Long Equity- Star Buffet, Inc. (OTC:STRZQ)

I am recommending the purchase of the common equity of Star Buffet, Inc. (OTC: STRZQ).  Current price is $1.81 and my conservative 3-6 month target price is $4.23.  Star’s total market cap is under $7 million and, due to its small size and illiquidity, this write-up should probably be used for personal accounts and extremely small funds.  It is not actionable if you need to put $1 million to work.  However, it is due to its small size that the opportunity exists and is so compelling.

Company Description and Situation Background

Star is currently operating while attempting to reorganize through Chapter 11.  As of now, there is a Plan of Reorganization in place that is supported by most parties.  There is a hearing on the Plan that is scheduled for December 3, with oral arguments concluding on December 6.  Assuming no delays, Star could exit Chapter 11 by mid-January 2013.

Put simply, Star is a restaurant holding company. Its subsidiaries own and operate a variety of moderately priced, family-oriented restaurants in suburban and rural areas throughout the US.  Most of the restaurants are branded in some form or another (Star owns most of those brands and franchises others, though a few of the restaurants are operated singularly).  Some of the brands are buffet style, others are just country diners.  (Here are some examples: JB’s Family Restaurant, K-Bob’s Steakhouse,  HomeTown Buffet ) At its peak in 2008, Star operated somewhere in the neighborhood of 58 restaurants (some were always opening and closing) and produced approximately $98 million in sales.  Star had levered up in early 2008 to acquire 20 Barnhill’s Buffet restaurants.  Wells Fargo provided approximately $9 million of debt to fund the acquisition (term plus revolver).

During the recession that began in 2008, people cut back on discretionary expenditures across the board and small town restaurants suffered severely.  Star was forced to close unprofitable restaurants, sometimes prior to leases ending, and they could not fully service their debt.  Further, what drove Star to seek Chapter 11 protection was litigation with some of its landlords who were seeking immediate lease termination fees and other damages in excess of what Star could provide.

Star’s Assets and Liabilities and the Plan of Reorganization

At the time of filing, it appeared that Star operated approximately 32 restaurants (15 of which it owned the land and building), leased two other properties it owned to other restaurants that operated them and owned five vacant buildings that formerly housed restaurants.  Through research and conversations with the Controller, it appears that Star currently operates 27 restaurants (13 of which are owned). 

At the time of filing, Star had a little under $10 million of secured debt ($5.575 million under Wells Fargo facility plus property-specific mortgages) and subordinated debt of $2.3 million in the form of a note to its Chairman and CEO Robert Wheaton.  It should also be noted that Mr. Wheaton owns approximately 45% of the common equity.  Capital structure as of petition date is shown below.

Secured debt (Wells faciltiy plus property-specific mortgages): $9.6mm

Sub debt (Wheaton Note): $2.23mm

Total debt: $11.91mm

Once it filed, certain of Star’s landlords and vendors who were also owed money filed unsecured claims.  Those claims have not yet been allowed/disallowed, but the attorneys have told me that the upper limit of the unsecured claims pool is approximately $2 million, though it could very likely be much less as there is a Chapter 11 statute capping landlord claims at the greater of one year’s rent or 15% of the total amount remaining on the lease and apparently some of the landlords have filed claims significantly in excess of these amounts.

Now, for the Plan of Reorganization.  Since Star did not file because it was insolvent, there is no need to liquidate.  Its assets are in excess of its liabilities, so long as its assets can be monetized prior to being forced to satisfy creditors.  Essentially, that is the goal of this plan.  Basically, 10 of Star’s owned properties are to be sold to satisfy its creditors over the course of the next four years.  These 10 properties include 3 restaurants that Star currently operates, 2 restaurants that Star leases to third parties and 5 closed restaurants.  These properties are being marketed for $13.5 million.  As you can see, that amount would be enough to pay off all of Star’s debt.  Basically, on the Plan’s effective date, Star is only required to pay admin claims (lawyers/other professionals) and approximately $327,000 to Wells Fargo.  These payments are being funded by cash on hand and an exit loan from Mr. Wheaton for $300,000 that will then be subordinated to all secured claims.  Then, from the proceeds of property sales and cash flow generated by its remaining restaurant operations, Star will make quarterly payments to its creditors according to a traditional waterfall until all creditors are paid in full.  Proceeds from the restaurants that have mortgage debt on them will go toward paying off that specific mortgage or lienholder, and the remainder will be applied 50/50 to Wells Fargo and the unsecured creditors.  Shareholders retain the entirety of their equity interests.  The plan leaves shareholders completely unimpaired and, post effective date, the shares will continue trading in their current form and will not be diluted at all.

