Description

Piccadilly Cafeterias is an operator of cafeteria-style family dining restaurants in the Southeast and Mid-Atlantic regions of the United States. The company is an interesting investment idea because (i) it currently offers an approximately 40% leveraged annual free cash flow yield, (ii) it will de-leverage substantially over the next few quarters, (iii) over the last year it has successfully implemented a restructuring, which has been led by a new President/COO, that has yielded impressive cost savings and a working capital reduction, and (iv) management’s initiatives for same-store sales growth may be achievable in the near future through advertising & store remodelings.

Piccadilly is the dominant cafeteria chain in the Southeastern and Mid-Atlantic regions of the United States with 216 cafeterias. The typical cafeteria offers a wide food selection including up to 18 entrees, 2 soups, 20 salads, 18 vegetables, 7 breads, and 22 desserts. Guests make their meal selections by combining these items according to their individual preferences. The typical combo meal is between $5 and $9 per person. Here is a brief synopsis of the financials:

On an LTM basis, the company generated $389 million in revenue, approximately $24.3 million of EBITDA, and $15.6 million of free cash flow after interest expense ($1.38 per share). The current price per share is $3.22. There are 10.74 million common shares outstanding, 0.85 million warrants with a strike price of $1.17, and 0.86 million management options with a weighted average strike price of $9.12. The fully-diluted market cap is $36.3 million, the company has $10.1 million of cash on its balance sheet, $42.0 million of Term A Notes, and $5.5 million of a Term Credit Facility. When calculating enterprise value, I have also included a $6.1 million reserve for ongoing obligations of cafeterias closed and a $17.0 million pension liability (see risks below). The company’s fully-loaded enterprise value is therefore approximately $97 million, or $74 million excluding the pension liability and reserve. Additionally, the company has NOLs of approximately $29 million, which will be sufficient to shield taxable income for the foreseeable future. Finally, the value of the company’s real estate is between $20 million and $25 million (according to management, who had to appraise the properties, as they used the properties as collateral for their funded and unfunded debt).

Management has had their hands tied financially for the past few years because of an unsuccessful acquisition of Morrison Cafeterias in May of 1998. At the time of the acquisition, Morrison was the largest cafeteria chain in the Southeastern and Mid-Atlantic regions of the U.S. with 142 cafeterias in operation (Piccadilly had 130 cafeterias at the time). Morrison cafeterias were similar to the traditional Piccadilly cafeterias in terms of size and markets served. Although Morrison Cafeterias had been experiencing declining operations for two years prior to the acquisition by Piccadilly, management believed that the acquisition would eventually be accretive to Piccadilly. The purchase price was $57.3 million (including $10.4 million of debt assumed) and it was financed with unsecured debt. Management’s rationale for acquiring Morrison was that the acquisition would eliminate the company’s only major competitor in its markets, more than double the size of its operations, enhance purchasing power, eliminate redundant costs and potentially increase sales at Morrison cafeterias to Piccadilly levels. In fiscal 2000 (fy end is 6/30), the Morrison cafeterias contributed only $0.9 million of EBITDA. During that same time period, Morrison cafeterias on average generated only $1.6 million of sales per cafeteria compared to $2.2 million of sales at the traditional Piccadilly cafeterias. Since the acquisition, Piccadilly has spent approximately $7.3 million converting Morrison cafeterias to the Piccadilly name. These conversions were completed between September of 1999 and September of 2000. Forty-four non-performing Morrison cafeterias have been closed since the acquisition.

Prior to the acquisition, Piccadilly performed reasonably well. Net sales per unit increased from $1.9 million in 1994 to $2.2 million in 1998. On a net basis, the company has not expanded its cafeteria footprint since 1994 (16 opened & 17 closed from ’94 to ’98). Same store sales increased 1.5% from FY1997 to FY1998 and 3.5% from FY1996 to FY1997. EBITDA was within a fairly tight range between $25 million and $27 million from fiscal years 1997 to 2000 and maintenance capex was approximately $4 million to $5 million per year. The downturn was the most pronounced in fiscal year 2001. The company was struggling to implement the conversions of the Morrison cafeterias, the Piccadilly name was not well recognized in some of the areas where Morrison had operated and the promised synergies did not materialize. EBITDA fell to $19 million in fiscal 2001. This deterioration in operating performance forced the company to refinance the debt that it had taken out for the Morrison acquisition. In December of 2000, the company issued $81 million of rather toxic debt for proceeds of $72.9 million. The debt was tranched into 12% Senior Secured Notes due 2007 ($71 million) with warrants to purchase 746,210 shares, $4.5 million of Term B Notes due 2007 (LIBOR +4.5%) with warrants to purchase 47,295 shares, and a $5.5 million Term Loan Credit Facility (LIBOR + 4.5%) with warrants to purchase 57,805 shares. All of the warrants have a strike price of $1.16875.

