Description

Worldwide Restaurant Concepts ( SZ )
Price: $4.39

I recommend purchase of the common stock

WRC is trading for less than the intrinsic value of the sum of its parts. Given management’s newfound commitment to stockholders, the appreciation of the Australian dollar, the success of the KFC business and the $100MM NOL are no longer there just to taunt investors. Additionally, I think the market underestimates the Australian business’ potential and overestimates the risks associated with Pat & Oscar’s.

In 2001, Roark304 posted an excellent write-up of Worldwide Restaurant Concepts (‘Sizzler’ or ‘WRC’). The company operates Sizzler and a southern California chain called Pat & Oscar’s, but the crown jewel is WRC’s 80% ownership of Collins Food Group, an Australian subsidiary that is the franchisee for KFC in Queensland. At the time of Roark’s write-up, Sizzler was a post-bankruptcy stock further tarnished by an E.Coli problem and a decline in the Australian dollar. The stock was just over a dollar then, and it quickly shot up to $3 at which point Roark closed the discussion with this post:

“Just disclosing that I no longer see an attractive risk-reward proposition at current prices given the recent run-up, without commensurate fundamental developments (that I know of) save a decent set of comps, a new store opening, and a decent Australian dollar. I completely eliminated my already-reduced position this morning. I frankly can’t remember when more capital flowed into crappy restaurants in such a short period than in recent months [writer’s note – see Denny’s in 2004].”

Fast forward to 2004 and Sizzler found itself in a similar situation. The Aussie dollar strengthened and the company was recovering from another E.Coli problem (this time at Pat & Oscar’s, and considerably more damaging given the geographic density of the chain, and its reliance on catering business). There was even another VIC write-up (albeit a much worse one) and the market has rewarded SZ with a 40% run up.

Before we get to the valuation, I think it’s important to answer this question: What makes Sizzler in early 2005 different from the Sizzler that Roark so wisely jettisoned in mid-2002?

I see three differences. Well, two and a half, since the third one is really lame:

1) The excellent performance of the Australian subsidiary

Roark identified WRC’s core businesses, including the Australian subsidiary, as having “zero to moderate growth” at the end of 2001. But ever since WRC granted Australian management options to purchase roughly 19% of the Collins Food Group in 2001, the KFC and Aussie Sizzler businesses have been doing significantly better. Since 2002, KFC has gone from a moderate growth business with average quarterly comp-sales increases in the 1%-4% range, to a major success story with comp-sales increases averaging nearly 9% over the last 10 quarters. Margins have followed suit: Operating income for the KFCs increased over 35% (real) from FY2003 to FY2004. Australian Sizzler comp sales grew 6.7% from FY2003 to FY2004 and 9% for the first two quarters in FY2005.

2) Departure of James Collins and emergence of a shareholder-friendly management

Jim Collins is the founder, a board member and the largest shareholder of WRC. He founded Collins Food Group in 1960, bought Sizzler in 1967 and accepted the franchise for Queensland, Australia in 1968. I never really understood why WRC held onto the Australian sub and why there was any reason to have all these businesses under the same umbrella. Still, I figured that as long as Collins was around, the company wouldn’t sell off his baby. After all, he is an industry legend and management had to face him at board meetings 4 times a year. Plus, I always imagined that he took a lot of first-class flights out to Queensland on the company dime . . . but maybe that was just me being grumpy.
Guess what happened in September of 2004? Sizzler announced at the annual meeting that Jim Collins was retiring from the Board of Directors. Guess what also happened in 2004? The 1,000,000 options (exercisable at $2.19) granted to CEO Charles Boppell when he joined the company in 1999 became fully vested. So it was not surprising on December 8th when the company announced it was exploring strategic alternatives including complete or partial sale of the company. CEO Charles Boppell was quoted in the press release: “Management and the Board believe that our stock price does not reflect the true value of our Company and our prospects.”

2.5) Continued appreciation of the Australian dollar versus the US dollar

I know, this is sort of weak, but it is a significant change nonetheless. Since Roark posted his write-up in 2002, the Australian dollar (and thus the value of the Australian subsidiaries) has continued to appreciate. In FY2002, the average exchange rate was .52 USD/AUD. In FY2003, FY2004 and LTM (ending 10/17) it was .57, .71 and .73 respectively. Today it’s around .776.

Valuation

Worldwide Restaurant Concepts can be broken down into 4 segments: KFC, Domestic Sizzler, International Sizzler and Pat & Oscars.