The reason that this plan has such a high likelihood of confirmation is its adherence to the strict priority rule.   Since every class is going to be paid in full and equity holders will not be paid anything prior to creditors being fully paid, there is minimal cause for unsecured creditors to reasonably object.  However, just because there is no cause to object does not mean that the Unsecured Creditors Committee (UCC) has not objected.  Though they have objected a few times, from speaking to UCC counsel I gathered that their main concern is not if there will be adequate proceeds to pay them off, but more along the lines of setting a timetable with milestones so that Star will not just keep “marketing” these properties into perpetuity.  I think it is likely that by December 3, there will be some agreement on consensual monitoring terms to give the UCC confidence that there will not be bad acting among the parties.

Valuation

Thankfully, once the properties are laid out, the future operations of the business are determined and the creditors are tabulated- it becomes a simple net asset value calculation.  I’m being moderately sarcastic now.  All three of these things are extremely difficult to track down, evaluate and quantify in a small bankruptcy like this one.  I did my best, but there is always incomplete information and certain assumption made to fill in gaps.  I will try to illustrate my thought process and rationale in detail below.

First, what are the ten properties being marketed for sale actually worth?  Well, the Disclosure Statement lists them all and what they are expected to sell for.  I tried to confirm this.  I was able to find listings for half of the properties, only one of which is actually listed for less than stated in the Disclosure Statement.  Next, I called brokers.  Since some of these properties are operated by Star, some are operated by third parties and some are vacant, each has a different buyer profile. The properties that are leased are in fairly decent sub-markets in Florida, being sold to triple-net buyers and are both leased by restaurant companies with more than one location.  Even the vacant lots are in good sub-markets and the brokers have said that they are in good locations that have shown solid demand from buyers (think Wal-Mart/Target outparcels, near malls, close to main streets, etc.).  Two of the three open restaurants are HomeTown Buffet’s in Scottsdale and Yuma, AZ and are currently operated by Star.  They are being marketed to both financial buyers whereby Star will lease the restaurant back and continue operating, or other restaurants that want that location for themselves and Star will vacate.  This flexibility should make them easier to sell and brokers have told me that there has been more interest than usual around these properties.  The total value of the properties being marketed is $13.5 million.  Although I don’t believe this is especially ambitious, for conservatism I am assuming these properties are all sold for 85% of list price, valuing the real estate being marketed for sale at $11.48 million. (Note: just for clarity’s sake, I have broken up the properties for sale into buckets based on whether the individual properties are secured by the Wells Fargo facility, property specific mortgages, or are unencumbered)  Also, it is worth noting that I do not project any tax leakage from these property sales, as Star currently has approximately $10 million of NOL’s.  The net book value of the buildings being sold is likely significantly greater than $1.5 million, which means that the book gain on sale will be less than $10 million.

Next, what are the operations of the business worth?  To help us a bit, in the Disclosure Statement filed on March 26, 2012, Star provides projections of its pro-forma operations.  These projections are designed to be conservative and show a pro-forma FY 2013 projected revenue of $39 million and EBITDA of $3.5 million.  My goal was to make sure that this passes the reasonableness test and, if necessary, to adjust the pro-forma EBITDA to a level that does. 

Since Star has constantly been opening and closing restaurants, it is important to understand how many locations were assumed to be operating when these projections were produced.  The Controller would not tell me exactly, but led me to believe it was in the 29-30 range.  This makes sense since, historically, these restaurants have done somewhere in the neighborhood of $1.3-1.6 million in yearly sales per location.  (What makes me feel even better about this number is that, in a worsening economy in 2008, Star’s 58 restaurants averaged $1.7 million per year in sales.  Going forward with less than half those restaurants enabled Star to shutter the underperforming locations.  Also, it is worth noting that a cursory examination of the only public peer over the past few years, Buffets Holdings, shows those roughly 400 similar buffet-style restaurants averaging $2.6 million in sales over the five year period from 1999 to 2004, which shouldn’t be too different from the 2013 economic environment). 

