Description

Rubio’s (RUBO), trading at 4.3x EV / EBITDA with no debt and 21% of its market cap in cash, is one of the cheapest restaurant stocks you can purchase. It will grow EBITDA by at least 15% over the next several years yet it is trading at close to half the multiple of many its competitors. RUBO has several upcoming catalysts including the McDonald’s spin-off of Chipotle, commencement of an expansion program, easing comps, a reinvigorated menu and remodeled store base driving traffic and the sale of the company to either a financial or strategic buyer within the next 12 months.

Background:
Rubio’s is a fast casual Mexican dining concept. Currently, it is the only pure play public Mexican chain. The company operates 152 restaurants, 147 company owned and 5 franchised. Its stores are primarily in California (120). RUBO claims to have invented the “affordable fast casual” segment. Its average check size is $7 - $8, between that of fast food and casual dining restaurants.

Ralph Rubio, the company’s founder, opened the first “Rubio’s Home of the Fish Taco” in 1983. After raising $17M in venture capital in 1995, the company renamed itself “Rubio’s Baja Grill” in 1987 and more recently “Rubio’s.” The company went public in 1999 with 64 stores. Historically, the company was known as the home of the fish taco but has since changed its menu to be more of an authentic Mexican chain. The company used its IPO proceeds to expand aggressively. RUBO opened 31 stores in 1999 and 36 stores in 2000. These stores were opened with very little market research. Same store sales growth slowed and expenses rose. During 2000 and 2001 the company took several impairment charges and lowered its growth plans while closing underperforming stores. At the end of 2002, the company began a re-branding effort that drove menu prices higher, lowered store traffic and raised product costs. Additionally, the company went on an aggressive marketing campaign that further hurt its ROI.

By mid-2003, the company hired John Fuller, its current CFO, and began to focus on lowering costs and adjusting menu prices. By the end of 2004, the company was a year into its turnaround efforts and promoted Sheri Miksa, the company’s COO, to CEO. At this time, the company announced its plans to grow units by 10 – 15% annually over the next several years and hired an “expansion” team to survey the market. The stock ran in anticipation of this growth only to be disappointed that the expansion team needed additional time to determine the most appropriate growth strategy (they had only been with the company for less than two months). Since then, the stock has lingered in the $9 area for most of 2005. With future growth plans set to be laid out, remodeled stores and a new menu driving traffic and a management team and insiders willing to sell, I believe that the stock is poised to rise by at least 50% over the next 12 months.

Stores:
New Rubio’s stores cost approximately $500k to build plus $45k in pre-opening costs ($25k of which is cash) and average $1M in revenue with 20% operating cash flow margins. These stores generate 40% cash ROI and have a 2.6 year payback period. Unit volumes and cash flow margins have increased from $885k / 16.5% in 2002 to $908k / 12.4% in 2003 and $942k / 17% in 2004.

Financials:
2003 2004 2005e 2006e
Revenue $125M $137M $140M $160M

Gross Profit $16.1 $23.7 $25.3 $29.3
Gross Margin % 12.8% 17.2% 18.1% 18.3%

EBITDA $5.1 $12.1 $13 $16
EBITDA Margin % 4% 8.8% 9.3% 10%


Cap Structure
Shares outstanding: 9.38M
Share Price: $9.32
Market Cap: $87M
Debt: $0
Cash: $18M
Enterprise Value: $69M

Valuation:

Current:
2006 EBITDA: $16M
EV / EBITDA: 4.3x

Projected:
Historically, RUBO has traded at approximately a 10% discount to its comps. Depending upon which comps you use, the space is generally trading between 8 and 10x EV / EBITDA with several comps trading much higher. I think 7x EV / EBITDA is a very conservative valuation for RUBO and believe a takeout multiple could easily reach 8 or 9x EV / EBITDA.

Multiple 7x 8x

2006e EBITDA: $16M $16M
2006 EV $112M $128M
Debt $0 $0
Cash $18M $18M
2006 Mkt Cap $130M $146M
Current Mkt Cap $87M $87M
Upside 49% 68%



Catalysts:
One of the reasons I like this stock so much is that there are multiple catalysts: 1) store remodelings driving increased traffic; 2) McDonald’s spin-off / IPO of Chipotle; 3) announcement of store growth initiative later this year; 4) easing comps; and 5) sale of company within 12 months.

