I recommend going long Ruby Tuesday (RT, Financial) whose declining earnings and high level of debt have scared away investors. Further investigation shows that the company has posted very strong Cash Flow from Operations over the past ten years as their large investments have continually paid off. Now that the company has almost violated its debt covenants, it will force management to make repayment of the debt a priority and limit its growth spending for the next couple of years. The resulting decline in CapEx (from a 5-year average $153.0M to a projected $20M) will lead to a very large influx of free cash flow.
Summary of business
-----------------------------
Ruby Tuesday is a well known casual dining restaurant chain that started business in 1972 and has grown rapidly over the last couple of years, increasing its number of company-owned restaurants from 397 in 2002 to 680 in 2007. It has invested a significant amount of money over the last 5 years, spending an average $153.0M in CapEx compared to an average Cash Flow from Operations of $182.3M. It has also invested in a re-imaging initiative that came with a cost of $50-55M over the last 9-12 months. Through this initiative, Ruby Tuesday would like to take a place in the slightly more upscale range of the casual dining sector, separating itself from the bar & grill types. The company would like to increase traffic by offering higher quality food and a better service than in the past.
Thesis
---------
The company is currently undergoing a certain transition period as it starts focusing on growth through improved operations and increased traffic rather than by simply opening up new restaurants as it has done in the past. This shift in strategy was probably forced in part by the slowing sales resulting from the current economic conditions. This slow down happened at the same time as the company was investing in its re-branding which was obviously bad timing. At the same time, Ruby Tuesday kept opening up new stores until this year and continued pushing its marketing spending, an area where they can difficultly compete with the larger chains. Basically, management should have cut down on growth spending earlier but did not anticipate the slow down in sales.
Another factor which, in hindsight, was a very bad move by the management, is the large share repurchases that have occurred over the last two years. Those buybacks, which were done at a time when the stock was selling for about 3-4 times today’s market price, were made possible by a large accumulation of debt, going from $358M at the end of 2005 to $591M today. This represents an increase from 0.71 to 1.49 as a proportion to equity.
2007 started well for Ruby Tuesday but things turned for the worst around the middle of the year as the company started issuing warnings that it would not meet guidance two quarters in a row. The bad news continued when it was announced later on that the company had suffered a loss in Q2 of FY ’08 and that there was a possibility it could violate its debt covenants, resulting in a re-classification of its long-term debt under short-term debt. As a bonus, the company also said in early ’08 that it would not pay a dividend in January as it had done the previous year, but rather start making annual payments in August instead of semi-annual payments. The market was quick to punish the stock as it went down from $27.44 at the beginning of ’07 to $6.55 today, hitting a 7-year low on the way down.
I believe this large decline in the market price creates an interesting opportunity for investors as Ruby Tuesday tries to rebound from a difficult year. This near-violation of the debt covenants could be a blessing in disguise as it should act as an incentive for the management to be more careful in their deployment of capital. The company issued a press release on March 5th stating it had entered into Limited Waiver Agreements and that it was well on its way to restructure the covenants. The repayment of the debt will now become priority number one.
What the market appears to be missing here is that although RT has spent a lot of capital in order to open restaurants and reinvigorate its image (average of $153M p.a. the last five years), its maintenance CapEx is actually quite low, standing at around $20M p.a. The management did state that it was planning to cut growth expenditures to zero over the next three years, meaning RT’s CapEx will go down very significantly over that period of time. Looking at the CFO and FCF of the last 5 years, or 10 years for that matter, one quickly realizes the big impact such a cut in spending should have:
Year 2007 2006 2005 2004 2003
CFO 184.66 191.70 184.53 219.99 152.93
CapEx (125.83) (171.64) (162.37) (151.49) (153.80)
FCF 58.83 20.06 22.16 68.50 (0.87)
It should be expected that there will be a large influx of free cash flow coming in over the next three years as the company dramatically limits its spending. This should allow RT to quickly lower its debt to a level similar to the one at the end of 2005. Many positive impacts will ensue from this optimization of the capital structure: a rise in equity, a decrease in interest payments (potential $16M p.a. gain if the company was to go back to its 2005 levels), and a gain of confidence in the management by investors, leading to higher multiples. This repayment of debt theme is explored in more details by Sanjay Bakshi in his 2002 Talk at the Oxford Book Club: http://www.sanjaybakshi.net/Links.html
It should also be mentioned that the management has had a history of quickly returning capital to its shareholders, paying nice dividends and making important buybacks in the past. I estimate that over the next three years, the company could easily repay the $233M required to go back to the level of debt seen in 2005 (this is only a guesstimate, the company may wish to remain more leveraged than this as the resulting equity from such a payment would be higher than in 2005), and have plenty of money left for dividend payments and perhaps share repurchases. A reinstatement of the dividend next August or next year could also act as a strong catalyst. This eagerness to pay the shareholders back probably has a lot to do with the fact that the CEO is himself owner of about 5% of the company and that as a group, the directors and officers own about 10% of the shares. In January, an impressive 900 000 shares were bought by insiders as the stock was approaching $6.00. Large purchases were also made last October as the market price was close to $15.00.
