Description

Long – Red Robin Gourmet Burgers (RRGB)

Red Robin is a compelling turnaround within the casual dining restaurant industry, led by a strong new CFO with a stellar track record of operational enhancements and shareholder value creation.  With the stock trading at a material discount to its peers, we believe that new CFO, Guy Constant will begin to improve RRGB’s industry-low margins and enhance the capital structure.  Importantly, we believe RRGB can materially exceed current market expectations by simply aligning its core operational practices with basic industry standards. 

Over the next four years, we see a path towards 280 basis points (“bps”) of margin expansion, and a significant increase in the franchisee unit mix from 15% to 40%, resulting in meaningful free cash flow generation of $10.17 per share, implying a yield of 14%.  After focusing on debt paydown over the next two years, RRGB can utilize its strong cash position to repurchase an estimated 15-44% of its current shares outstanding.  Furthermore, we believe the market has largely dismissed the sales value initiatives already underway, which has led to a traffic inflection at RRGB relative to the industry over the past four quarters.  Overall, Guy Constant brings a new era of operational discipline to RRGB, and we expect him to outline potential margin and capital structure opportunities in more detail during RRGB’s May 22^nd Investor Day in Colorado. 

Due to the Company’s poor execution on both the sales and margin front over the last few years, RRGB is trading at a severely discounted 6.7x 2018 EV/EBITDA valuation, a 2.6x turn discount to its restaurant peers of 9.3x.  As the Company embarks upon its longer-term initiatives, we believe the market will award it an in-line multiple.  Applying the 9.3x peer multiple to RRGB on our 2018 estimates implies a fair value of $93.00 per share, or 56% upside from current levels.  Moreover, given the significant 12% 2018 free cash flow yield, we view downside risk as limited, and applying a trough 6.0x EV/EBITDA multiple supports a downside valuation of $51.00 per share.    

We believe the following catalysts will help unlock the value inherent in the RRGB story: 1) new CFO Guy Constant introducing his plan for operational and financial discipline within the organization at the May Investor Day; 2) a multi-year operating margin opportunity of 280 bps driven by both front of house (“FOH”) and back of house (“BOH”) initiatives; 3) the franchisee mix improving from 15% currently to 30-50% of RRGB units over time, resulting in a higher valuation multiple and enabling a material share repurchase program; 4) a topline turnaround fueled by increased marketing spend, as well as RRGB’s new off-premise and carry-out initiatives comprising a larger part of the overall mix from 5% towards the industry average of 12%; and 5) a potential acquisition of the Company given its strong free cash flow profile, current depressed margins relative to the industry, and well-recognized brand.

Business Overview

RRGB is a leading casual dining burger chain with 464 company operated locations and 86 franchised restaurants.  Widely regarded for its gourmet burgers, RRGB also offers vegetarian alternatives and non-burger entrees including salads, pastas, seafood, and fajitas.  Red Robin currently has average unit volumes (“AUVs”) of $2.8 million, which is in-line with the six-year average, but below the AUVs of the last three years.  Moreover, unlike most other casual dining restaurants, RRGB does not have a material presence in lower wage markets like Florida or Texas, with its highest state exposure in California, Washington, and Colorado.  RRGB’s core customer demographic is higher income, with over 50% earning more than $75,000 annually.  RRGB’s menu has broad appeal with its 3-tier pricing menu, including: Gourmet priced at around $10.00 and carrying the highest margins (80% of total sales), Finest priced up to $15.00 (10% of total sales), and Tavern priced at $6.99 (10% of total sales).  The Food and Beverage mix is roughly 80% and 20%, respectively, with non-alcoholic beverages comprising a greater percent than alcohol.

New CFO Guy Constant Brings Operational Expertise to RRGB

Guy Constant joined RRGB in December 2016 and has since been working on ways to improve RRGB’s margin gap versus the industry, and help enhance its capital structure.  Over the last 10 years, the market has viewed RRGB as an inconsistent operator that has lacked a credible plan to expand margins and differentiate its concept, or deliver earnings growth and shareholder value.  Guy Constant’s arrival therefore marks a significant inflection point as he brings a proven track record of cost reduction, operational enhancements, free cash flow generation, and shareholder returns.