1) Store Remodelings:

The company is currently in the process of remodeling 20% of its store base. The stores will be updated with more colorful and festive paint schemes, additional lighting, new music and more attractive furniture. I have seen both a “before” and “after” store and the improvements are dramatic. Management has indicated that remodeled stores are performing significantly better than non-remodeled stores although they have not given details. I expect the remodeling program to drive additional traffic against easing comps over the next several quarters.

2) MCD spin-off / IPO of Chipotle:

MCD announced that it is spinning off Chipotle, its Mexican fast food chain, during Q1 of 2006. Sell side analysts estimate the company could be valued at between 11x and 13x EV / EBITDA. While I am not suggesting that RUBO should trade at these valuation levels, the valuation discrepancy will be so drastic that it will provide a catalyst for RUBO’s shares.

3) Store growth initiative:

The company has plans to grow units by 10 – 15% over the next several years. I anticipate that a detailed plan for this growth will be laid out before year-end. The street has been eagerly anticipating new news on this front and since unit growth has been slow to non-existent over the past few years. When the announcement did not come earlier this year as initially expected, the stock sold off to the levels it is currently trading at. I am confident that a plan for future growth will be laid out before the end of 2005. If the company is able to grow its store base by 10 – 15% over the next several years, it will be able to grow EBITDA by at least that amount making the current valuation of 4.3x EV / EBITDA even more absurd.

4) Easing comps:

The company’s results were disappointing in Q1 and Q2. Most of the disappointment was due to weak SSS numbers. Q1’s SSS were negative, the first time RUBO put up a negative comp in 14 quarters. RUBO blamed the negative comp on record rainfall in California. All of RUBO’s stores have outdoor patios and the company relies on good weather to drive traffic. During Q2, the company faced a comp of 5.7% and put up a 1.2% number. Comps will ease to 4.1% in Q3 and 3.2% in Q4. With 20% of the stores being remodeled and new menu introductions, the company should be able to put up at least 2 – 3% comps to generate my EBITDA estimates.

5) Sale of company:

RUBO is the only public pure play Mexican fast food / casual dining concept. All of the others have been purchased by either fast food or casual dining chains: 1) Wendy’s owns Baja Fresh; 2) CKE owns La Salsa; 3) Jack in the Box owns Qdoba; and 4) McDonalds owns Chipotle (until 2006 Q2 spin-off / IPO). I am confident that the company will be purchased over the next 12 months. I am aware of several private equity firms with restaurant expertise that are in the process of kicking the tires. Additionally, there are multiple casual dining companies that are contemplating expansion into a Mexican concept. Management has publicly stated their willingness to sell the company. Furthermore, Rosewood Capital, RUBO’s initial venture investors own approximately 16% of the company’s shares and Ralph Rubio owns 11% of the company’s shares. Both are willing sellers. RUBO’s CEO told us that Rosewood is more sensitive to price than time but is looking to entertain an offer. Indications from both management and Rosewood are that they would look to sell the company in the $15 range, or 60% above the current share price.

Risks / Concerns
There are two primary concerns that are often cited. One is that the company has not proved that its concept can travel. I believe that this argument was true when the company was focused primarily on fish tacos (how many people in Utah would be interested in fish tacos?). The company has a vastly different menu today than it did a few years ago with a focus on fresh Mexican, not fresh Mexican seafood. However, stores outside of the California region are negatively affected by a lack of scale in certain areas that makes advertising uneconomical. The company’s expansion plans will focus on building scale in these markets making it more economical to do business. Additionally, the company benefits from lower labor and occupancy costs outside of California.

The other concern is competition. Primary competition comes from La Salsa (owned by CKE Restaurants), Chipotle (owned by McDonald’s), Baja Fresh (owned by Wendy’s), Qdoba (owned by Jack in the Box) and Taco Bell. The company primarily competes with its fresh ingredients and “street style” menu. It has positioned itself as the value leader within the fast casual segment and attacks both ends of the quick service segment. – fast food competitors with quality and freshness of food and casual dining competitors with price. While competition is abundant, there is a longer-term secular trend towards the growth of the Hispanic population. As a result, Mexican concept chains have grown in popularity and in demand.

I believe that the aforementioned risks plus a whole lot more is priced into the current valuation. At today’s price, you can buy the one of the cheapest restaurant stocks (on an absolute and relative basis) with a debt free balance sheet and 21% of its current market share in cash. The margin of safety is just too high to pass up at these levels.

Catalyst

1) McDonald’s spin-off of Chipotle
2) commencement of an expansion program
3) easing comps
4) reinvigorated menu and remodeled store base driving traffic
5) sale of the company to either a financial or strategic buyer within the next 12 months