Description
If a bankrupt, debt-ridden restaurant chain that features E. Coli on selected Midwestern menus doesn’t spell good investment, I don’t know what does. Worldwide Restaurants Concepts is the artist formerly known as Sizzler, that being the Sizzler which entered Chapter 11 in June of 1996. SZ, originally and wisely spun off to shareholders when Pepsi acquired most of the KFC related assets of parent Collins Foods in 1991, emerged from Bankruptcy in September of ’97. That was pretty much the high water mark. Sizzler trades today 75% & 60% lower than its average stock prices in the respective Bankruptcy years of 1996 and 1997.
Sizzler’s trip toward bankruptcy started when it revamped its restaurant strategy, shifting from a middle range steakhouse to an all-you-can-eat buffet format, in response to increased casual dining competition in the late 80s. It continued to build stores while SSS were nosediving (otherwise known as the retail death spiral), as big eaters, a diminished brand, and cannibalization bit into margins. It didn’t help that it was competing with all-you-can-eat joints that were double its size. At one point, (91-98) SZ actually had 27 consecutive quarters of US SSS declines. In 1992, revenues had reached $543 million, more than double where they stand today, a decade later. The Bankruptcy was actually mostly tactical (re-negotiate operating leases) and didn’t wipe out or even dilute the equity. The plan was to close 130 or so under-performing stores and refocus the brand back up to the middle market, away from the all-you-can-eat concept. No serious changes were made to Sizzler’s "other" business, the 90 or so KFCs it operated in Australia, which themselves had been consistently profitable while the core business withered.
Initial post-bankruptcy results were encouraging. SSS rocketed, debt was reigned in, and operating income was $11.6m and $11.8m in 1998 and 1999, despite revenue dropping from $300m in ’97 to $226m in ’99. Free Cash Flow (Operating Cash Flow less Cap Ex + Gains from disposals - other investment) in was $8.1m in 99 alone. Operating results have turned down in the last six quarters, caused by a number of factors, including E. Coli incidents into two Milwaukee Sizzler’s (franchised, not company operated) and a steady decline in the Australian dollar, impacting its KFC and Australian Sizzler operations. But notwithstanding the E. Coli issues, Sizzler’s return to the mid-scale market has create a fundamentally decent business. Here are the Same Store Sales for the last 14 quarters for US Sizzler, International Sizzler, and the KFCs it operates in Queensland, Australia. The E. Coli incidents hit at the end of Q1 01. The international and KFC SSS are constant currency.
Q1 99 Q2 99 Q399 Q499 Q100 Q200 Q300 Q400 Q101 Q201 Q301 Q401 Q102 Q202
US Sizzler 7.2% 7.4% 6.5% 3.3% 2.9% -0.6% 2.9% 5.7% 1.9% 0.7% 0.1% -1.6% -3.2% -0.7%
Int. Sizzler -5.3% -0.3% 2.2% 0.8% 4.3% 2.0% -6.0% 0.8% 0.6% -4.1% -0.5% -1.8% -2.0% 7.9%
KFC (Au) 1.3% -0.8% -1.2% 10.5% 2.8% 6.4% 6.5% 3.7% 6.1% 4.0% 2.6% -2.7% 1.3% 3.7%
(I hope that turns out legible)
It’s worth noting that the US drop off coincides with the fairly well publicized E. Coli problems, and that the MRQ marks the first period reversal of trend, despite it including the weeks following 9/11. International Sizzlers also produced strong comps in Q2 as compared to recent numbers, albeit off of an easy base period. Australian KFCs have been strong performers, and the 2001 hiccup came in conjunction with Australia’s imposition of a 10% Goods and Services tax, and itself seems to be reversing.
The E. Coli incidents and the decline in the Australian dollar conspired to depress results in Fiscal 2001. In addition, SZ made an acquisition in FY 2001, spending around $18 million for 82% for family owned Oscar’s, an 8 store take-out/catering/dine-in chain of California restaurants. It immediate expansion of that chain (now known as Pat & Oscar’s) resulted in a negative earnings contribution in FY 01. Here are operating results from 1998 through 2001, excluding charges in 2000 related to a sale leaseback transaction and remaining Bankruptcy debt (the debt is now extinguished and all liens were lifted last year).
1998 1999 2000 2001 Revenue $242,300 $226,326 $239,494 $245,341
Op. Earnings $11,573 $11,762 $11,993 $7,072
Net Income $5,400 $7,392 $8,819 $2,412
(2000 net income assumes 1999 effective tax rate after adding back one time charges mentioned above)
Pat & Oscar’s took $1.783m from operating income in 2001, meaning the existing business actually generated operating profit of $8.85m, E. Coli and exchange rates considered. The exchange rate in particular cost $.9m in operating profit in FY 01 ($19.9 million in revenue less $19m cost savings), which would make ’01 results $9.75m. Normalized operating margins for the combined operations was around 5% for the entire period, after taking into account P&O pre-opening expenses and exchange rate problems.
