Restaurant Group PLC

What happens when a stock priced for growth stops growing? It tanks. And what happens when a stock priced for growth reverses trend and starts recording fall in revenues? It gets pummeled. Take a look at Restaurant Group Plc (RTN:LSE), the UK based restaurant operator with over 500 establishments and with principal trading brands including Frankie & Benny's, Chiquito and Coast to Coast. Its stock has lost over 51% of its value since the high of £7.24 in November 2015, wiping out £747m from its market cap in the process. It currently trades at £3.52, this after having fallen to £2.72 recently. The recent uptick is mostly on the back of rumors that a private-equity backed takeover may be coming.

I want to take a look at whether this fall offers a value opportunity. Has the market overreacted? Could the fall in sales simply be a hiccup, with no structural or fundamental reasons, offering a great opportunity to buy and wait for mean reversion? Let’s investigate.

First some key facts on the company. In the below table I look at cheapness (EV/EBIT) & quality (ROIC). I have also shown these ratios for before the fall in the stock (i.e., Nov15). 

As can be seen from the table above, the company’s EV/EBIT ratio has fallen from a high of 17.24x in Nov15 to 10.55x today. If one back’s out market’s implied growth & ROIC estimate for this fall, assuming a cost of capital of 8% and a tax rate of 15%, then this implies that the market has wiped out all or most of its growth & ROIC expectation from the stock. For example, the 17.24x multiple would imply that the market had priced the stock for a ~5% growth with a ~13.25% ROIC; and at 10.55x multiple, growth would be almost non-existent, with a fall in ROIC to ~10%. Note that my assumption of 8% cost of capital and 15% tax rate is based on my calculation of the company’s WACC and effective tax rate, and for completeness, I calculate my implied growth & ROIC percentages using the following formula for the multiple.

From ~5% implied growth and 13.25% ROIC to ~0% growth and >300bps fall in ROIC, has the market overreacted? Does one trading update from a company signalling poor trading conditions and a potential 2.5% to 5% fall in like for like sales merit such a pummeling?

This company has grown sales at a CAGR of over 7% over the last 5 years (FY11 – FY15); is extremely cash generative with a free cash flow from operations yielding ~9%; and it has a dividend yield of ~5%. Surely it is a buy, and it is only a question of waiting for mean reversion to take its natural course and revenue growth will come back, giving a handsome return for the value buyer? Not so fast. 

I dug up the last 5 year financials to piece together the pattern in sales growth, knowing that the company’s 7% CAGR growth in revenue has come from both like-for-like sales growth, and from new store openings. Take a look at the table below.

As the table above shows, LFL revenue growth has been falling, and was at its lowest level over the last 5 years in FY15, just a 1.5% LFL revenue growth. In particular, over the last 3 years, majority of the growth in sales have been coming from new restaurant openings, with 81% of the growth in sales for FY15 coming from new openings. This is at the heart of the challenges facing the company. Growing revenues by opening new restaurants is fine as long as your ROIC is greater than your cost of capital (which seems to be the case for the company at present, and as long as it stays that way, it should go on opening new restaurants); but LFL revenue growth is the better indicator of the company’s long term health. If LFL sales are faltering, then it is only a matter of time before it starts biting into new openings and on ROIC. So what’s the story here? The answer in one word – competition.

Michael Porter in his classic 1980 book - Competitive Strategy - described that the intensity of competition in an industry is determined by five forces: threat of new entry, pressure from substitute products, bargaining power of buyers, bargaining power of suppliers, and the degree of rivalry among existing competitors. As this recent FT article nicely sums up, UK restaurants are having to fight multiple battles at the same time:
with new entrants in the traditional eating out space (rivalry among existing & new competitors is intense); new rivals offering the online/delivery options are thriving and gaining ground (substitute products); more people are choosing the option of ordering at home more often and even when they eat out they have plenty more options to choose from (bargaining power of buyers); all of this makes the cost of leasing out space in the best locations more expensive (bargaining power of suppliers). Data from Euromonitor show that growth in home delivery and takeaway food has outpaced that of restaurants each year since the financial crisis. Between 2009 and 2014, the UK market for take away and delivery expanded 2.7 per cent to £6.5bn, while the value of food bought in restaurants fell 5 per cent to £17.1bn. Restaurant Group is heavily exposed to this trend as it does not deliver, and hardly has an online presence which could compete with rivals. In addition to the intense competition, the increase in national minimum wages from this year is going to eat into margins further (for Restaurant Group this will add at least £2m to its cost base this year). 

If an entire sector is in distress, then distressed companies within that sector could be good bets – as the sector recovers, those companies could bring great returns. But if a sector is thriving overall – overall revenues for the consumer/retail food sector is growing and people are spending more on food – and there are pockets of distress due to rapid changes in the industry, then it calls for caution when inspecting distressed stocks in that sector. There could well be a valid reason for the distress.

Given the intensity of competition in the sector, and the difficult / uncertain trading conditions faced by Restaurant Group, the approach to determining its intrinsic value needs to take account of the many possible outcomes. I have used a scenario based approach, with intrinsic value being the expected payoff taking account of the various outcomes. I have analysed intrinsic value under 5 scenarios which combine various assumptions for revenue growth  & decline and for development capex (determined by the number of new openings or closures). My analysis concludes that the intrinsic value per share for Restaurant Group Plc is in the range of £3.5 - £4. Given the current share price of £3.52, I don't believe that the stock offers adequate margin of safety for a value investor.

You can see a table with my summary of probability weighted intrinsic value, including detailed DCF calculations for each scenario, in the tables at the end the end of this write-up. My sources and reference material have mostly been the company’s last 5 years financial statements (FY11 – FY15).

