I think there is still an interesting opportunity in owning OSI Restaurant Partners today in the context of the going private transaction announced on 11/06 by Bain, Catterton, the company’s founders, and the entire senior management team for $40/share in cash. The current offer provides for a return just slightly below current arb spreads, but with a strong possibility for a raised offer. Considering that the risk of a broken deal is very low in my opinion, this is a very safe way to shoot for a 10% plus return in just 3 or 4 months. Using the option market offers a much more interesting risk/reward scenario with the $35 strikes trading just under $5.00 and the $40 strikes at about $.40.

-         $40 deal price is below where OSI began the year despite strong performance by most in the sector

-         The apparent multiple of 8.5 EV/EBITDA seems reasonable on current earnings, but it ignores the seriously depressed earnings of Outback, the growth potential of several of their brands and probable losses of some of their start up brands.

-         EBIT margin has declined just about every year from 14.0% in ’99 to a projected 4.9% in ‘06

-         Due to the margin declines, EBIT is actually down from 6 years ago despite over $1.2 billion in growth capex

-         The companies founders as well the senior management team are part of the deal and will be rolling their equity into the new private company

-         Price negotiation process was not fair to shareholders as the only ones negotiating on their behalf were the independent directors whose loyalties with the founders run deeper than their token equity interest

-         The deal was announced with the most recent data points being

o       Q2 EPS report with substantial cut in guidance based on industry trough same store sales continuing

o       Removing the spin-off of their emerging brands as a consideration

o       An accounting issue with their gift cards that will force a restatement

-         News out of the industry has gotten better yet we still have not received any update on OSI’s operations

o       Same store sales have sequentially improved and valuations are paying more attention to the depressed nature of earnings

 

 

Having posted OSI late last year at a price above the current offer ($41.64), I wanted to first review where I was wrong as well as where I was right.

 

 

The major error I made was underestimating the casual dining slowdown that intensified in the spring of this year and likely reached a trough this summer. The slowdown was just about as widespread and intense as anything the industry has ever experienced. There were basically no companies immune to the slowdown although the severity was clearly greater for some. It is interesting that this all happened while most other areas of consumer discretionary have been spared so far.

 

The other key error I made was ignoring that my thesis was not as unique as I would have liked. There were many at the time that were already buying into the turnaround story and this resulted in a more substantial decline this summer in the face of the weak trends as investors through in the towel. I am not suggesting that this is the reason why the idea didn’t work, just that I overestimated the margin of safety due to the presence of so many believers in the turnaround.

 

 

 I would argue that the premise of my thesis was somewhat validated in that there is tremendous value in the assets and earnings power of this company. The proof of this is that the entire management team, the original founders of the company as well as two private equity firms are teaming up to buy the company at a similar price and are likely to earn an extremely nice IRR for their efforts.

 

 

OSI had discussed on occasion, including their Analyst Day in February of ’06, that their Board was reviewing ways to maximize shareholder value. The implication was clearly on taking on more debt given their balance sheet strength as well as possibly doing something with their emerging brands. Pirate Capital filed a 13D in early June arguing for the company to take aggressive actions including spinning off their emerging brands. In response to Pirate, OSI said in their July 27^th Q2 EPS release that they had hired Wachovia in April to help analyze various strategic actions that included possible spin-offs, leveraging their balance sheet, monetizing their real estate and aggressive share repurchase. However, they had decided that any emerging brands spin-offs were not in the best interest of shareholders and thus no longer a consideration.

 

It was at this time that sales for the industry had reached their absolute though and OSI gave EPS guidance for the remainder of the year for these trends to remain consistent. The combination of the weak sales, very disappointing guidance, and removing any chance for a spin-off, caused the stock to tank (it became evident later that part of the stock pressure was a result of Pirate exiting their entire 5% position).

 

There was only one more datapoint that we have received from them since this July 27^th EPS release and that was another disappointing sales release for the August period (although similar to July trends).

 

The October 25^th EPS release that was to include September and October SSS which had clearly improved for the industry was never received because it was delayed due to an irrelevant accounting issue in regards to their gift cards. The stock fell further on this news and I should note that plenty of restaurant companies with more severe accounting issues have been able to release sales information even when EPS was delayed.