I also believe the $3.5 million in EBITDA to be fairly reasonable.  It is based on restaurant operating income of approximately $4.65 million, or 12% of revenue.  This would be about the lowest among all publicly traded restaurant companies.  Even terrible concepts like Ruby Tuesday do over 16.5% restaurant operating margins.  This is even more plausible when you remember that Star will continue to own the real estate at 9-10 of its restaurants going forward, causing it to expense non-cash depreciation rather than paying cash rent.  It is also worth noting that, in the two year period from 2003-2004, Buffets Holdings generated restaurant operating margins of 13.6%.  Considering that 2013 should not be a worse economic environment than 2003- 12% restaurant operating margin is certainly more than plausible.  The last point to remember is that Chapter 11 affords companies the opportunity to reject leases.  I was told that Star took this opportunity to only keep its most profitable restaurants open.  Therefore it stands to reason that the Company’s revenue per unit and 4-wall operating margin would be a good bit higher than the historical system average.

The second portion of the EBITDA calculation is the projected $1.1 million of SG&A.  I think that’s extremely plausible for a company with only six corporate employees and likely only $200k in public company costs.  After speaking to the Controller, he told me that some restaurants have closed and some re-opened since these forecasts were provided in March.  Assuming the buyers of Star’s two Arizona properties are owner/operators, that would mean Star would be operating 25-27 restaurants going forward.  I ran that by the Controller and he told me that the projections would only change minimally since the restaurants that have been closed in the interim and are for sale are not great performers.  Star’s lawyer confirmed that when I spoke to him, going so far as to say that new projections would likely be filed as exhibits to updated declarations by the middle of next week with EBITDA changing “only by around 1%”.  Even with $3.5 million of EBITDA passing the reasonableness test, to be conservative I have discounted my estimate of 2013 EBITDA down to $3 million.  Using $3 million of EBITDA and adding back the $1.1 million of SG&A, we arrive at a pro-forma restaurant operating margin of only 10.5%.  This is more than reasonable and is likely too conservative.

To quantify the going concern value of this business, I think it is more than fair to use a 6x EBITDA multiple, especially when mature, value-oriented lower-casual concepts like Cracker Barrel, Ruby Tuesday, Denny’s and Texas Roadhouse are trading in the 7-9x range.  Multiplying $3 million of EBITDA by 6x values the restaurant operations at $18 million. 

It is important to note that the continuing restaurant operations include 9-10 owned properties.  Even assuming that my value for the restaurant operations is incorrect, according to property tax records and my estimates, these 9-10 buildings are worth a minimum of $5-7 million.  This at least provides a decent margin of safety once Star exits Chapter 11 and a potential source of future value extraction for shareholders.  It is also worth pointing out that Star has some current cash on hand, generated from its restaurant operations while in Chapter 11.  Star’s attorney would not tell me the exact amount, but did say it was “significant”.  When I asked him to give me a range, he gave me between $1 million and $5 million.  I use $1 million in my calculation of value.  A table of my pro-forma estimate of “sources of value” is shown below.

Exit Loan from Wheaton: $300k

Cash on hand: $1mm

RE Sales of 5 WFC encumbered properties: $5.44mm

RE Sales from 4 other encumbered properties: $4.126mm

RE Sales from 1 unencumbered proeprty: $1.92mm

Value of continuing restaurants: $25mm

Total sources of value: $30.78mm

Conceptually, this valuation of approximately $30.8 million for the entirety of the enterprise is not unreasonable.  In the middle of 2008, on a similar asset base, in a severely worsening economy, the market valued Star’s enterprise at over $33 million.  The only thing that has changed about the assets is that Star has closed underperforming, leased locations.  The owned locations that Star chose to continue operating should be profitable.  Also, shareholders actually have a path toward value realization (the monetization of the real estate) that, prior to Chapter 11 was not realistically going to occur.  Therefore, the entirety of the previous $33 million valuation was based solely on Star’s restaurant operations.

