Ignite Restaurant Group’s Acquisition Of Macaroni Grill: Assessing The Potential Risks And Rewards

On February 7th, Ignite Restaurant Group (IRGannounced it was acquiring Golden Gate Capital’s 80% interest in Romano’s Macaroni Grill (RMG) for $55 million. According to an article in Nation’s Restaurant News, Brinker International’s (EAT) 20% stake was also part of the transaction. In this article, I will analyze some of the risks and rewards of the acquisition for IRG shareholders.

Background

RMG is a 25-year-old restaurant chain with 210 units in 39 states. Brinker International acquired the chain in 1989. Golden Gate Capital acquired 80% of the chain from EAT in 2008. Golden Gate initially offered $131 million for its 80% stake, but that price was later reduced to $88 million as the financial crisis hit and financing became difficult and same-store sales declined. At the time, there were 226 company-owned sites with average unit volumes (AUVs) of $3.2 million or about $700 million in system-wide sales. Today, RMG has 210 units, of which 186 are company-owned. Since the Golden Gate acquisition, the concept has suffered substantial declines in both sales and traffic. AUVs are down over 33% to $2.1 million and system-wide sales are only around $450 million. This is where the risk and opportunity arise. RMG is an established brand with substantial upside to AUVs, but with no operating momentum at this time.

Valuation of Deal

IRG management held a conference call to explain the metrics and rationale of the acquisition. Based on information from the press releaseand subsequent conference call, IRG seems to be paying approximately 14% of sales for the company. I have grossed up the enterprise value (EV) to $69 million to reflect EAT’s 20% stake and divided that by the $390 million in estimated company-owned store revenue. Since this is a turnaround situation, I believe using EV-to-EBITDA is not a useful metric. In fact, it appears that the current level of EBITDA is near zero. The EV/Sales price tag is a very attractive valuation on both an absolute basis and a relative basis. In the table that follows, I have listed several restaurant concepts that are similar to RMG and their current EV/Sales percentages. As you can see, the chain was acquired at a significant discount to the group. The extremely attractive purchase price provides current shareholders with some comfort that management did not overpay for RMG and it leaves plenty of potential for value creation if their turnaround plan is successful.

Company EV/Sales
Macaroni Grill 14%
Ruby Tuesday 58%
Red Robin 62%
Ignite 70%
Bravo Brio 73%
Bloomin’ Brands 92%

Strategic Rationale and Synergies

On the conference call, IRG management explained listed five strategic points for the acquisition. They are summarized as follows:

  • High quality brand complements IRG’s current portfolio.
    • 25-year-old brand in a new segment in the market for IRG.
  • Creates a company with $1 billion in system sales.
    • Benefits of economies of scale in SG&A and purchasing.
  • Opportunity to significantly improve operations with similar game plan as used in Joe’s Crab Shack.
    • Focus on marketing and differentiated experience
    • Restaurant level margins are substantially below peer group.
  • Attractive real estate portfolio
    • Long-term leases (23 years on average) with below market rents
    • Attractive DMAs
    • Potential for conversions to existing concepts at 16-18% discount to build-out model.
  • Immediate return from G&A synergies of at least $7 million.

Here is my analysis of some of the most important points.

Opportunity to significantly improve operations and margins

Based on the information provided by management in the press release and on the conference call, I have attempted to create a basic income statement for RMG. I believe that these numbers are close enough for the purposes of discussion. On the call, management indicated that the operating margin for RMG was approximately 6.2%. However, that included approximately $24 million in marketing costs (slide 10 in presentation). Backing that out of total restaurant operating costs, I calculate the restaurant-level operating margin is approximately 12.5%.

Estimated Income Statement

Macaroni Grill $ Mil % of Revenue
Restaurant Revenue $390.00
Franchise Revenue $3.00
Total Revenue $393.00
Expenses
Operating Costs $344.00 87.5%
Operating Profit $49.00 12.5%
Advertising $24.00 6.1%
Depreciation $5.90 1.5%
G&A $25.00 6.4%
EBITDA $0
EBIT ($5.90)

Source: Company presentation

As a sanity check, I have provided the distribution of operating margins of RMG provided by management in the presentation. While my numbers may not be 100% accurate, I believe they are reasonably close for this article and minor changes in the percentages do not alter the analysis or conclusions.

histogram-of-units-2012

Source: Page 10 Company presentation.

There is no doubt that there is substantial upside to operating margins. As you can see below, restaurant-level operating margins of its peers range mostly between 15-17%, including IRG’s current margins. IRG management believes that it can raise RMG’s operating margins to near peer levels using a strategy it successfully implemented at Joe’s Crab Shack. In that case, management was able to increase AUVs from $2.4 million to $3.1 million and boosted operating margins by 450bps. Most of that improvement was likely the result of leveraging labor and other operating expenses as sales increased and not by lowering food costs or cutting other expenses. While I do believe that, with a modest increase in guest counts, a 200bps of improvement in operating margin within the next two years is achievable, I do not believe that a significant improvement will be as easy to achieve as it was at Joe’s Crab Shack. However, if RMG were to achieve 15-16% restaurant level margins, the acquisition would prove to be extremely successful.

