Inaugural Pick - Red Robin Gourmet Burgers
One quick ground rule before we begin: In my CAPS blog, I’ve explained numerous times how "thinking like a short" has helped me become a better investor. With that in mind, for each stock I highlight I will attempt to point out the bearish indicators right along with the bullish ones. Not only do I think this presents a more balanced and honest recommendation, it’ll also help point out potential trouble spots to monitor going forward.
At least a few of you are familiar with Chipotle Mexican Grill (NYSE: CMG) and Buffalo Wild Wings (NASDAQ: BWLD), two rising stars in the restaurant business that also carry four-star CAPS ratings. What if I were to tell you that there’s a lesser-known, possible up-and-comer in this field whose revenue growth is matching its better-known competitors stride for stride and can be had for a mere fraction of the multiple that either Chipotle or B-Wild is sporting these days?
Interested? Then pull up a chair and let me introduce you to Red Robin Gourmet Burgers (NASDAQ: RRGB).
History / Profile:
Red Robin began as Sam’s Tavern back in the 1940s. The company has been through quite a few changes since then, including changing its name to Sam’s Red Robin and eventually Red Robin. In 2000, Red Robin had grown to 150 stores, and in that same year the company merged with its largest franchisee. The company had its IPO in 2002 and has since grown to 363 stores (as of the end of Q1 2007) with plans to add 21 to 26 units by the end of FY2007. Additionally, the company has been gobbling up its franchisees as of late, with 13 franchisees reacquired in 2006 and 17 so far this year.
Red Robin competes in the casual dining arena and strives to be family friendly. As the name implies, the specialty is gourmet burgers, but there are chicken, salad, pasta, and seafood dishes to be had, too. The company’s target market is middle to upper middle class households, and it tries to site new locations in areas with lots of families where household income is over $70,000 a year. According to the company, keys to its success for its target market include low pricing (average guest check of $10.70, with a beverage), convenience, and fast but friendly service. To that end, Red Robin targets an average meal preparation time of eight minutes. With a three-year-old at home, I can tell you that fast service is indeed one of the key factors our family considers when choosing a place to dine. Having eaten at Red Robin with Mrs. Eldrehad and Little Eldrehad in tow, I can personally attest that our local store lives up to this standard (fast service has its operational benefits, too, as it helps to increase throughput).
Of course, one can’t do justice to the history of Red Robin without mentioning former CEO Michael Snyder. Snyder was pretty much run out of the company on a rail along with the CFO (although Snyder officially "retired") in August 2005 as the result of an internal investigation regarding travel and entertainment expenses and documentation that was inconsistent with company policy. Mr. Market doesn’t take kindly to these kinds of shenanigans (and rightfully so), and the stock price plummeted 24% immediately after this announcement. To make matters worse, the SEC subsequently launched an investigation and shareholders filed lawsuits. The cloud of this incident has hung over the company ever since, though it should be noted that in June of this year the company received word from the SEC that the investigation had been terminated and that they determined that no enforcement actions should be taken. In additional recent developments, both of the shareholder suits were dismissed by the courts and subsequently settled by the company for a combined total of $1.75M.
The Financials: Income Statement: The Bullish:
As I mentioned, Red Robin has been growing the top line rather briskly. Trailing twelve month revenue growth is 28.6% year over year (by comparison, Chipotle clocks in at 29.0% and Buffalo Wild at 29.7%). Furthermore, the company has been growing the top line at a rapid pace as top line growth has clocked in at an average compounded rate of 23% over the past four years (FY02 through FY06). Over this same four-year period, the company has been quite successful translating this top line growth to the bottom line as diluted EPS has seen a CAGR of 29.6% over the same timeframe.
While earnings growth has been quite brisk and more than keeping pace with revenue growth over the past four fiscal years, when we look year by year we see earnings growth actually slowing. From FY04 to FY05, revenue growth clocked in at 20.5%, while diluted EPS grew at the slightly more sedate pace of 17.1%. By itself this statistic wouldn’t trouble me, but it gets worse from FY05 to FY06 when revenue growth was 27.3% vs. diluted EPS growth of only 7.2%.
Further analysis of the income statement reveals what I believe to be the two main culprits. The first is G&A. FY05 to FY06 year over year G&A expenses outpaced revenue increases by 17.7%. This takes a back seat to the real heavy-hitter, though: interest expense. Growth in interest expense outpaced revenue growth by a walloping 60.2%. Opening new stores and buying up franchisees with debt financing can be an expensive business.
On the G&A front, at least, there’s some small bit of good news. Q106 to Q107 revenue growth clocked in at 24.5%, which outpaced G&A expense growth of 19.5% over the same timeframe.