Prior to RRGB, Guy Constant spent roughly 10 years at Brinker International (“Brinker”), a casual dining company, focused on its Chili’s concept.  In 2004, he started as Senior Director of Compensation and worked his way up to become CFO in September 2010.  As CFO at Brinker, he developed a 5-year restructuring plan, and exceeded all initial targets.  In March 2014, he decided to leave the industry and become CFO of Rent-A Center (RCII), the home electronics, appliances, and furniture retailer.  Despite his solid performance there from June 2014 through December 2016, we believe the RRGB opportunity provided him a greater and more exciting opportunity to leverage his skillset given his proven track record within the casual dining industry.  Additionally, we are encouraged by management’s alignment with shareholder interests, and view Guy Constant’s recent $236,500 purchase of 5,000 shares at an average price of $47.30 as a strong indicator that he firmly believes in the long-term upside potential.    

Guy Constant’s Previous Margin Restructuring Plan at Brinker

Guy Constant’s prior success restructuring the Chili’s concept during his tenure at Brinker, bolsters our conviction that RRGB will execute effectively upon its very similar turnaround plan.  At Brinker’s 2010 Investor Day, Guy Constant laid out a 5-year restructuring plan that set a 500 bps EBITDA margin improvement target, driven by back of house (BOH) initiatives such as new conveyor grill equipment and prep stations, as well as front of house (FOH) “team service” efficiencies.  More specifically, they forecasted 300 bps of EBITDA margin improvement from the kitchen restructuring and 200 bps of EBITDA margin improvement from the FOH efficiencies over five years.  Under his leadership, Chili’s was able to consistently grow EBIT margins every year, taking margins from 6.4% to 10.5% in five years, and actually exceeding his initial target.  Moreover, Guy Constant set an EPS target of at least $2.80 off a 2010 base of $1.18, and at the end of the 5-year plan, Brinker achieved earnings per share of $3.09, or 10% above the initial target.  Guy Constant is therefore a proven operator and value driver within the casual dining industry, and we strongly believe a similar long-term path of successful execution will occur at RRGB.

Margin Opportunity at Red Robin

Industry Overview

Red Robin operating margins are 470 bps below the industry average and 400 bps below RRGB’s prior peak during 2006.  We believe that there is significant “low hanging fruit” enabling RRGB to narrow its margin gap.   In fiscal year 2016, the casual dining industry had an average operating profit margin (EBIT) of 8.7% compared to RRGB at 4.0%.  The casual dining industry saw margins bottom in 2009 at approximately 6.0% and improve quite rapidly to roughly 8.0% in 2010 due to a sales re-acceleration, off a very depressed base, combined with increased operational discipline and a broad commodity deflationary cycle.  The average industry margin rate remained between 7.4% and 8.3% from 2010 to 2015, however, in 2016, the industry saw a nice improvement to 8.7% as commodity deflation outweighed a broadly sluggish sales environment and labor wage increases. 

Conversely, RRGB’s EBIT margins fell by 150 bps year-over-year (“y/y”) during 2016.  Moreover, in 2016 throughout the industry, food costs fell approximately 70 bps as a percentage of sales, while labor costs increased approximately 80 bps.  In contrast, RRGB’s labor expense increased by 173 bps in 2016 due primarily to its larger exposure to the west coast’s higher wage rates and tip credit states (Washington, California and Colorado).  Finally, RRGB’s EBIT margin over the last 10 years peaked at 8.0% in 2006 and troughed at 1.8% in 2010.

CPI Food-at-Home Deflation has Subsided

Currently, investors are skeptical about the sustainability of current margins for the restaurant industry.  There is concern that a mean-reversion will occur in the favorable commodity backdrop and that labor pressure will become more of a headwind.  The current consensus view is food-at-home inflation will accelerate in the second half of 2017, a sentiment that has been supported by commentary made from BJ’s Restaurants (BJRI), Jack in the Box (JACK), Sonic (SONC), Texas Roadhouse (TXRH), as well as RRGB.  We believe this general concern further highlights the critical nature of RRGB’s plan to lay out specific margin drivers going forward.

RRGB Margin Opportunity

Based on our analysis, we believe RRGB has two primary avenues to achieve meaningful margin expansion of approximately 280 basis points over the next few years, through both FOH and BOH initiatives.  We believe that the majority of these operational efficiencies have not been incorporated into the current fiscal 2017 EPS guidance.  