The turn-around really began in March of 2001 with the hiring of Azam Malik as the company’s COO and President. Mr. Malik was previously Executive Vice President of Operations at Chi-Chi’s, where he was the executive credited with turning around the Mexican restaurant chain. Under Mr. Malik, Chi-Chi’s went from double digit year over year same-store sales declines to positive same-store sales growth. Mr. Malik now has primary operating responsibility at the company, although Ronald A. LaBorde remains as the company’s Chairman and CEO. Mr. Malik reorganized the company’s management team, eliminating 25 positions in the process. This alone has saved the company approximately $1.9 million annually. The closing of 14 non-performing stores in July of 2001 resulted in savings of $2.0 million on an annual basis. Moreover, purchasing efficiencies implemented by Mr. Malik have resulted in a gross margin increase of 200 basis points in the 9 months ended 3/31/02 vs. the 9 months ended 3/31/01. My conversations with management indicate that the manner in which the company is currently being managed is “night and day” vs. the prior management. For example, the company is currently monitoring store-level financials on a daily basis, whereas the company had previously monitored store-levels financials on a monthly basis. The culture of promoting only from within is gone and management is considering various strategies to further improve operating results.

The other aspect of the restructuring dealt with a restructuring of the company’s balance sheet. On March 30, 2001, the company completed a sale-leaseback transaction of 12 properties. The company received $20 million in cash for the sale of the properties and simultaneously executed long-term leases for a term of 20 years. With the proceeds, the company retired $16.0 million of the 12% Senior Secured Notes and all of the Term B Notes. The annual rent expense for these properties going forward is $2.3 million. By my calculation, this transaction was slightly favorable on cash basis, as the interest payments would have been $16.0 million * 12% + $4.5 million * approximately 10%. The transaction was more accretive to GAAP earnings, however, as it reduced annual depreciation expense by $0.8 million, and the amortization of the note discount was being amortized through the P&L (the amount pertaining to the debt that was repaid was fully written off upon the closing of the sale/leaseback transaction). Another rationale for the sale-leaseback is that the note indenture requires a 50 basis point increase in the interest rate for the Term A Notes for every $1 million EBITDA exceeds $27 million (an annual increase is limited to no more than 150 basis points and the interest rate has ceiling of 16.5%). Therefore, transferring interest payments to rent payments helps to limit the interest rate increase, if any. On July 31, 2001, the company completed another sale-leaseback transaction involving 6 cafeterias. The company was paid $9.0 million in cash and executed long-term leases for the 6 cafeterias. The company retired $9.4 million of its 12% Senior Secured Notes due 2007 with the proceeds. Net rent expense will be $1.1 million for the 6 properties going forward. Again, this is essentially a break-even transaction in terms of cash (at the current level of EBITDA), but will be accretive to earnings, especially if EBITDA increases. For both transactions, the company has no obligation to repurchase the properties sold, and the purchaser does not have the ability to compel the company to repurchase the property at any time in the future. There are no guarantees on the purchaser’s investment or a return on its investment by the company.

While the success of the company’s recent restructuring is evident from recent financial results, the key to long-term success is the company’s ability to reverse the same-store sales trends. The year-over-year same-store sales decline has been 2.6%, 5.2% and 3.8% for fiscal years 1999, 2000 and 2001, respectively. Despite the recent success at reducing expenses, year-over-year same-store sales declined by 6.7%, 3.8% and 2.3% for the months of January, February and March (2002), respectively. The company has several initiatives in place to reverse these trends, including an advertising campaign and store remodelings. The company has stated that they are pleased with the results of the advertising campaign and the first store remodeling has resulted in very substantial year over year same-store sales increases (the company told me that the improvement has been so dramatic that they choose to not give exact numbers to the street because it would set expectations too high for future remodelings). It is too early to tell whether the ad campaign and store remodeling will be effective, however, and management only announces same-store sales figures on a quarterly basis (although they plan to move to monthly reporting). The company is in the process of remodeling 4 additional stores. Management told me that they do not plan a widespread remodeling, but rather will roll it out on a store by store basis gauging the results and then deciding whether the return on future remodelings is sufficient.