 

Finally, the deal was announced on November 6^th for a cash offer of $40 by an investor group that included all the major founders of Outback, the senior management team of OSI, Bain and Catterton Partners. OSI has not given any sales update since the industry’s trough in August or an EPS update since July 27^th that was predicated on trough sales continuing.

 

The transaction has been approved by the Special Committee which is made up by the independent directors. There are 10 directors on the board and 6 of them are considered independent (at least 3 of the 4 dependent directors are part of the transaction). From my experience, the board of directors of OSI has always been considered extremely friendly towards management and the founders. After spending a little time looking up the background of these independent directors is clear why this is the case. Most have been on the board for many years and most live in the Tampa area where the company is based.

 

I am sure that these independent directors followed appropriate guidelines prior to recommending this transaction, but it also seems likely that they were not able to negotiate a price that was in the best interests of shareholders given their relationships with the counterparty.

 

 

There are many ways to think about fair value for OSI. But it should first be noted that OSI is the only mid cap casual dining company that is actually down year to date despite the deal price. So despite pretty weak fundamentals, the whole group has done okay as valuations have risen given all the restructuring opportunities and turnaround potential.

 

It also should be noted in the context of peer valuations and other takeout multiples, that OSI has one of the strongest balance sheets in the industry with debt/EBITDA under 1.0x. They also own the building for about 340 of their restaurants (30%) and the land for 313 units (28%).

 

 

It is interesting to look at the return on investment from capital expenditures by this management team over the past 6 years. I have attached it below.

 

Over this time period, OSI has been aggressively growing their emerging brands and they clearly have not been contributing much on the EBIT line given the inefficiencies and high growth rate (G&A, D&A, preopening expense, etc). I also think that some of their brands are losing money at the EBIT level which clearly hides the earnings power for the more promising brands.

As an outside investor, it has been hard to evaluate this poor performance because it is not clear if this is wasted capital or just a delayed return on the invested capital. The fact that those responsible for this investment record are the ones attempting to acquire the company down here tells me that there is more likely to be a delayed return.

 

Rerunning this analysis using the assumption that they earn a 10% return on growth capex and the legacy business remains stable would imply 2006 EBIT of over $350 million as opposed to the $190 million or so they are set to earn.

 

 

Despite the significant improvement that this EBIT level implies, it would still represent an EBIT margin substantially less than historical levels. This would imply a valuation level of just under 6.5x EV/EBITDA yet still only assumes an EBIT margin of 9.2% (not quite back to 2003 levels).

 

 

 

The margin destruction has been truly extraordinary since the peak of ’99 with an EBIT margin of 14.0% to an expected 4.9% this year.

 

 

Here is a look at the implied takeout EV/EBITDA multiple using various normalized EBIT margin assumptions for next year:

 

 

With peers trading closer to the 8-9x range next year without severe margin destruction, these implied levels are extremely low particularly given their capital structure and real estate value.

 

 

One simpler way that a PE firm could approach this transaction would involve selling off each of the emerging brands to the highest bidder. Given their growth characteristics and high quality new assets, most of these brands could be sold at attractive levels. I have assumed that Carrabba’s could be sold for about 1.2x sales, the two most promising brands could be sold for 1.3x revenue (Bonefish and Fleming’s) and Roy’s for 1.0x. This would get you about $1.2 billion after-tax. I don’t believe that the operating business for Cheeseburger in Paradise is worth anything, but they should be able to net something for its assets if they attempted to dispose of it.

 

Subtracting this $1.2 billion from the $3.3 billion purchase price leaves a $2.1 billion investment.

 

 

Several restaurant companies have been publicly levering up over 3x Debt/EBITDA recently or at least showing the desire to do so. Some of these companies include CBRL, EAT, SONC, and possibly APPB. Like Outback, CBRL and EAT are both predominately company owned units and this good proxies for the leverage capacity of OSI.