Estimating the “uses of value” is a little more straightforward.  The only real estimates to be made are in quantifying the admin/priority tax claims and the actual amount of the unsecured claims pool that is likely to be allowed.  The other obligations are the revolver, term loan, mortgage debt and unsecured note listed in the capital structure above.  I was told by the attorneys that Star is fairly current in its payment of professional fees.  And, since bankruptcy is seemingly run solely for the benefit of lawyers and bankers, their fees get paid before anyone else does.  Because these invoices are generally prepared/submitted with lag time of a few months, it is my estimate that the unpaid priority/admin claims should total no more than $100,000-$200,000 as of the effective date.  The IRS has submitted a tax claim in the amount of $2.4 million.  I can’t get much color on this claim, other than that it will be paid over a 4+ year period, while the admin fees will be paid on the effective date.  However, the IRS is no different than other creditors and often submits a claim in excess of what it actually is owed and ends up getting.  But, since I can’t truly quantify what this claim actually may end up being, to be conservative I will count the entirety of the claim as a “use” and cap the “priority/admin” bucket at $2.5 million.

The unsecured claims pool is a bit trickier.  This one will flex depending on who is opining.  Obviously Star would like the number to be lower and UCC counsel would like it to be higher.  It appears from various schedules that over $5 million of claims have been filed.  Anyone who has been involved in a bankruptcy before will know that people who don’t have legitimate claims submit them anyway, and parties with legitimate claims will try to grossly inflate the value of those claims.  From looking through the schedules on the first day petition, it appears that there are roughly $2-3 million of claims from legitimate parties that have not been already counted in my capital structure (i.e. non-mortgage holders).  Going back to the point I made above, Chapter 11 allows for leases to be rejected.  Outside of Chapter 11, these landlords would be entitled to a negotiated lease termination fee or the balance of the rent payments for the duration of the lease.  However, in Chapter 11, landlords are only entitled to either one year of rent or 15% of the remaining rent on the lease.  So, even if a landlord thinks he is owed the rent for the duration of the lease and files a claim for $700k, he may only have an allowable claim for $150-$200k depending on the lease terms (in this case this specific example applies to Star’s landlord Oshunola LLC).  Based on talking to all of the attorneys and reading all of the filings, I have decided to be conservative and estimate the general unsecured claims pool at $2.3 million, the total of the claims submitted by legitimate parties, even though it is likely that these parties will see their actual claims come in a good bit lower.  A table with my estimated “uses of value” is shown below.

Estimated Priority Tax/Admin Claims: $2.5mm

Wells Fargo initial revolver principal reduction: $327k

Wells Fargo Revolver/Term Loan: $5.25mm

Property-Specific Mortgage Debt: $4.11mm

Maximum Estimated Unsecured Claims Pool: $2.31mm

Unsecured Debt (Wheaton Claim+Exit Loan): $2.53mm

Total Uses of Value: $17.02mm

With total sources of value of $30.8 million and total uses of value of $17 million, the residual value all accrues to common equity.

Residual Value for Equity: $13.76mm

   Shares outstanding: 3,250,000

Total Estimated Equity Value: $4.23

Thus, I arrive at my base case equity value of $4.23 per share.  For reference, I also ran possible upside and downside scenarios that take into account different real estate sale values and different EBITDA multiples for the operations.  These scenarios provide an equity valuation range of $3.56 (RE sold for 80% of list and restaurants worth 5.5x PF EBITDA) to $4.90 (RE sold for 90% of list and restaurants worth 6.5x PF EBITDA).

Potential Risks

The possible risks to this analysis are threefold: 1) The real estate does not get sold ever or gets sold for significantly less than asking price.  I don’t believe there is a risk of the real estate never getting sold, since the court will likely set milestones for creditors to actually get paid.  We also know that everything can get sold if the price is right.  I think that conservatively valuing all of the assets being marketed for 85% of list price mitigates that issue fairly well.  2)  The 25-27 restaurants being operated by Star post-Chapter 11 are not worth $18 million.  My analysis is above so I will not repeat it here.  However, the Company is projecting somewhere in the neighborhood of $3-3.5 million of 2013 EBITDA- I use $3 million for my analysis.  I don’t see the lower end of the casual dining industry falling off a cliff again like it did in 2008. All signs point to continued stabilization and low to moderate growth.  3)  The unsecured claims pool is actually greater than $2.3 million.  I think it is more likely that the final allowed unsecured number comes in lower than $2.3 million for the reasons espoused above, but there is a chance it comes in higher.  For reference, if it were to double and actually be a pool of $4.6 million, the estimated equity value would drop to $3.45, still a significant premium to today’s market price.