The Current Business
Sizzler’s currently operates the following owned and franchised restaurants:
Owned Franchised
US Sizzler 67 185
International Sizzler 30 56 (plus 3 JV)
KFC (Australia) 107 0
Pat & Oscar’s 14 0
The business strategy, an extension of the post-bankruptcy tact, has been to reposition Sizzler back up the ladder as a middle market casual steakhouse rather than an all-you-can-eat Buffet. Even with the terrible E. Coli trouble, US Sizzlers have been consistently profitable since the Bankruptcy. A lot of Cap Ex went toward remodeling all of the company owned stores in the past two plus years ($11.8m in ’01 alone) to a more upscale environment. The remodels are finished (in all, they cost $225K per store), but Franchise remodels are now underway, and should finish by the end of FY 03. Meanwhile, KFCs continue to rumble along, with some period cross-selling through the other YUM stepchildren.
Pat Oscar’s is an interesting business that was cruising along at 16% operating margins (20% EBITDA) margins before SZ acquired them and started expanding and incurring pre-opening costs. The California economic troubles as really hut the take-out and delivery business – as has some cannibalization – so comps have not held up (but also have hardly cratered). With 14 stores open now, and 4 or 5 to open in the next year, P&O should be a reasonably significant contributor to operating income in FY 2002 and begin to suck up some of the substantial NOLs.
Management is led by CEO Chuck Boppell, who came from La Salsa in April ’99, but also includes officers that were around to see what went wrong leading up to the Bankruptcy, like ex-CEO Kevin Perkins. There has been significant insider buying in the past several months at or around recent prices. Significant buying has include Boppell, Perkins, Directors Robert Muh and Charles Smith, Chairman emeritus and Director James Collins and Phillip Matthews (some of the buying from International Officers related to covenants entitling them stock option rights upon purchases). Officers and Directors own over 19% of shares out. In the last year, the company announced and implemented a 2 million share repurchase.
Valuation
The core three business: SZ US, SZ International and SZ Australia are in a zero to moderate growth mode. Although the long term plan to resume outside franchising of the Sizzler brand in the US, none is underway right now. Store growth is limited, but will likely exceed shrinkage in all three segments. If they can be successful off of an E. Coli scare and very poor US & Australian economies, there’s reason to think they have some staying power. Average operating income for the past four years (i.e. since emerging) has been approximately $11.5 million, reflecting very attainable 4.7% operating margins from current run rates.
It’s a restaurant, so operating cash flow regularly exceeds operating income (NIBCLS exceed AR+INV). OCF for the first two quarters of FY 02 alone were $8.65 million. But if you assume that operating income will be flat going forward save for a slight inflation-pacing growth, the impact is nil. Although Cap Ex exceeded D&A significantly in FY ’01, that solely because of the one-time remodels, and it is not expected (and in fact has not this year) to continue. Applying normalized effective tax rate (ignoring NOLs for now) of 35% and discounting at 15% and assuming 2% inflation-pacing growth nets a pre-debt value of $57.5 million for the three core businesses.
Pat & Oscar’s is a bit of a wildcard. SSS grew like gangbuster while it was private, but as mentioned have slumped recently (Last 5 quarters from most distant to most recent: 4.9%, 5.5%, 2.5%, -0.9%, -1.8%). The 14 current stores are good for around $40 million in annual sales at recent outputs. Profitability is hard to judge. After supposedly producing 20% EBITDA as a private business, it will likely generate only a small operating profit this year ($.5 operating profit in the first half versus a $0.3 loss last year). Despite the issues, SZ has this year been very successful at cutting P&O’s prime costs, getting them down below 60% from the 65% area a year ago. Management believes that 15% operating margins would be attainable ASAP if they put a halt to expansion. I’ll assume that P&O can only generate 1/2 of its prior EBIT margins as it grows, producing $4 million in operating income at the current run rate ($2.6 million in NOPAT). Ignoring growth entirely, that fair values the business (excluding debt) at 15% discount rate at $17.33 million (which is substantially less than SZ paid last year, including debt assumed).
The four business then are good for $72.9 million before debt but after taxes (under the obviously subjective assumptions).
Unfunded Pensions
SZ has a $9.4m liability relating to a discontinued (1992) retirement plan for 11 employees, which is run through the P&L as interest expense, so it has to be taken into account if you’re starting from a higher line item, like EBIT, which I did. The $9.4 million is a fair reflection of the present value of the annual outflow, and should be treated exactly like debt and added to EV. That takes value down from $72.9 to $63.5.