Cash Flow Statement: The Bullish:
While the company has been struggling to translate revenue growth into earnings growth over the past year or so, it’s been doing a better job of converting that revenue growth into operating cash flow growth. From FY05 to FY06, net income grew by 7.2% while operating cash flow growth clocked in at 20.3%. The prior year saw operating cash flow and revenue growth match stride for stride (clocking in at 20.5% and 20.7%, respectively). This is somewhat comforting news given that it’s the operating cash flow that needs to be used to pay the increased interest expense.
While it’s true that operating cash flow grew faster than net income FY06 over FY05, it still lagged growth in revenue by a full 7%. While not terrible, this bears watching. Furthermore, operating cash flow Q107 vs. Q106 remained relatively flat (a decline of 1.8%) while revenues grew 24.5%.
It appears to this Fool that this company, both in terms of stock performance and operational performance, has been stumbling a bit lately. The issues, however, seem related to growing pains and appear fixable. Per the most recent conference call, the stores opened in new markets aren’t performing as well, out of the gate, as similar stores opened in existing markets. The company largely attributes this to the lack of awareness and brand recognition in these new markets.
In an attempt to fix the brand recognition problem, the company has recently embarked on a national advertising campaign targeting cable television, and, to a lesser extent, the Internet. It also hired a new marketing executive. On the Q1 call, managers stated that it was too early to tell how successful the ad campaign would ultimately be, but that early signs were encouraging.
Furthermore the company has additional initiatives designed to lengthen the honeymoon period of high sales when a store first opens as well as to try to hasten the maturation process. To this end, the company has increased the pre-opening store budget by $25K to cover additional training. The company also stated that it was too early to tell, but they were pleased with results thus far.
By every measure I’ve run, Red Robin’s past growth and future growth potential can be had at a very significant discount when compared to its other fast-growing peers.
RRGB CMG BWLD
TTM Rev Growth YoY 28.6% 29.0% 29.7%
Price /Sales (TTM) 1.0 3.6 2.1
Price /OCF (TTM) 8.9 27.9 18.0
Trailing P/E 23.5 61.1 32.1
Ratios on a diluted basis and based on most recent data available
(Q2 07 for BWLD & CMG, Q1 07 data for RRGB).
There are plenty of risks with this one. Company fortunes are closely linked to food costs -- they buy their beef on the spot market … can we say Mad Cow? -- labor costs, and utilities costs, just to name a few volatile factors. Furthermore, the casual dining arena is highly competitive with a whole host of both entrenched, large-pocketed players and young, aggressive upstarts. Casual dining in general is also somewhat sensitive to macroeconomic trends as many families see dining out as an area they can curtail spending on. “We spent how much on gasoline last month? Our variable rate mortgage payment jumped again? We need to eat at home more often, honey!”
I perceive the biggest company-specific risk to be the increasing debt. Debt financing works great when the company allocates capital well -- and it can provide a nice boost to return on equity. It doesn’t work so well when the company allocates capital poorly. Given the recent operational stumbles, one could argue that over the past year or so, capital allocation hasn’t been so hot. I believe there’s some downside protection here (which I’ll get into later), but how well the company allocates the funds raised through debt financing is an area to keep one’s eye on going forward.
While the company has been doing well at growing revenue, for this to be a market-beating investment it has to start delivering more and more of this top line growth to the bottom line. That said, management seems to be taking an honest look at the trouble spots and putting measures in place to correct the problems, and I like their chances. The long history of revenue growth tells me, pretty convincingly, that the concept works -- that the stores, the food, the guest experience, and the value proposition they offer are resonating with their customers. With that in mind, the troubles seem relatively minor and temporary. Buying a good company suffering a temporary setback can be a great way to achieve market-beating returns.
Given the valuation of its peers, if Red Robin is successful in righting the ship and translating revenue growth into earnings growth, I see no reason why its long history of brisk growth should be priced at much less than a multiple of 30 to 35X current earnings (if the company rights the ship, both trailing earnings and the multiple should increase), or at about $53 to $60 per share. Additionally, there’s some downside protection here. Per the company’s conference call, maintenance items will account for about 12% to 15% of total capex spending in FY2007. Using the high end of the range and applying it to the past four quarters I estimate maintenance capex $14.7M while operating cash flow was $78.0M. This leaves us with a P/FCF (with growth capex backed-out) multiple of about 10.9. That’s almost like getting a 9.2% return on one’s money while waiting for the operational improvements to take hold.
The Bottom Line:
While there are some things to keep an eye on going forward, the overall picture is encouraging. Given the history of growth and the success of the concept, I think Mr. Market -- due to the aftermath of the Snyder debacle followed by a few operational miscues -- is handing us some great growth potential at a discount price.
Let the Fool community know what you think by joining the discussion regarding this pick on the dedicated discussion board. Per the newsletter ground rules, the author owns no shares of Red Robin, though he does own shares of Buffalo Wild Wings. The Motley Fool has a disclosure policy.