Leading sector analyst Karl Burns at Investec has said that The Restaurant Group (TRG) remains in a difficult spot with declining LFL sales, rising cost inflation and an uncertain outlook.
He said: “We do believe the group holds value in the concession and pub restaurant divisions, yet supply concerns remain, particularly within retail parks, while pricing may have been pushed too aggressively across many of the group’s brands. We expect no quick fix, yet management changes, the beginning of menu engineering and initial churn of the estate give cause for optimism.”
Burns said that based on the broker’s industry analysis, TRG’s pricing for Frankie & Benny’s, Chiquito and Coast to Coast is c.2-7% above the industry average.
He said: “At the same time, customer satisfaction analysis suggests some brands score poorly against peers, with Frankie & Benny’s the lowest ranked restaurant brand. That said, the new management team has identified some of the issues and begun addressing them.”
F&B space in UK retail parks is estimated to have doubled over the last two years, as commercial landlords look to add space to compensate for declining food retail space and, to a degree, general retail space.
Burns said: “In 2016 alone, an estimated 33 operators have planned 250 new retail park restaurants, highlighting the threat to Restaurant Group’s incumbent brands. Looking ahead, it is hard to see this trend changing which could continue to put pressure on the core Leisure division.
“We estimate the concessions and pub restaurants could hold a combined value of up to c.£340m, effectively valuing the leisure business (at the current share price) on an implied EV/EBITDA multiple of 6.4x, or £1,100k per site, below replacement cost.
“With a FCF yield of c.10%, little debt and property assets of £105m on the balance sheet, we believe TRG is a potential takeover target. We upgrade FY16E EPS by 2%, but cut FY17E EPS by 2% as we expect a limited recovery in LFL sales growth and slower estate growth. Our FY18E EPS estimate is unchanged.”
Burns also gave a breakdown of the performance of the group’s brands and divisions. He said: “In 2015, concessions had a strong year of turnover and profit growth with the underlying fundamentals of the business said to be strong. Given the captive audience and continued projected passenger growth in both railway stations and airports, we believe concessions remains well placed to continue seeing positive turnover and profit growth, with plenty of scope for future space growth.”
In terms of the 85-strong Chiquito, Burns said the brand appeals to the core millennial demographic and in FY15 had strong growth in turnover, margins and profits.
He said: “All sites have been refurbished, with new space added said to have performed excellently, and operational changes (e.g. menu refresh) have led to a significant improvement in trading performance. In FY16, management suggested that some of the mistakes made at Frankie & Benny’s have also impacted Chiquito, with a refinement of the offer required. TRG management believe this brand is core to future growth, yet the new restaurant roll-out will slow while operational tweaks are made. Chiquito has very little retail exposure.”
In terms of the 22-strong Coast to Coast estate, Burns said: “The brand remains focused on the more affluent adult market, with a premium offer in a more ‘sophisticated’ environment. Coast to Coast enjoyed good turnover and profit growth in FY15, with new menus and new openings performing well. In FY16, like Chiquito, some mistakes have been made with the offer, suggesting a slowdown in trading, and similarly we expect the roll-out to slow for now.”
On the 56-strong Brunning & Price, Burns said: “The pub restaurant business reportedly performed extremely well in FY15. The market for traditional, high quality, food-led pubs continues to grow and management sees future growth potential in this division, with the return on investment said to be ‘substantial’. Trading in FY16 is similar to the prior year.”
The analyst said that It was early days for the new brand Joe’s Kitchen, but the encouraging performance of the three individual sites so far suggests growth potential remains, with some Garfunkels being converted into Joe’s Kitchen.
On the 10-strong Garfunkel’s, Burns said: “While this Central London focused brand is not the strongest performer of the last few years, weaker Sterling could encourage more UK bound tourism and UK tourists opting for a ‘staycation’ could aid performance. However, we suspect most Garfunkels will likely be disposed or converted to other brands.”
With the first phase of the operating strategic review complete, management is taking a number of actions to address poor LFL sales performance at some of the company brands.
Burns said: “We await details of the second phase, with new CEO Andy McCue likely to have a big influence.
“We believe pricing has been pushed too aggressively at TRG, with average annual inflation of 2.7% since 2013. One of the likely solutions is giving up margin and reinvigorating menus in order to make the business more competitive.
“While this could harm profitability in the short term, we believe TRG is well placed to absorb the impact as the company generates one of the highest levels of EBITDAR per site in the sector, with only Cote marginally higher. Every 100bps drop in the group gross margin would impact profits by £5.5m (assuming no volume uplift), reducing our FY16E PBT by c.7%.
“Management announced 33 immediate site closures (with an exceptional charge of £39.3m or £1.2m per site) while taking a non-cash impairment charge on a further 29 sites (totalling £17.8m or £0.6m per site). The company expects exceptional charges taken boost operating profit by £6m-£8m – the majority of which will impact FY17.
“Looking further ahead, we believe management may look to reinvest and remodel the remaining Frankie & Benny’s sites. The standard industry cost for a remodel is around £200-250k per site, and up to £400-500k for a brand conversion. We would expect the group to aim for a minimum return on capital of around 25%. Assuming TRG remodelled/converted 50% of the Frankie & Benny’s estate, with a 50/50 ratio for remodel/conversion, this could cost c.£50m and assuming a 25% return, add £12m of EBITDA (or c.10% upside to 2017 consensus).”
Burns believes that an acquisition cannot be ruled out given that TRG is relatively underleveraged (even when taking into account capitalised leases) and with the fast casual sector growing three times quicker than the casual dining sector (source: MCA).
He said: “We believe an acquisition here could transform the company’s growth prospects and valuation, reinvigorating the roll-out programme. Equally, a disposal of one or more divisions also cannot be ruled out, and we believe the concessions and Pub Restaurants divisions could quite easily be divested with little impact on the remaining business.