 

Using my estimate of Outback only EBITDA of $275 million from 2005 (actual total was 392.4 million); I think they could comfortably raise an incremental $1,125 million in debt on top of the $250 million they currently have outstanding. This would put their leverage level at 5x Debt/EBITDA based on ’05 EBITDA or assuming an interest rate of 7.0%, an interest coverage ratio of almost 2x. Considering they will still own 30% of their real estate and that we are using trough earnings, this rate and leverage level does not seem overly aggressive to me.

 

Subtracting the $1,200 million I estimated for after tax proceeds from the emerging brands as well as a large one time dividend representing the incremental debt, I get an equity value of only $802 million. The ’05 EBIT yield on this would be almost 25% or just under 12% after interest expense.

 

 

 

 I have also included my LBO work assuming the above scenario with the sale of the emerging brands. I have assumed that a significant capex program will be necessary to remodel most of the Outback units ($450 million spent over the next 3 years).

 

 

 

And here is my income statement trough 2010 for Outback only:

 

 

 

The range of potential equity value per share using my 2010 EPS estimate of $2.16 would be $32-$38. This compares to a cost basis of less than $10/share after the emerging brand proceeds are paid out as well as the incremental $1,125 of debt.

 

 

 

The lack of transparency into this company has made it terribly difficult to evaluate and to understand where the real issues and problems are coming from. You can easily form entirely different conclusions with the limited information provided. Is the 7 year declining EBIT a result of weakness at the core Outback business? Is it being masked by money losing brands that can simply be disposed of which would provide a boost to EBIT? Or is it the more promising brands lack of early contribution that will be seen in the coming years?

 

The investment community has been asking for this segment detail for many years and they have simply refused to provide it. The new CFO finally promised to provide a little bit more information in the 2005 10K, but the information that he did provide was not much more helpful. He broke out the EBIT contribution of 3 of the emerging brands. There are several reasons why this was not helpful. One is that these brands are much bigger EBITDA contributors than they are EBIT, so without providing the brand D&A, you still don’t have much of a sense of what to expect from these brands going forward. The other reason is that Outback EBIT was not provided, just total company. Thus, to the extent the other emerging brands are losing money, we can’t tell what the Outback EBIT is by itself.

 

I think this whole transaction is clearly a conflict of interest as the management team, founders and private equity sponsors have dramatically better information to base their valuation work on. If they provided the same level of information as a few of their peers like PF Chang’s, the investment community would have a much easier time understanding the true earnings power of this company and all of its parts.

 

 

I think the best strategy involves the disposal of the emerging brands because their potential would be much greater in the hands of other owners. The Outback turnaround won’t be easy, but the pieces are already in place. As discussed in my prior writeup, OSI has already spent considerable time and money to study their consumer and to craft a new marketing campaign based on this information. So while there are other competitors that have clearly impacted their franchise, Outback needs to focus on what makes the brand special in order to take advantage of the very clear brand equity that exists. They need to remodel their units, refocus on service, and communicate their superior quality food. If they are able to achieve these things, they will be able to get their volumes and margins back to prior levels as the customer will give them credit for their differentiation.

 

The market check period will end on December 26^th. Given the involvement of the management team and two PE shops, the possibility of a competing bid is low, but still exists.

 

I think the more likely scenario is to force the buyers to raise their offer that provides shareholders something closer to fair value. I am aware that most of the large holders are unhappy with the current offer price, but it is less clear if anyone plans to do anything about it. It is possible that they take the opportunity to raise the offer to something around $45 when the market check period ends. In addition or instead, the pressure should intensify when the proxy is filed and it becomes clear this process was not handled in the best interest of shareholders.

 

Here is my best guess of the various scenarios and the probability of them occurring:

 

 

The two opportunities for an increase in the offer price will be when the market check period ends and after investors have a chance to review the Proxy materials which should be filed shortly after this period.

 

Based on my LBO calculations, the investor group could still earn an IRR of 20-25% if they paid $45/share or the 15-20% range if they paid $50.

 

Catalysts:

 

-         December 26^th marks the end of the “market check” period and could lead to an increase in the offer price.

-         The filing of the proxy after the end of the market check could shed more light on the poor handling of the entire process in regards to this deal. I also think to the extent that more information is made available, the more the market will recognize the $40 price as unfair to shareholders.