Net Debt
MRQ interest bearing debt plus capital leases totaled $29.8 million. Cash on hand plus restricted cash were $21.7 million. Though an $8.1 million face difference, I’m adding the estimated $1.8 million of restricted cash related to employee benefits (the rest is debt covenant related). Add the resultant $9.9 million to EV. $63.5 goes down to $53.6
Taxes
SZ gives a virtual 100% allowance to its substantial carry-forward NOLs and Tax Credits. Of $62 million in deferred tax assets (that’s net, not gross), all but $2 million are written down. The allowance is surely conservative and there should be annual periodic valuation reversals in future periods, though there is a very good chance some is postponed indefinitely due foreign income, AMT or the plain inability to produce enough income. I assume, somewhat arbitrarily, that only $2 million per year for the net 15 years can be recognized, with the remaining 50% lost forever. That’s a present value (discount rate of 15%) of $11.7 million for the discounted, reduced tax asset. Add that to $53.6 million for $65.3m in value to equity holders.
Options and Warrants
There are approximately 2.5m options out and another 1.2 million in Warrants. The Warrants, given in the Pat & Oscar’s acquisition, are K = $4, so they’re not much of a cost at recent prices. The company has no history of repricing, but does offer a direct option plan to management of its Australian operations that can dilute up to 15% of its Australian business (not the rest of the business). $5 million exceeds the standard (Black Scholes) value of the warrants, but I’ll use it to account for unknown such as repricing. The net result is a $60.3 million value to equity holders employing a 15% discount rate. That compares to a current market value of approximately $32.6 million.
Some Historical Valuation
Historical P/B and P/S ratios:
2001 2000 1999 1998 1997 Current
Price/Book 1.13 1.47 1.54 2.28 1.96 0.58
Price/Sales 0.24 0.34 0.28 0.34 0.20 0.13
I didn’t provide historical Price Earnings ratios because my investment thesis relies in part on distorted trailing earnings. I believe that net income for FY 2001 and the first two quarters of FY 02 are not representative of true earnings power due in part to (1) the impact of Pat & Oscar’s losses (2) The negative impact from the falling Australian dollar (3) The impact of the Milwaukee E. Coli incidents that seems to be fading I import. That said, the current PE based on 01 earnings is 12, but comparisons are difficult to due the bankruptcy and one-time charges. On a price to operating cash flow basis, SZ looks ridiculously cheap, (3.2 times last year’s and less than 2X estimated 02) but P/OCF can be misleading.
Risks
*The E. Coli incidents in Milwaukee have invoked a spate of lawsuits. The primary parties at risk are Excel corporation, the meat supplier, and the relevant franchisees (franchises are since closed). SZ also has legal liability, but the extent would normally be easily covered by insurance. However, its primary insurer, Reliance, was declared insolvent this year by Pennsylvania. Still, management seems absolutely convinced that SZ has plenty of secondary insurance to cover any E. Coli claims, and say that settlements to date have confirmed that idea. It’s conceivable that Reliant’s problems could also hurt SZ’s chances of recovering on a BI claim, but that’s not on the balance sheet.
*Pat & Oscar’s SSS trend is a red flag. With only 14 locations, you hate to see negative comps, even given the recessionary environment. Moreover, P&O reflects management intent on growing the business, which is a dangerous inclination for a company like Sizzler.
*Management doesn’t always strike me as scared enough. Considering they are four years out of Bankruptcy and trading near an all-time low, there is not enough fear in eyes of management for my tastes. Debt is very much under control, with only $8 million in debt over liabilities, but the Sales leaseback in Australia to help finance the P&O acquisition created additional operating lease obligations ($89 million total, PV around $58m) which are added leverage. Expansion has been moderate, thankfully, and planned cap ex is down, but acquisitions and repurchases instead of debt reduction shows some hubris, which can be dangerous.
*To a substantial extent, you are betting on a mediocre brand name in a very competitive field with management that has been effective but is relatively new. That’s a risk.
Catalyst
With the E. Coli problems & Exchange rate blips mostly behind it, and Pat & Oscar's quickly reversing operating losses to becoming accretive, look for results to improve in the intermediate term (six quarters). Sizzler's $15-$20 million remodeling program and debts from its bankruptcy has funneled the plentiful cash flow in recent years to areas that don't shout out to investors. With reduced cap ex and zero bankruptcy obligations remaining, future cash flow should bolster the balance sheet appreciably. The remodels appear to have prevent a SSS implosion during the downturn, and the core earnings power of the business will become more clear in the next several quarters. No information on any external (buyout) catalysts.