11x EV/EBITDA). The story is similar to that of the fine write up of MAIN by Oliver1216 which appreciated over 100% in just a few month (EBITDA doubled from 5 to over 10). In fact, MAIN was featured in a recent Street.com article as a stock that could double from here. We think the same sort of appreciation is very likely to occur with CASA (although not necessarily that quickly), as the company continues to grow and execute their business plan while buying back shares.

The company is quietly executing their business plan, generating enormous free cash flow and buying back shares. Our suspicion is that the company will be brought out by a private equity firm at some point in the not so distant future. They don’t have any analyst coverage, don’t have an IR firm/person, don’t even have an investor presentation or do conference calls. The management team is solely focused on operating the business well, generating cash and buying back stock.

As the company is generating strong amounts of FCF, the balance sheet is very healthy, especially for a restaurant. Debt ($6.5 mm) is less than 20% of EV, and they have been paying it down.

The CASA story is pretty simple. The company was originally incorporated in February, 1996 under the name, Casa Ole Restaurant, Inc. Over the last eight years, CASA has made three significant purchases, along with a few smaller purchases and restaurant openings. CASA currently operates 61 company owned restaurants, 18 franchises and 1 licensed restaurant. The company’s restaurants are primarily in the South/Southwest under names such as Casa Ole (operating for 32 years), Monterey’s Tex-Mex Café and Monterey’s Little Mexico (49 years), Tortuga (10 years), Coastal Cantina (17 years), La Senorita (25 years) and Crazy Jose (17 years). In January 2004 the Company purchased 13 restaurants and related assets from its Beaumont franchisee. They paid $13.7 mm for the restaurants and then sold the underlying real estate for $8.3 mm. While those restaurants were nicely profitably, they were considered underachievers, and CASA’s management skill has already improved operations significantly. Given the concentration of restaurants, management is able to continuously leverage their marketing dollars to drive same-store sales growth without cannibalizing their existing restaurants.

The broader trends are also very favorable for CASA. According to management, over $1 billion of Mexican food is consumed annually within a 150 mile radius of Houston. With the growth of the Hispanic community in the Southwest, these trends will only increase.

The company is currently on a measured growth plan, selectively adding to its lineup of restaurants. The restaurants are primarily located in small and medium sized communities and the middle income areas of larger cities.

The company aims to the value leader in the Mexican-themed, full service casual dinning space. The average restaurant is approximately 4,500 square feet, with a capacity of approximately 180. The menu is a traditional Mexican one, with a clean, family environment. The company can do well in difficult times, as a family can eat at one of low-end restaurants for about as much as it would cost to cook at home. Most dinner entrees are priced between $5.95 and $9.95 with most lunch entrees priced between $4.99 and $8.95. Recently, several casual dinning restaurants (Red Robin, Ruby Tuesday, etc) have experienced some weakness, but CASA has not seen that. Typically, when times are tough, CASA has held on to their customers as their prices are competitive with eating at home, while picking up new customers who are searching for a less expensive option.

CASA’s restaurant economics are very attractive. According to the company, their prototype restaurant generates approximately $1.5 mm in revenues with a net profit of approximately $250k. Cash costs to open a new restaurant are approximately $500k (they limit costs to $550k), so cash on cash return is 50%. Upon opening, revenues can go higher during the honeymoon period, but then settle into the approximately $1.5 mm level petty consistently. The Beaumont purchase was typical of their metrics, as they disclosed the 13 restaurants they purchased (which were poorly run by the franchisee) generated over $20 mm in revenue the following year. Their franchises pay them between 2-5% of gross revenues and contribute another 2.8% into a general fund used for marketing. While obviously the franchises are not as profitably as the company owned restaurants, they represent little risk, cap ex. etc. Management expects G&A, as a percentage of sales, to trend down a bit over the next few years. In a few years, they will probably need to hire one more field supervisors to oversee the 1-2 new restaurants per year they will plan on building.

