The banks have to be extremely concerned.  This is an asset light operation and liquidation will not get them a recovery.    Foreclosing to take-over operations is a horrendous option for them as well as they have to continue funding losses.  There isn’t a junior tranche to fund the subsequent free cashflow burn or absorb the losses.  As such, the banks have written one of the worst loans in recent memory.    They either fund losses into perpetuity with dim prospects for a recovery or they place massive pressure on the company to find a way to de-risk their position.  Fortunately, the banks have massive leverage as the company will breach covenants shortly.  As a result, once RRGB breaches covenants one of three outcomes will likely occur.  A)  If the stock is this high, they will insist on equity issuance to help fund the free cashflow burn.  They are almost certainly insisting on this as we speak in advance of the breach.  B)  if the stock has declined (reasonable assumption), they may insist on a forced marriage with a strategic partner.  The partner would inject extremely dilutive equity to reduce the debt balance and fund some losses between here and the recovery.  I suspect that this would be 75-85% dilutive to the equity.  C)  If the board refuses the bank’s terms, the banks may foreclose and sell their control position to a distressed buyer in return for a debt pay-down.  The only hope for the equity is that this miserable concept may not be able to find a buyer at a $200-300mm TEV.  If so, the banks may be forced to fund loses while we wait for a recovery.  In this scenario, they may force measures that limit cash burn today at the expense of the recovery down the road.

Other:

Prior to the pandemic, the concept had multiple flaws:

1) Highly competitive industry.  The casual dining space is a lower growth and highly competitive industry.  Margins are low and require rapid table turning with most of the profit derived from the last 10-15% of customers.  This is elevated in burgers.  Every day a hot, new burger concept is born.  Shake Shak, Smash Burger, 5 Guys….  Further, QSR’s have elevated the quality of their burgers and are encroaching on the low-end in the casual dining space.  This has been occurring as RRGB quality has dropped to optimize profits. 

2)   RRGB management teams have been weak and with poor incentive alignment.  This leaves the concept poorly positioned as it was losing relevancy.

3)   RRGB had a fair bit of mall-exposure (30%) where traffic has been in structural decline

The above factors combined to create a concept that was treading water at best before the pandemic.  We believe that RRGB is particularly exposed to the pandemic.

1)  RRGB positioned its stores at malls and other big box stores, lifestyle centers and other mass gatherings.  These locations are less convenient than other restaurants now.

2)  Burger and Fries mix shift will move toward QSR in this down-turn.  Is it worth being infected w/ Covid to get a Burger/Fries at busy casual dining restaurant when you can go to the drive-thru and get a product of similar quality product?  Shake Shack or Red Robin?

3)  Weak concepts prior to the crisis will likely underperform after the crisis.  As mentioned above, this is a highly competitive industry that requires rapid table-turning to leverage fixed cost utilization.  If RRGB is forced to adopt social distancing, it will never return to prior profit levels.  Many of its locations will be EBITDA negative and forced to close before the full recovery takes hold.  We suspect it needs traffic to get back to 70-80% of prior levels to get back to EBITDA positive.   85-90% of prior traffic to get to $50mm of EBITDA and obviously 100% of prior traffic to get to $100mm. It seems like $50mm is a reasonable new-normal mid-cycle with modest social distancing measures in place – especially given where its restaurants are located and the fact it’s product competes actively with QSR.

Positively: 

1)      Management has turned.  It seems unlikely they can do a worse job

2)      In a typical recession, approximately 15-20% of restaurants close.  I suspect it will be far higher in this recession a)  the pandemic is an unprecedented hit to restaurants  b)  pride may have kept many poor locations open in prior down-turns.  Covid is a face-saving excuse for operators to walk away.  If we can quickly return to normal behavior, supply/demand may tilt in RRGB’s favor for some time.

3)   Stocks in the sector seem to be rallying on the fact that we have fundamentally troughed.  This rally creates the opportunity in my opinion.  While we have moved from DefCon 3 to Defcon 2, RRGB may not be EBITDA positive until a vaccine is widely distributed which would be 2022.

4)      Initial credit card data has spiked for restaurants in states that have opened their economies back up.  A component of this is likely funded via the stimulus checks and is short-lived.