Finally, my thoughts on the recent news of a private equity takeover of the group. Any takeover of a public company would have to be at a premium of at least 20% - 30% to current the share price, giving a target price of at least £4.23 to £4.58 a share based on closing share price of £3.52 on 20 May 2016. Given that a private equity buyer will have a return (IRR) expectation of at least in the mid-teens, I find it difficult to see that level of return for at current price. I am not ruling a bid out, or the fact that a buyer with an edge and detailed knowledge of the portfolio on a restaurant by restaurant basis may well know how to generate that return. But any buyer will need to get their hands very dirty with the operational aspects and I suspect will also need to place a lot of faith in growth reverting.

This stock could yet be a value buy. There could well be a sell-off - e.g. if market's recent expectations of a private equity buyout in the near future does not materialize. Secondly, it is worth watching closely the outcome of the strategic review being carried out by the management, the results of which are to be announced in August. This situation merits monitoring on an ongoing basis. 

Probability weighted intrinsic value per share under various scenarios

DCF valuation for Scenario 1 - LFL sales continues to be a struggle; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 2 - LFL sales continues to be a struggle; development capex is discontinued from FY17, with restaurant numbers falling.

DCF valuation for Scenario 3 - LFL sales fall is arrested & mean reverts; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 4 - LFL sales fall is arrested & mean reverts; development capex is discontinued from FY17, with restaurant numbers falling.

What’s ailing Utilitywise Plc?

The shares in Utilitywise Plc (UTW:LSE), a company that helps small businesses find the cheapest energy and water supply contracts and takes a cut from suppliers, have fallen 30% over the last year. Its shares currently trade at a low P/E of 9.4 and EV/EBITA of 8.3. For a company that is growing revenue at 36%, with healthy gross and EBITA margins of 40% and 20% respectively, the stock looks cheap. Quality, which I measure as Return on Invested Capital (ROIC), is not bad at all at 26%. The market it caters to is huge and largely untapped – there are over 4.5m small businesses in the UK and many more in Europe where the company has just started operations. My Discounted Cash Flow valuation for various scenarios comes up with an intrinsic value per share of £2.6 - £2.8, implying a potential 60% to 75% upside on the current price of £1.60 per share.

So why this sell-off? Shouldn’t this stock be a screaming buy?

Two major concerns merit market’s skepticism. The first is to do with revenue recognition and risk of future write-downs, and the second is a lack of moat and increasing competition which seems to be eating into margins and putting the sustainability of growth and returns at risk.

Revenue recognition

Utilitywise earns a significant chunk of its income as commission from energy suppliers; a fair amount of this commission is paid over the life of the contract (typically 5 years) that the end consumer signs with the energy supplier. The commission paid by energy supplier is based on actual energy consumed by the end consumer over the life of the contract. However, the group recognises revenue on the entire contract at the point when the contract goes live; using a fair value method, the group applies a 15% variance discount (for variance in projected consumption) & present values the projected cash flows using a 3% discount rate. There are obvious risks associated with such an approach – a) the end consumers are small businesses and the risk of a default will be high; the 3% discount rate that the company uses is based on the credit rating of the energy suppliers not the small businesses, and b) it cannot be easy to project energy consumption over the life of long contract period with any degree of certainty; any variance in consumption could have a material impact on prior year revenue already booked.

This approach means:

1. A significant chunk of the revenue is sat as trade receivables and accrued revenue on balance sheet and takes a fair amount of time before converting to cash; and,

2. There is constant downward pressure on this prior year revenue both due to variance in projected versus actual consumption and due to risk of default by the end consumer.

The group has already taken significant write-downs against its FY14 and FY13 receivables and accrued income claiming that its initially projected consumption variance was lower than actual. To put this into context, the group in its FY15 accounts wrote off a total of £6.35m of accrued revenue and trade receivables booked in FY14 and FY13 (net of tax). Adjusting the group’s operating profit in FY14 and FY13 for these write-downs would result in operating profit after tax falling by 42% for FY14 and by 52% for FY13. This is significant and throws into question any DCF valuation based on group’s revenue numbers in the accounts (out of the window goes my intrinsic value estimate of £2.6 to £2.8 per share when such uncertainty exists in revenue recognition). Furthermore, the FY15 financial statements say that no adjustments have been made for years prior to FY13, not because none exist, but because it would be difficult to estimate due to lack of information.

Competition, moat, and falling profitability

When a sector offers juicy margins, a large & untapped market, and low barriers to entry (Third party intermediaries are currently unregulated), one can bet top dollar that competition will come. This is evident in the company’s results - operating margins have fallen from a peak of 31% in FY11 to 20% now, and arresting the fall will be difficult. The company also seems to be facing significant difficulty in retaining sales staff – the high staff attrition rates are a clear sign of high competition  in the sector. The company looks to be trying to counter competition by diversifying (it has made some technology acquisitions – i.e., enabling energy consumption tracking, providing energy consulting services etc.) and expanding into new markets (it has recently commenced operations in Europe). It has also recently put new management team in place to counter the challenges. But given the low barriers to entry, it is difficult to see how the current high margins and ROIC can be sustained.

In conclusion

If one were investing simply based on attributes – cheapness (low P/E & low EV/EBITA) & quality (high ROIC) – Utilitywise Plc would be a buy. But as Michael Mauboussin has repeatedly said in his writings circumstances trump attributes when it comes to investing success. To paraphrase a quote of Michael’s – “Sometimes our nostrums work, but more often they fail us. The reason usually boils down to the simple reality that the theories guiding our decisions are based on attributes, not circumstances.”

I highly recommend buying Michael Mauboussin’s two books - More Than You Know and Think Twice; both are great investment in time for a value investor, but I would pass on Utilistywise Plc’s stock for the time being.