Importantly, the company only opens new restaurants very judiciously. They do enormous amounts of research, along with a consulting firm on retainer before they proceed with any new restaurants. They use a variety of demographic and financial models, and only open restaurants they think have an outstanding chance of matching their prototype model. Their aim is to only open 1 or 2 new restaurants per year, waiting for that fat pitch in the middle of the strike zone. The incremental new restaurants are valuable as an additional $250k to free cash flow or .08 per share.

Due to large amounts of depreciation and amortization it is a free cash flow story not an EPS story. In Q2 alone, there were significant depreciation and amortization expenses which rose 100 basis points to 3.4% due to remodeled restaurants, new restaurants, and the replacement/updating of equipment and leasehold improvements. There were also charges for asset disposition including the building from the Beaumont stores. In Q2 depreciation was $699k and 2.3 mm over the past four quarters, while there was a $131k charge for the Beaumont building.

We think there is very little risk in the story. As the company operates a simple business (Mexican food) in restaurants that have been profitable, in some cases for decades. The company has bought back shares in the past, and have announced a major $1 mm share buyback this past May which should provide a strong floor to the stock. The company has experienced six consecutive quarters of same store sales growth, while total revs grew 5% in the last quarter. As the company is starting to operate more efficiently, they are opening new restaurants at a measured paced. They announced that their newest restaurant is greatly exceeding expectations and setting weekly company records.

In addition to the lack of liquidity (partially explaining the valuation), there are few negatives to the story. In terms of investment risks, CASA assumes the ones typical in the space: rising food and energy costs, etc. They have some adjustable rate debt which would go up if rates continued to rise aggressively. However, the company has been paying down debt, they have paid down $500k so far this year, and have announced they are planning on paying down another $500k, using cash from operations this year. We would have preferred not to have seen the CEO and CFO sell some shares here. However, in speaking with them they are adamant it was done for personal reasons and is not reflective of their opinion on the prospects for the business. They describe themselves as working stiffs with most of their net worth in the company. In our minds, that concern has been offset by Nierenberg buying their shares.

In terms of additional catalysts, the company has announced that they are planning to moderately remodel several restaurants in the last half of 2005, and significantly remodel one restaurant. In the past these, remodels have lead to greater operating results. They will also being opening one new restaurant in the second half of 05/early 06, and are currently negotiating a lease for a new site.

In terms of comps, there are relatively few low/mid Mexican restaurant comps. However, most restaurants, including casual dinning ones, trade at significantly higher valuations. Small cap casual dining comps include:

Company EV/EBITDA EV/REV

CASA 5.5 0.5
BOBE 8.7 0.7
IHP 9.8 3.1
DENN 8.4 1.0
CHUX 8.5 0.6
DAVE 10.7 1.2



In sum, CASA represents a terrific risk/reward opportunity with very limited downside and significant upside. The stock is incredibly cheap right now and with multiple catalysts in place the stock could easily appreciate 70%-100% over the next year. We feel that the stock is getting closer to an inevitable buyout, most likely by a private equity firm. Their steady cash flow from company-owned and franchised restaurants, derived from decades of operations could be very attractive to a private equity fund, especially with the opportunity to add debt. The company is extremely well run, and management takes pride in running operations as efficiently as possible. CASA could also be very attractive to a restaurant group or another strategic buyer.

This is a classic example of a company that derives no benefit from being public, especially in these SarbOx days. The company has little debt, and no need to raise additional capital, given their measured growth plan. Much of the heavy work is done and with the company starting to hum operationally, many shares having been bought out and past acquisitions are being successfully assimilated - it is only a matter of time. This can be demonstrated by the laser-like focus management has on improving the business, with a total indifference to short term stock price movements. Without even providing quarterly calls, clearly management is not concerned about the stock price, knowing the exit strategy is probably already defined. This could benefit investors buying the stock here. In the meantime, we are happy to see free cash flow grow, and stock get retired.

Catalyst

1. Extremely low valuation.
2. Continued strong free cash flow generation.
3. $1 mm share buyback program.
4. Strong results from new restaurants.
5. Increased population in Houston area.
6. Recent insider buying.
7. Excellent candidate and potential timing for private equity buyout.
8. High probability of shareholder value being recognized with David Nierenberg owning 30% of the stock and serving on the board.