Company Restaurant Operating Margins
MRG 12.0%
EAT 15.0%
RT 16.0%
IRG 16.5%
BLMN 17.0%
BAGL 18.0%
RRGB 21.0%

Potential Income Statements

I have included a couple of theoretical income statements to show the potential levels of EBITDA and operating income of RMG. I have made no assumptions as far as unit growth or sales improvements and only reduced G&A by the $7 million in current guidance. I have made no distinction in how the margin improvement happens. It could come from leveraging labor and operating costs. It could come from cost improvements at all levels from better management. At this point, the specifics aren’t as important as just creating a new income statement. I would also like to point out that food costs and labor costs may actually increase in the short run as IRG management attempts to improve food quality and service levels in order to increase guest counts and satisfaction levels. These assumptions most likely underestimate the potential EBITDA because I am using flat revenue. I believe that most of the margin improvement will come only with revenue gains and not from cost cutting. Therefore, it is most likely that if RMG is hitting these margin levels, sales will be over $400 million, boosting EBITDA even higher.

200BPS of Margin Improvement

Income Statement $ Mil % of Revenue
Restaurant Revenue $390.00
Franchise Revenue $3.00
Total Revenue $393.00
Expenses
Operating Costs $338.00 86%
Operating Profit $55.00 14%
Advertising $22.00 6%
Depreciation $5.90 2%
G&A $18.00 5%
EBIT $9.11
EBITDA $15.00
EV $55
EV/EBITDA 3.67

400BPS of Margin Improvement

Income Statement $ Mil % of Revenue
Restaurant Revenue $390.00
Franchise Revenue $3.00
Total Revenue $393.00
Expenses
Operating Costs $331.00 84%
Operating Profit $62.00 16%
Advertising $22.00 6%
Depreciation $5.90 2%
G&A $18.00 5%
EBIT $16.11
EBITDA $22.00
EV $55
EV/EBITDA 2.50

Potential Value Creation

In order to gauge the potential benefit to current IRG shareholders, I calculated the value of RMG in terms of dollars per share of IRG stock based on various margin and EV/EBITDA multiples. Since it appears as though IRG is paying $55 million for the entire company and not just Golden Gate’s 80% stake, I am deducting that amount of debt from the EVs I calculated. I used 25 million shares outstanding to get a per share dollar amount. For example, if RMG can generate $15 million in EBITDA and I assign a 5X EV/EBITDA multiple, that would equal $75 million in enterprise value. Subtracting the $55 million in debt leaves $20 million in value (or $0.80 per share) to IRG shareholders. This is not an exact science and there will be no real way to break out the valuation of RMG separately from IRG. But I do believe this does give shareholders some sense of the value creation that is possible. EBITDA could be even higher than $22 million if revenue actually grows. For example, direct competitor Bravo Brio Restaurant Group (BBRG) produces $43 million in EBITDA on $390 million in revenues and Ruth’s Hospitality Group (RUTH) produces $42 million in EBITDA on $385 million in revenues. It should be noted that BBRG only spends about $4 million a year in advertising and has $4 million less in G&A costs than RMG. But it does seem as though $15 to $22 million in EBITDA on $390 million in revenues is not a stretch.

Per IRG Share EV/EBITDA Multiple
EBITDA 5X 6X 7X
$15 $0.80 $1.40 $2.00
$22 $2.20 $3.08 $3.96

Attractive Real Estate Portfolio

Another motivating factor for the purchase of RMG was the access to a reasonably attractive real estate portfolio. According to the presentation, 84% of the units are in the top 50 DMAs. This is important because these are the most attractive areas for all of IRG’s concepts growth in the future. More importantly, however, is the fact that a large percentage of the leases are at below market rates and for an average of 23 years. This gives IRG a margin of safety as it attempts to turnaround the chain. The long lease term buys the company time and eliminates the chance that the lease is not renewed in the middle of the turnaround. The below market rate means that lower rent rates can boost margins. Finally, if some of the restaurants are not turning around, the company has the ability to convert an RMG to a Joe’s Crab Shack or Brick House Tavern+Tap. While this would not be preferable for a significant number of units, the conversion of a few at a 16-18% savings over the cost of a new build of its existing concepts would be a reasonable backup strategy. The possibility of conversions also reduces the risk that the company is saddled with a significant number of long-term leases of underperforming stores and is exposed to lease charge-off costs.

Risks

While the purchase price and the real estate portfolio provide a degree of downside protection if the turnaround does not succeed, the acquisition is not without significant risks. In this section, I will discuss the more important ones.

Turning around a neglected concept is always difficult and the timing of success is uncertain.