Numbers
------------
It is practically impossible to pinpoint the exact value of Ruby Tuesday as there is some uncertainty regarding the direction of sales over the next couple of years, let alone the next ten. The same is true for the impact of the rising cost of commodities on the company, weather it is the price of food or energy. Still, one does not need to determine a specific value to see that the stock is selling at a deep discount.
Making the following conservative assumptions:
- Total decrease in sales of 10% this year (company expects 5-8%), another 10% cut in 2009, flat sales in 2010, followed by 5% growth in 2011. This reflects the impact of a slowing economy and a significant impact on the casual dining restaurants.
- CFO/Sales margin of 10%, compared to a median rate of 16% over the last five years and 13% over the last ten years. This reflects a risk of margin compression as commodity prices increase.
- Slightly increasing CapEx from $20M in 2009 to $24M in 2011
2007 2008E* 2009E 2010E 2011E
Sales 1 410 1 300 1 165 1 165 1 225
CFO 185 135 116.5 116.5 122.5
CapEx 126 130 20 22 24
FCF 59 5 96.5 94.5 98.5
*company projects $120-130M in CapEx and to be slightly FCF positive
These projections indicate that with a current Market Cap of $411M, the stock is trading for only 4.3 times 2009 projected FCF and 2.8 times the past 3-year average FCF (subtracting only the $20M maintenance CapEx). A total of $290M could be accumulated over the next three years and be used to repay the debt and pay dividends. These back-of-envelope calculations, although imprecise, show how beneficial a cut in growth spending will be. The currently low earnings and FCF figures as well as the high debt quickly scare away investors who neglect to separate the maintenance CapEx from the growth CapEx.
Risks
------
- Sales decrease and commodity prices increase more than expected and hurt the FCF line over the next couple of years. Still, the low maintenance CapEx would allow an eventual repayment of the debt, although it may take more than the projected three years to attain the desired level.
- Re-imaging initiative fails to bring in more sales and the company loses market share to competitors. Surveys indicate that customers definitely prefer the new image but until this is reflected in sales, nothing is certain.
- Management returns to its bad habit of over paying for its own stock, once again leading to a level of debt that is unsustainable.
Potential Catalysts
-------------------------
- Quick repayment of debt (rise in equity, earnings)
- Reinstatement of dividend, share buybacks
- Higher than expected earnings following decrease of interest payments, better than expected revenues
- Investors gain confidence as new debt covenants are fixed and debt comes down
Summary of business
-----------------------------
Ruby Tuesday is a well known casual dining restaurant chain that started business in 1972 and has grown rapidly over the last couple of years, increasing its number of company-owned restaurants from 397 in 2002 to 680 in 2007. It has invested a significant amount of money over the last 5 years, spending an average $153.0M in CapEx compared to an average Cash Flow from Operations of $182.3M. It has also invested in a re-imaging initiative that came with a cost of $50-55M over the last 9-12 months. Through this initiative, Ruby Tuesday would like to take a place in the slightly more upscale range of the casual dining sector, separating itself from the bar & grill types. The company would like to increase traffic by offering higher quality food and a better service than in the past.
Thesis
---------
The company is currently undergoing a certain transition period as it starts focusing on growth through improved operations and increased traffic rather than by simply opening up new restaurants as it has done in the past. This shift in strategy was probably forced in part by the slowing sales resulting from the current economic conditions. This slow down happened at the same time as the company was investing in its re-branding which was obviously bad timing. At the same time, Ruby Tuesday kept opening up new stores until this year and continued pushing its marketing spending, an area where they can difficultly compete with the larger chains. Basically, management should have cut down on growth spending earlier but did not anticipate the slow down in sales.
Another factor which, in hindsight, was a very bad move by the management, is the large share repurchases that have occurred over the last two years. Those buybacks, which were done at a time when the stock was selling for about 3-4 times today’s market price, were made possible by a large accumulation of debt, going from $358M at the end of 2005 to $591M today. This represents an increase from 0.71 to 1.49 as a proportion to equity.
2007 started well for Ruby Tuesday but things turned for the worst around the middle of the year as the company started issuing warnings that it would not meet guidance two quarters in a row. The bad news continued when it was announced later on that the company had suffered a loss in Q2 of FY ’08 and that there was a possibility it could violate its debt covenants, resulting in a re-classification of its long-term debt under short-term debt. As a bonus, the company also said in early ’08 that it would not pay a dividend in January as it had done the previous year, but rather start making annual payments in August instead of semi-annual payments. The market was quick to punish the stock as it went down from $27.44 at the beginning of ’07 to $6.55 today, hitting a 7-year low on the way down.