First, we believe the largest opportunity for margin expansion will come from the FOH, which encompasses all servers, bussers and floor space except for the kitchen.  We estimate 225 bps of the total 280 bps of margin opportunity will come from the FOH initiatives.  Moreover, due to many antiquated policies and a lack of conformity to basic industry practices, we foresee that the FOH opportunity at RRGB will be greater than Guy Constant’s prior restructuring plan at Brinker’s Chili’s concept.  Encouragingly, our industry channel checks and conversations with Red Robin suggest that each designated FOH change is standard practice and has already been widely practiced by most of RRGB’s peers in the past. 

We expect that “team service” changes will drive the majority of the improvement in the FOH.  Over the next few quarters, we expect Guy Constant to implement new practices such as two servers sharing eight tables versus one server having responsibility for four tables.  Likewise, we expect RRGB to eliminate the busser position, excluding peak hours.  We estimate that busser labor costs per store are $33,251, implying that at RRGB AUVs of $2.8 million, the busser labor savings could yield 117 bps alone. 

Furthermore, the “team service” initiative is a meaningful and unique margin driver for RRGB specifically, given the Company’s minimum wage and tip credit state exposure (California, Washington, Colorado).  Per the Fair Labor Standard Act (FLSA), a tip credit permits an employer to take a tip credit toward its minimum wage obligation for tipped employees equal to the difference between the required cash wage (which must be at least $2.13) and the federal minimum wage.  The rationale behind taking a tip credit is tip income generally brings employee wages back up to the federal minimum wage, or higher.   With RRGB’s high exposure to Washington (minimum wage $11.00), California (minimum wage $10.50), and Colorado (minimum wage $9.30), and its lack of exposure to Texas (minimum wage $7.25), the potential for labor cost savings is significant.  When you take a full shift, or even an hour, in any of these states we believe RRGB can save 3x what was accomplished during the Chili’s restructuring.  Furthermore, we believe that taking one server out for any given shift will improve the morale for the remaining servers.  Each store operator will have less need for a weaker performing server and the remaining better performers will touch more tables allowing them to earn more money and also provide a higher quality service to the customer.  Importantly, RRGB corporate and local store operators now have the ability to see if a particular store is over- or under-staffed on a daily basis, allowing for seamless adjustments to the wait staff in real-time.

Second, we estimate that BOH will contribute 55 bps to margin improvement.  Even as recently as last year, RRGB relied on antiquated operational practices like using paper tickets to relay orders to the kitchen.  In order to catch up with basic industry practices, over the last six months RRGB has started using a kitchen display system (“KDS”).  This system incurs a capital cost of approximately $10-$15 million and allows kitchen orders to display on an iPad screen as opposed to the physical kitchen paper tickets.  This drives down ticket time and eliminates food waste, and will ultimately help to improve service time by at least five minutes.  Since a server physically taking an order is a non-value add service, this initiative should help speed up order times and allow for more customer interaction, enabling RRGB to better compete against its peers.  Importantly, the recently rolled-out KDS has already exceeded initial internal targets and contributed 20-30 bps of the 90 bps of cost of sales leverage in Q4 2016.  We also believe there is a further opportunity to streamline the menu and remove less frequently ordered items, further benefitting the cost side.

Sales Turnaround Initiatives Already Underway

Notably, we are not relying on a material sales inflection to drive our longer-term model.  Similar to the margin expansion plan, RRGB’s sales initiatives focus on making progress towards average industry standards, not relying on an improvement in overall consumer behavior.  We forecast $1.4 billion in sales for 2017 predicated on a negative 0.1% same store sales growth estimate.  In our longer-term model, we forecast $1.5 billion in sales driven by a positive 1.0% annual same store sales growth, adding $53 million in annual sales, and RRGB doubling its off-premise business.

Importantly, only 17% of RRGB’s locations are mall-based.  Contrary to overall investor sentiment around weak mall traffic, those stores actually outperformed the broader chain in the most recent quarter.  We agree however, that the relatively limited mall-based exposure is a positive as mall traffic could remain structurally challenged.  Should traffic recover, we would see upside to our estimate, with every 100 bps change in same store sales equating to $0.40 in annual earnings.