I can certainly recall more restaurant chains that have failed to be turned around compared to those that have been successfully revitalized. And the degree of success in many turnarounds can be only marginal. Because management was recently successful in revitalizing the Joe’s Crab Shack brand within four years, they believe they can employ the same template to RMG and achieve similar results. I do not believe that the turnaround of RMG will be as easy and may take significantly longer than the Joe’s turnaround. There are several reasons why the RMG turnaround is more difficult.

The Italian dining segment is much more competitive and harder to differentiate than the seafood segment. One reason IRG management was able to successfully turnaround Joe’s is that the chain had a rather unique food offering. Joe’s is synonymous with crabs the way Red Lobster is with lobster. However, it is going to be significantly more difficult for RMG to find its unique voice in a crowded and competitive space like the Italian segment. The price point is similar to Carrabba’s and the company is trying to increase the service to levels similar to Bravo Brio or Maggiano’s. It will be difficult to achieve a marketing balance. Management plans on re-emphasizing the concept of a “on your honor” jug of wine on the table. While a nice touch, it is not enough to entice a significant number of new customers. The 33% decline in guest counts over the last four years and the heavy use of coupons has hurt the image of the brand. Management talked about bringing in a sommelier type level of service. But the recent struggles at Ruby Tuesday (RT) illustrate the difficulty in weaning customers off of coupons and attracting a higher paying customer. I do not believe that the new strategy will be without some disruption and have fits and starts.

Turning around a struggling restaurant chain is difficult in a strong economy. Trying to do it with high unemployment and weak job creation makes it even more difficult. That is because when the market is stagnant, it becomes more of a market share stealing game and some competitors choose to compete on price more than service. Just look at the 2 for $20 meal type battles that were waged between Applebee’s and Chili’s over the last few years.

Same Store Sales Recent Quarter 2011
Bravo Brio -0.1% 1.3%
Olive Garden -3.2% 1.8%
Carrabba’s 1.0% 4.6%

The recent same-store sales reports of competitors show increasing weakness in the segment. Olive Garden, after years of significant outperformance has stumbled badly recently. While this does provide RMG with an opportunity to attract new diners, it also means competitors are becoming more focused on their own customers. In fact, Olive Garden recently appointed a new President in an attempt to reinvigorate its marketing strategy. On the last conference call,management of Olive Garden’s parent company, Darden (DRI), painted the competitive landscape this way:

“As a result, large chains have been increasing use of promotional price incentives, from nationally advertised promotions and couponing to increased levels of more targeted digital offers, and the promotional intensity has, if anything, been ramping up recently.

RT has boosted advertising on TV to $80 million in an attempt to offset its dramatic reduction in couponing. It remains to be seen if the $22 million marketing expenditures planned for the RMG turnaround will be sufficient to break through the increasing amount of advertising directed at the casual dining consumer. I have included a table that shows approximate advertising expenditures of selected competitors and the percentage of sales they represent.

Advertising In $ Mil As % of Sales
BLMN $161.00 4.0%
RT $80.00 6.8%
EAT $80.00 3.0%
DRI $357.00 4.4%
IRG $20.00 4.5%
MRG $22.00 5.0%
CHUX $35.00 4.0%

Turnarounds can distract management from its core brands.

In the past, I have seen numerous times when management of a company with slowing prospects in its core business resorts to an acquisition to distract investors from that weakness in its main business. If the acquisition is complicated enough, management’s time is consumed with the new problems and the old problems in the base business get worse. The result is significant value destruction for shareholders. The recent troubles at Hewlett-Packard (HPQ) and its disastrous Autonomy acquisition is just one example. While I am not suggesting this was the motivation behind the RMG acquisition, it does come at a time when IRG management has “a lot on its plate” so to speak.

After working through an embarrassing, but not really material accounting restatement soon after its IPO, management has been trying to refocus on maintaining its 10% unit growth rate and dealing with slowing same-store sales at Joe’s. Each of these situations alone should consume a substantial amount of management’s time. I view this as a real risk to the company in the coming year. However, I also view the fact that IRG’s controlling investor, J.H. Whitney still owns over 65% of the shares, as a mitigating factor because they will eventually want to exit this investment and want to see a higher stock price before that happens. If they thought there was a significant chance that this acquisition was going to be value destroying to shareholders, they could have attempted to stop the transaction.

Conclusion

While I believe this acquisition will eventually create value for shareholders, it is certainly not without risk and comes at a time when competition in the Italian dining segment is intensifying. Turnarounds in this type of operating environment are always difficult to achieve and the timing of the outcome is highly uncertain. However, the low EV/Sales purchase price and 33% decline in guest counts from their peak, reduces the potential loss if the turnaround is unsuccessful. The financing is not expensive, nor does it place undue leverage on the company. The acquisition has the possibility to produce $1-$4, or more, per share (10-30% of IRG’s current share price) in value to IRG shareholders depending on the ultimate margins achieved and valuation multiples assigned to the deal. When taken altogether, the risk/reward seems to skew more favorably to the upside.

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About Tim Heitman