I believe this large decline in the market price creates an interesting opportunity for investors as Ruby Tuesday tries to rebound from a difficult year. This near-violation of the debt covenants could be a blessing in disguise as it should act as an incentive for the management to be more careful in their deployment of capital. The company issued a press release on March 5th stating it had entered into Limited Waiver Agreements and that it was well on its way to restructure the covenants. The repayment of the debt will now become priority number one.
What the market appears to be missing here is that although RT has spent a lot of capital in order to open restaurants and reinvigorate its image (average of $153M p.a. the last five years), its maintenance CapEx is actually quite low, standing at around $20M p.a. The management did state that it was planning to cut growth expenditures to zero over the next three years, meaning RT’s CapEx will go down very significantly over that period of time. Looking at the CFO and FCF of the last 5 years, or 10 years for that matter, one quickly realizes the big impact such a cut in spending should have:
Year 2007 2006 2005 2004 2003
CFO 184.66 191.70 184.53 219.99 152.93
CapEx (125.83) (171.64) (162.37) (151.49) (153.80)
FCF 58.83 20.06 22.16 68.50 (0.87)
It should be expected that there will be a large influx of free cash flow coming in over the next three years as the company dramatically limits its spending. This should allow RT to quickly lower its debt to a level similar to the one at the end of 2005. Many positive impacts will ensue from this optimization of the capital structure: a rise in equity, a decrease in interest payments (potential $16M p.a. gain if the company was to go back to its 2005 levels), and a gain of confidence in the management by investors, leading to higher multiples. This repayment of debt theme is explored in more details by Sanjay Bakshi in his 2002 Talk at the Oxford Book Club: http://www.sanjaybakshi.net/Links.html
It should also be mentioned that the management has had a history of quickly returning capital to its shareholders, paying nice dividends and making important buybacks in the past. I estimate that over the next three years, the company could easily repay the $233M required to go back to the level of debt seen in 2005 (this is only a guesstimate, the company may wish to remain more leveraged than this as the resulting equity from such a payment would be higher than in 2005), and have plenty of money left for dividend payments and perhaps share repurchases. A reinstatement of the dividend next August or next year could also act as a strong catalyst. This eagerness to pay the shareholders back probably has a lot to do with the fact that the CEO is himself owner of about 5% of the company and that as a group, the directors and officers own about 10% of the shares. In January, an impressive 900 000 shares were bought by insiders as the stock was approaching $6.00. Large purchases were also made last October as the market price was close to $15.00.
Numbers
------------
It is practically impossible to pinpoint the exact value of Ruby Tuesday as there is some uncertainty regarding the direction of sales over the next couple of years, let alone the next ten. The same is true for the impact of the rising cost of commodities on the company, weather it is the price of food or energy. Still, one does not need to determine a specific value to see that the stock is selling at a deep discount.
Making the following conservative assumptions:
- Total decrease in sales of 10% this year (company expects 5-8%), another 10% cut in 2009, flat sales in 2010, followed by 5% growth in 2011. This reflects the impact of a slowing economy and a significant impact on the casual dining restaurants.
- CFO/Sales margin of 10%, compared to a median rate of 16% over the last five years and 13% over the last ten years. This reflects a risk of margin compression as commodity prices increase.
- Slightly increasing CapEx from $20M in 2009 to $24M in 2011
2007 2008E* 2009E 2010E 2011E
Sales 1 410 1 300 1 165 1 165 1 225
CFO 185 135 116.5 116.5 122.5
CapEx 126 130 20 22 24
FCF 59 5 96.5 94.5 98.5
*company projects $120-130M in CapEx and to be slightly FCF positive
These projections indicate that with a current Market Cap of $411M, the stock is trading for only 4.3 times 2009 projected FCF and 2.8 times the past 3-year average FCF (subtracting only the $20M maintenance CapEx). A total of $290M could be accumulated over the next three years and be used to repay the debt and pay dividends. These back-of-envelope calculations, although imprecise, show how beneficial a cut in growth spending will be. The currently low earnings and FCF figures as well as the high debt quickly scare away investors who neglect to separate the maintenance CapEx from the growth CapEx.
Risks
------
- Sales decrease and commodity prices increase more than expected and hurt the FCF line over the next couple of years. Still, the low maintenance CapEx would allow an eventual repayment of the debt, although it may take more than the projected three years to attain the desired level.
- Re-imaging initiative fails to bring in more sales and the company loses market share to competitors. Surveys indicate that customers definitely prefer the new image but until this is reflected in sales, nothing is certain.
- Management returns to its bad habit of over paying for its own stock, once again leading to a level of debt that is unsustainable.
Potential Catalysts
-------------------------
- Quick repayment of debt (rise in equity, earnings)
- Reinstatement of dividend, share buybacks
- Higher than expected earnings following decrease of interest payments, better than expected revenues
- Investors gain confidence as new debt covenants are fixed and debt comes down