KFC

WRC owns 81% of Collins Foods Group, which runs 27 Australian Sizzlers and the 112 Queensland KFC franchises. The KFC franchises generated $15.9MM of EBIT in FY2004 (ending 4/30) and $17.7MM for twelve months ended October 17th. The company feels that Queensland is nicely saturated with KFCs, so they only build about one new restaurant a year. As mentioned above, same-store sales grew nearly 10% from 2003 to 2004. The company does a very good job of keeping its stores fresh: for FY2005 it has 10 major KFC remodels and 4 full scrape-and-rebuild projects. Surprisingly (to me at least), a full scrape-and-rebuild project only costs about $500,000. Capex and depreciation are around $3MM-$4MM a year.

Putting an 7.5x multiple on EBIT gives WRC’s stake a value of $102MM or $3.58 a share. If you adjust upward for recent appreciation in the Australian dollar (6.6%), the KFC stake is worth over $114MM and around $4.01 a share.

Domestic Sizzler

WRC operates 45 Sizzler restaurants and generates additional revenues through 192 Sizzler franchises. The company continues to sell company-operated restaurants to franchisees and it is implementing system-wide remodeling requirements over the next three years for franchisees. Domestic Sizzler generated about $6.3MM LTM EBIT and $6.8MM FY2004 EBIT. EBIT has declined from $7.3MM in FY2002 as the number of restaurants has gradually shrunk. Management believes that they will be down to a nice core group of profitable restaurants after they exit the NY market in FY2005. I don’t have too much faith in their belief that Sizzler is on the way back, but to their credit, franchise comp-sales have been up 5 quarters in a row and some franchisees have enough confidence in the brand to open new sites.
While Sizzler has been a cash cow for WRC, it’s hard to deny that it’s a crappy restaurant chain with declining operating income. The switch to a franchising model (coupled with increasing franchise comp-sales) is a nice development, but this is no growth story.

Putting a 5x multiple on EBIT (3.3x EBITDA) values Domestic Sizzler at $31.3MM or $1.10 a share.

International Sizzler

The International Sizzler segment features 39 franchised Sizzlers in Asia and 29 company-operated Sizzlers in Australian and New Zealand. The 29 Australian restaurants are run by Collins Food Group, so WRC only owns 81% of those sites. WRC does not break the segment’s $2.8MM of LTM EBIT down between the Australia restaurants’ contribution and that of the Asia franchises, so we have to do a little bit of estimating.
Over the past 5 years, the Asia franchises have produced between $1.5MM (in FY 2000) and $1.7MM (LTM) in franchise revenues. Assuming 70% margins gets you over $1MM of dependable income. Management indicated that there were very few costs on the Asia franchise revenues, but 70% is just my estimate. I don’t know what the true figure is. A 6x multiple on the Asia income stream comes out to $.21 a share.
We have to do a little more guestimation to value the Australian Sizzlers. There were no new sites built over the last year, so we can just assume that the current remodeling schedule (CAPEX of $1.7MM essentially equal to D&A of $1.6MM) is required to keep stores fresh. If we put a 6x multiple of our estimated EBIT of $1.8MM, the value of WRC’s stake in the Australian Sizzler equals $.30 a share ($.32 after adusting up for appreciation in the Aussie dollar).


Pat & Oscar’s

Pat & Oscar’s is the real wildcard here. I’ve valued the other three businesses at $5.64 a share. I think a 7.5x multiple on a rapidly growing KFC business and a 5x multiple on domestic Sizzler -- which may find growth – are both very conservative. WRC has $.48 a share in pension liability that I’d like to treat as debt as well as another $.03 cents in net debt. This reduces our valuation to $5.13 and begs the question: Is Pat & Oscar’s weak enough to justify the dollar discount per share that is applied by the market? I do not think so. Before I start defending myself on that one, let’s list all the negatives:

1) Negative operating income of $6.5MM. FY2004 CAPEX was $5.5MM, so we’re talking negative $10MM FCF. Youch. WRC has continued to open a few restaurants despite the E.Coli debacle. Opening a new site costs between $1.4MM and $1.6MM.
2) The original family business (with 20%+ EBITDA margins) was very dependant on catering. Since catering tends to be very regional (and dominated by Ma & Pa businesses), it will be very difficult for WRC to reach the 20% targeted margins that P&O was able to reach in San Diego. Management acknowledges that the San Diego market is saturated. But new restaurants in different regions will have a harder time establishing a catering business.
3) As you can easily understand from reading #2, the E.Coli incident hurt Pat & Oscar’s badly. Not only is the chain located in one media market, you can imagine that catering is hurt more than restaurant visits after such an outbreak. Who wants to cater a party with food that was just on the news for causing illness?
4) Most of the Pat & Oscar restaurants outside of San Diego have underperformed. The company has already closed some LA locations and the only Arizona location. Is this evidence that growing this business outside of San Diego will be an uphill battle?