Off-Premise and Value Initiatives

RRGB has only recently begun its off-premise initiatives, comprising only 5% of its current sales, which is well below the industry standard of 10-12%.  The Company has recently initiated an online ordering platform for all locations, with curbside pickup to be available in 85% of its locations by June 2017.  Based on a conservative estimate of only 9% penetration (still below industry average), off-premise sales should improve from $57 million in 2016 to $115 million in 2021.  At the May 22^nd Investor Day, we expect the Company to offer additional detail on the rollout of the off-premise initiative, and the resulting revenue upside.  While we don’t have insight into how much of 2017’s 0.5-1.5% same store sale guidance is benefitting from increased off-premise sales, we do know that the higher sales volume will help leverage fixed expenses.  Furthermore, the margin contribution from off-premise sales is also higher than the overall RRGB margin.  In order to further integrate its digital ordering platform, RRGB has partnered with Olo, the leading provider of online and mobile ordering capabilities and expert in maximizing sales per square foot.  Nationwide, customers can order ahead of time, pre-pay, and seamlessly integrate with the RRGB loyalty program.  This enhanced technology platform is proof RRGB is committed to properly aligning its operations with the constantly evolving consumer digital focus.  Encouragingly, our channel checks in several states confirm that the execution of this initiative is progressing smoothly.

We believe that the market has given RRGB essentially no credit for the sequential improvement in traffic relative to the industry over the past four quarters.  Moreover, during the last two quarters, RRGB saw traffic outpace the industry, proving that the value-priced Tavern menu is already driving additional customer traffic to stores and taking customers away from competing fast casual peers.  As consumers are no longer reacting to one-off promotional value concepts within the industry as they have previously, RRGB’s shift to an everyday low price menu offering is proving very productive.  The Tavern burger offering is approximately 10% of total sales and is comprised of seven various offerings including the classic Red’s Tavern Double for $6.99, as well as a Four Cheese Melt and Pub Mac ‘N’ Cheese for $6.99.  We believe that Tavern could grow to 15-20% of Company sales over the longer-term and further drive incremental store traffic.    

As the Tavern offering rolled out in 2H 2016, the second half of 2017 will benefit by approximately 150 bps as RRGB laps the weaker price and mix components of the overall same store sales from last year.  We expect that as they lap the pricing and mix issues and hold traffic relatively constant with continued improving trends versus the industry, RRGB same stores sales should improve each quarter as the year progresses.

Franchisee Mix Shift to Unlock Material Shareholder Value

Restaurant Ownership Overview

Over the last 10 years, the restaurant industry has experienced a trend towards increasing franchisee mix relative to company operated units.  After a thorough review of the sector, we have concluded that Buffalo Wild Wings (BWLD), another portfolio position, and RRGB are essentially the only two restaurant companies to not participate in this broader industry trend.  In fact, these two companies have been buying in franchisees, the inverse of the majority of the industry.  BWLD franchisee mix was 68% in 2006 and is currently 49%, while RRGB franchisee mix was 40% in 2006 and is currently 15%.  Due to this key industry divergence, BWLD has attracted activist investor Marcato, who is currently attempting to shake up both the C-suite management and board of directors, as well as its capital structure.  This case study highlights the opportunity to refranchise restaurants and use the ensuing proceeds to repurchase stock.  We believe that RRGB may follow a similar path, and expect CFO Guy Constant to outline refranchising plans at its May Investor Day.

Refranchising Scenarios

At Chili’s, Guy Constant implemented a very successful restructuring process that quickly increased the franchisee mix from 20% in 2006 to 40% in 2009.  Based on our analysis, we believe that a similar 40% franchisee and 60% company operated mix is the right target for RRGB as well.  We conservatively assume that the primary locations are company-owned, and therefore estimate franchisee AUV at $2.6 million, below the Company’s overall $2.8 million AUV.  Based on our estimate of $439,000 in store level cash flow, and using a 4.0% royalty fee with a 5.5x valuation multiple, we expect $1.9 million of estimated proceeds per unit.