The capex per store for a remodeling is approximately $200K. Under its debt covenants, the company is unable to spend more than $8 million a year on capex for existing stores, plus $6 million for new stores. As the company has told me that there are absolutely no plans for new stores, the effective ceiling on capex is $8 million per year. The CFO has told me that maintenance capex is running at $3 million a year. Therefore, the company could remodel 25 stores a year ($8 million total capex - $3 million for maintenance capex = $5 million/$200,000 per store. At a run-rate of approximately $27 million of EBITDA (based on the last quarter, which is seasonally a weak quarter), approximately $4.5 million of cash interest, no taxes, no net working capital as there is no growth, and $8 million of capex, the company would still generate $14.5 million of levered free cash flow ($1.30/share). Moreover, at this level of capex (on an LTM basis capex was only $4.3 million), one would have the benefit of increased sales from the remodelings (which will not be undertaken unless they show sales increases), so my EBITDA number is probably conservative. Given that (i) the Morrison acquisition is behind the company, (ii) Mr. Malik was successful in drastically improving same-store sales at Chi-Chi’s, and (iii) the company’s success at streamlining the expense structure, I believe that there is a strong chance that the company will reverse same store sales trends.

Moody’s and S&P have indicated that they will consider an upgrade of the company’s credit rating if same-store sales growth is achieved. Even if same store sales are flat going forward, the payback period on your investment is 2.5 years. If same-store sales turn positive, I believe that there is a tremendous amount of upside in the stock. Management indicated to me that they do not want to go out to the Street and promote awareness of the company until the revenue side of the restructuring is completed, but at that time, they will aggressively re-introduce investors to the company. Management owns approximately 9.4% of the outstanding shares, so the incentive is there.

Given that the company is generating a substantial amount of cash, the next question is how they will use the cash. On the last business day in September of every year, the company is required to make an excess cash flow offer to purchase Term A Notes and prepay amounts outstanding under the Term Loan Credit Facility (on a pro-rata basis) at 101% of the aggregate principal amount plus accrued interest for the most recently completed fiscal year that excess cash flow (defined as EBITDA less interest expense, income tax expense, and capital expenditures) is at least $2.5 million. This excess cash flow offer is limited to the lesser of (i) excess cash flow that is greater than $2.5 million, and (ii) $5.0 million. Moreover, if excess cash flows are greater than $5.0 million, the company is required to offer to prepay amounts outstanding under the Term Loan Facility at 101% of the aggregate principal amount plus accrued interest. For the 9 months ended 3/31/02, excess cash flow was $14.2 million ($1.25 per share, or $1.68 annualized). Even if there were no excess cash flow in the 4th quarter ending 6/30, under the above formulas, the company will repay $10.0 million of debt in September of ’02. Net debt will then be $37.0 million and interest expense will be less than $4.5 million annually. Once the company has delevered further, management has indicated that stock buybacks and dividends are a strong possibility. Up until 2/7/00, the company paid an annual dividend of $0.48/share (a 15% yield based on the current price). This would be easily reinstated given the cash flows of the company even if same-store sales only remained flat.

Risks:

· Same-store sales continue to decline and the cash on cash returns decline also, as most of the cost reductions that represented low-hanging fruit have been implemented over the past year
· The company will record a pension liability of between $16-$18 million when it closes it books for the year on 6/30, as the present values of its defined benefit pension plan liabilities are estimated to exceed the fair values of plan assets. The liability will be offset with a reduction to shareholder’s equity that does not hit the income statement. All of the Company's defined benefit plans are now frozen and no further benefits are therefore accruing. The anticipated pension plan liability will have no immediate cash impact. If future earnings on plan assets do not recover to eliminate the under funding, the Company may be required to begin contributing to the pension plans beginning in fiscal 2004 or 2005. The Company has been advised that, in the event that contributions are required, those contributions will be spread over several years.
· Given the reduction in shareholders' equity expected on June 30, 2002, it is likely that the Company will not meet on schedule the shareholders' equity level needed to remain on the NYSE and that the NYSE could commence delisting of the Company's shares soon after the Company's financial results for fiscal 2002 are announced. Given the uncertainty that the Company will be able to continue its listing on the NYSE, the Company is evaluating its eligibility to list its stock on other stock exchanges. The CFO has indicated to me that the company is considering NASDAQ small-cap, the American Stock Exchange or over the counter. The company is very open to suggestions on this matter, but it will depend somewhat on where the company’s stock price is at the time.

Catalyst

very high levered free cash flow yield
deleveraging
future upgrade of credit rating
potential for same-store sales increases