Despite all the negative indicators, I think there could be some value in Pat & Oscar’s. While those 20% EBITDA margins may be forever out of its reach, the company was generating $1.3MM in EBIT (2.7% margins) right before the E.Coli outbreak. Additionally, while the company has added some new LA-area sites, they have no plans to rapidly expand Pat & Oscar’s. They are looking at a few more openings in the LA area for 2006 and a possible franchise opening in Colorado. The company also pointed out that their growth is further constrained by their inability to find suitable candidates to manage restaurants. They want to grow slowly and I think it is very unlikely that WRC sells off its CFG share and commits the proceeds to rapid growth of Pat & Oscar’s.
It is also clear that Pat & Oscar’s sales are still recovering from the E.Coli incident. Sales are still 5% - 10% below pre- E.Coli levels at the San Diego restaurants. But this is a vast improvement from the 60% drop immediately after the incident, which improved to a 25% drop over the ensuing quarter and a 16% drop the quarter after that. All in all, it has been a slow recovery. EBIT for the quarter ended October 17th 2004 was negative $663K. Still, the progess is notable:
Pat & Oscar’s quarterly operating income:
2004 Q3: - $2,718,000
2004 Q4: - $2,153,000
2005 Q1: - $ 978,000
2005 Q2: - $ 663,000

How about growth outside San Diego? While at first glance it may seem like Pat & Oscar’s lack of success in Los Angeles proves that the chain will have no legs outside San Diego, there are some other factors to consider. The founder of Pat & Oscar’s, John Sarkisian, was somewhat of a real-estate wizard. After Sarkisian’s departure as CEO of Pat & Oscar’s in 2002, then COO Robert Holden took over the job of selecting locations for new Pat & Oscar’s restaurants. The results have not been pretty. Many people blame the failure of Holden’s Los Angeles and Phoenix sites on the Pat & Oscar’s concept’s inability to gain traction in a new market. But I think the real problem with the new restaurants was their crappy locations. Several LA sites were in strip-malls without even having signage visible from the street. The performance of Holden’s new San Diego locations has been equally poor and thus provides evidence for my theory. In fact, just last month Pat & Oscar’s shuttered a location in downtown San Diego that Holden opened during his tenure. This has been the only San Diego Pat & Oscar’s to close since the acquisition of the chain in 2000.
Since Holden’s departure at the end of 2003, new Pat & Oscar’s have been freestanding sites that are more amenable to carry-out (the closed downtown San Diego location had “no parking for blocks”). According to management, the new LA freestanding location is performing above expectations, and far better than the strip-mall locations. WRC has even hired a catering specialist to seek business for Pat & Oscar’s in the LA market. I don’t know how that one is going to pan out, but I think hiring a professional schmoozer for such a role is a decent idea that might pay off.
In summary, I do not think of Pat & Oscar’s as a hidden value trap in Worldwide Restaurant Concepts. The company is finally recovering from the E.Coli incident and I think that problems with recently-opened restaurants were compounded by poor site selection.

Summary

If we assign a valuation of zero to Pat & Oscar’s, we are left with $5.13 value for WRC. This is nearly 20% above the current market value and I think I have left room for significant upside given our conservative multiples for CFG and Sizzler. Every KFC EBIT turn adds 50 cents to WRC’s share price. You can see this is not a home-run . . . but I think SZ provides a decent amount of upside with very little risk.
The company has insurance to cover all the claims relating to E.Coli at Pat & Oscar’s. So far, 45 claims have been settled with 10 remaining. The E.Coli came to Pat & Oscar’s through pre-packed infected lettuce. Obviously the supplier of the lettuce has been replaced. The company also has insurance to cover losses related to the incident, but this will take a while to calculate and collect.
WRC has NOLs of about $100MM and a tax basis around $90MM. Thus, if the KFC share is sold, the first $100MM in gain will be shielded from taxes. If the company is sold as a whole, the deal can be structured to retain the NOL, but I don’t fully understand the intricacies of this.

Risks:

- Pat & Oscar’s could continue to grow and continue to burn money
- Sizzler comp sales increases could just be a return to mediocrity rather than true positive momentum. In restaurant turnarounds, this is often a key question: Are these positive comps signs of real momentum or is this just a return to mediocrity?
- The company could sell CFG to CFG management for an unfairly low price. I don’t see why this should happen, but CFG management is the logical buyer and they might be tough negotiators. To compute its minority interest, WRC valued CFG at $111MM in its latest Q. This would value WRC’s share at $3.14 a share, which I think is too cheap.
- I suspect that management might sell the whole company rather than breaking it up into parts. Thus they would leave some money on the table for the acquirer, and leave the task of selling the pieces to them. I would not be surprised to see management sell the whole thing for $5 a share. This would be a nice return, but I feel the company is worth more than that.

Catalyst

Sale of the company