Under this base case scenario of a 40% franchisee mix assumption for RRGB,  the Company would need to refranchise 136 units, resulting in total proceeds of $251 million and after-tax proceeds of $198 million (assuming RRGB’s current 21% effective tax rate).  If RRGB were to use these proceeds to repurchase shares at an average price over time of $70.00 per share, the potential share count reduction would be 2.8 million, resulting in 27% earnings accretion.  If Guy Constant were to choose a more conservative target of a 30% franchisee mix, the total after-tax proceeds would be $117 million, resulting in a share count reduction of 1.7 million shares and 15% earnings accretion.  Conversely, if Guy Constant were to choose a more aggressive target of a 50% franchisee mix, the total after-tax proceeds would be $280 million, resulting in a share count reduction of 4.0 million and 44% earnings accretion.

Free Cash Flow

We estimate $10.17 per share in free cash flow in our longer-term model, equating to a current yield of 14%.  Throughout 2017 and 2018, we expect an aggregate $160 million of debt paydown.  This would considerably lower RRGB’s debt/EBITDAR ratio from 4.4x in 2016 to 3.0x in 2021.  Moreover, assuming a maintenance capex run rate of $25-$35 million going forward, suggests a maintenance capex free cash flow yield of 14% currently, and 19% longer term.  Furthermore, RRGB’s current 2018 free cash flow yield of 12% ranks as the highest in the casual dining industry with the peer group average at 6%, and is also above its historical average of 5% and in-line with the 2011 peak of 12%.  This serves as strong valuation support should the Company unexpectedly cut store growth and run the business for cash flow.    

Restaurant M&A

Recently, there has been a dramatic increase in mergers and acquisitions in the restaurant space.  Over the past 10 years, the average EV/EBITDA takeout multiple in the restaurant industry is 10.5x, with deal sizes spanning between $42 million and $11.4 billion.  In the past quarter alone, there have been three noteworthy M&A transactions: Panera Bread Company (PNRA) acquired by JAB Holdings at 15.4x EV/EBITDA, Cheddar’s acquired by Darden Restaurants (DRI) at 10.4x EV/EBITDA, and Popeyes Louisiana Kitchen (PLKI) acquired by Restaurant Brands International (QSR) at 18.5x EV/EBITDA.  The closest comparable peer out of these three names for RRGB is Cheddar’s, which was acquired for 10.4x.  Applying this multiple would imply an $89.00 share price, or 49% upside from current levels.  We believe that RRGB is an attractive takeout candidate given its industry low margins, superior free cash flow profile, and above-average industry traffic levels. 

Conclusion

We believe RRGB is in the early stages of a multi-year operational turnaround, initiated by the arrival of CFO Guy Constant, and his keen focus on enhancing RRGB practices to better align with basic industry standards.  With a clear path to 280 bps of margin improvement, a material opportunity to increase free cash flow per share and to re-align its current franchisee mix and repurchase significant shares, we believe these multi-year value enhancing initiatives will create substantial shareholder value. 

RRGB is currently trading at 17.6x 2018 P/E and 6.7x 2018 EV/EBITDA, compared to the peer group average of 19.0x and 9.3x, respectively.  We believe this material disconnect severely undervalues RRGB’s long-term earnings power.  We estimate earnings power of $6.71 and EBITDA of $200 million by 2021.  Based on our $200 million EBITDA estimate and a 10.3 million share count, our long-term price target for RRGB is $106.21 per share, implying 78% upside if Guy Constant’s plan is executed effectively. 

Our conviction, in part, is premised on Guy Constant’s prior achievement of superior results during the Chili’s restructuring process, and our belief that RRGB represents a very similar, if not superior, opportunity.  We anticipate that RRGB can improve margins at a faster rate than the market expects given the substantial “low hanging fruit” in both the front of house and back of house initiatives.  Furthermore, we believe the RRGB traffic inflection, versus the industry, over the past four quarters has not been properly reflected in the Company’s valuation.  As the off-premise and value menu initiatives take place this year, we believe these sales drivers will better align RRGB with average industry practices and further enhance top-line consistency.  As always, we will continue to monitor RRGB, the credit markets, and the overall casual dining industry, and will add to, or subtract from, the position as conditions warrant. 

Important Disclosures

 Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control.  Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete.  We undertake no responsibility or obligation to revise or update such Statements. 

Catalyst

Investor day with updated turnaroudn and  capital allocation plan

Operating margin improvements

Improved franchisee mix

Potential large share repurchase