Description

Suitable for small funds or PAs.

Bravo Brio Restaurant Group (BBRG) was presented by SlackTide on March 10, 2017, so this will be brief.  I don’t love the idea of re-submissions only eight months later, so I won’t count this toward my annual quota.  But I think there are some nuances to point out, and that it’s timely to revisit this microcap. For this write-up, I will not address the quasi-activism by TAC Capital, nor the company's February 2017 announcement that it would "explore alternatives to enhance shareholder value" as I have never viewed either of them as material considerations.

Since BBRG was posted on VIC in March, the company has reported three quarters of results.  While SSS remain weak (down 2.9% YTD), EBITDA has increased by 24% YTD. The thesis is that a baseline for EBITDA has been set, and with the stock down 39% this year, it is too cheap at 3.7x LTM EBITDA and 5x FCFE.

BBRG pursued an aggressive/foolish leasing strategy during its growth phase, whereby it accepted lease incentives in the form of large upfront cash payments. So BBRG signed many leases where the trade-off for an upfront cash rebate were payments over the life of the lease that are above the industry average, as a % of sales. Essentially, they pulled-forward cash out of their lease arrangements, as a form of financing. The cash proceeds were then re-invested into new locations, most of which are in malls.  The abnormally high ongoing lease expense has been exacerbated by the company’s decline in sales.  Further, this negative working capital cycle created by this strategy is now unwinding, as the company is no longer signing new leases and thus not receiving upfront cash. Finally, even accounting for the cash rebates, the company signed several leases that were too expensive for their revenue base over the last few years. It was a bad combination of aggressive financing arrangements and just plain bad lease deals. Notably, the CEO who led this charge left the company at the end of 2015.

As the accounting works, the amortization of these lease incentives is deducted from the Occupany expense on income statement, however it remains a cash outflow – this is now inflating the company’s reported “income statement” EBITDA. I have made adjustments to account for this lease incentive amortization with all of my references to EBITDA so that it reflects the true cash economics of the business.  I felt this was fully understood and discounted at under $4 per share, but apparently not.

With this piper now being paid, BBRG shares have become unusually cheap to this Adjusted EBITDA. Several years of declining SSS and EBITDA are the culprit, however EBITDA has turned demonstrably of late. LTM EBITDA is now 16% ahead of 2016; YTD EBITDA is up 24% versus 2016; and 2Q + 3Q 2017 EBITDA is double what it was for the same quarters of 2016. Despite revenue declines, I believe there is more margin improvement to be had.  The table below lays out the numbers, in comparison to the three best comparable companies in my judgement.  They’re not perfect, but they illustrate the delta in margins.

Note that I adjust EBITDA for the “lease incentive” portion that is amortized (and deducted) from the expense item on the income statement.  Therefore my Adjusted EBITDA is lower than what would appear in company screens.

As shown above, BBRG’s margins are improving but remain too low:

1. Food costs are line with its peers, and this is good news.  While they are certainly price-takers, they’re not in purgatory with regard to this line time

2. Labor/Operating/G&A expense has improved some, but I believe there is more to follow.  It remains too high

3. They have several bad leases and cash flow-negative stores from which they are exiting.  So far, they have exited 5 stores this year, and I expect 5 or so additional closures next year.  Finally, I believe there are selective opportunities for price concessions where leases that are up for renewal imminently (say 1-2 years out).  Many of the malls they are in are even more price-takers than is BBRG

I think item 2 above will continue to show modest improvement. And while there is not much they can do about most of their leases (they are stuck with above-market rent in most places), there will be marginal improvement there as a % of revenue. For comparison’s sake, below is comp table – I added KONA for another perspective, namely because it is also a microcap with debt.  And for comic relief.

There is not a lot to like about this group, and BBRG in particular.  BBRG has suffered a horrendous multi-year slide in SSS (-5.2%, -2.8%, -5.0%, -2.8% from 2016 back to 2013), and one must go back to 2012 to hit flat/positive comp sales.  In addition, the company recently required a waiver to their bank agreement, after threatening to trip a lease-adjusted leverage ratio – the lease capitalization pushed over what was a tight convenant, and it seems clear the banks want out of this one. One of the concessions was to move up the maturity from November 2019 to December 1, 2018.  I have low concern over the company’s ability to work out a new financing arrangement, likely with cash flow sweeps, which I expect in weeks to two months.

Next, the CFO departed for personal reasons in September (I am satisfied with what I have been told regarding this).  Finally, one of the few analysts still following the company, from Piper Jaffray, downgraded the stock upon the CFO announcement.  To the positive, the company filled the role within a month, luring back a BBRG veteran (ten years as VP-Finance / Accounting) who had recently left the company.

From the announcement of the beginning of the bank waiver discussions until now, the stock has been cut in half.  In between, they have reported two quarters that have reinforced my thesis.  I project that BBRG can achieve a 6% Adjusted EBITDA margin run-rate, on a sales base of $380M (pro forma for restaurant closures) by mid-2018.  This generates EBITDA of $23M and free cash flow to the equity of $9M, representing 3.1x EBITDA and a 25% FCFE yield.  This assumes an annual capex budget of $8M, which includes maintenance; continuation of their ongoing refurbishment program; and zero new stores.  This also assumes continued negative 2-3% comps for another year, followed by a leveling-off toward flat.  Remember, some negative-margin stores have been cut, with those benefits to be seen over coming quarters.   In addition, there is still room for expense improvement for the better locations, and the company has shown modest gains there over the last two quarters.  So coming from such a low base, there is still room to push margins upward.  I think the shares are too cheap to ignore.

Risks

-- Continued SSS declines

-- Bank maturity on December 1, 2018

Catalyst

-- Bank Debt Refinancing