While some restaurant chains regularly make adjustments and continue to prosper, others correct their mistakes in time. And some recognize their mistakes too late..
However, several casual dining restaurant chains that have lost their way have turnaround appeal. In this issue, we take a look at five.
Cabot Turnaround Letter 619
In This Issue:
Restaurants... Time to Take a Nibble?
Turnarounds in Australia
Recommendations:
Buy: The Kraft Heinz Company
Sell: Weatherford Int’l
Changes: Conduent
News Notes
Performance
RESTAURANTS… TIME TO TAKE A NIBBLE?
Like all businesses, restaurants succeed by offering customers what they want. And, what customers want from a casual dining restaurant is tasty food, great service, a clean and upbeat atmosphere, and of course appealing pricing. When offered these features, customers will keep coming back – producing strong profits for the owners.
Surprisingly, however, restaurant managements will sometimes let these basics slip, perhaps in pursuit of faster revenue growth or short-term margin expansion. While the stock market may applaud these moves, customers will eventually get the message of “we don’t care about you anymore” and stop coming to the restaurant. The change in same store sales (often called “comparable store sales” or just “comps”) from positive to negative will send formerly enthusiastic investors fleeing.
Some chains regularly make adjustments and continue to prosper, like Ruth’s Hospitality. Others, like Darden Restaurants, correct their mistakes in time. Some recognized their mistakes too late – newly bankrupt Kona Grill comes to mind.
However, several casual dining restaurant chains that have lost their way have turnaround appeal. Each has unique issues, but they all face challenges from new competition, other meal alternatives and rising costs. Another common trait: meaningful undervaluation compared with their post-recovery potential. Listed below is our menu of five appetizing potential turnarounds.
Bloomin’ Brands (BLMN) – This company owns popular restaurant chains like Outback Steakhouse, Carrabba’s Italian Grill and Bonefish Grill, with nearly 1,500 restaurants across the U.S. and twenty other countries. After its share price more than doubled following its 2012 initial public offering, decaying revenues and profits have pushed shares BLMN shares down 30% during a strong bull market. However, the company is refocusing on basics by improving in-store execution, remodeling tired locations and bolstering food quality and staff training. Also, they are building on their off-premises sales and international successes. So far, these efforts have started to reverse the negative same-store sales trends. If its turnaround continues, the company could return to revenue growth with wider margins, providing a juicy lift to its heavily discounted shares.
Brinker International (EAT) – Founded in 1975, Brinker has 1,600 Chili’s Bar & Grill and Maggiano’s Little Italy restaurants in 31 countries. The shares have struggled in recent years, hurt in part by negative same store sales growth. While international comps remain weak, domestic comps have turned positive, indicating that it is regaining some consumer appeal. Brinker is working to offset margin pressure from its promotional pricing and rising labor and other expenses. While lower, free cash flow remains healthy. A recent $470 million sale-leaseback transaction has helped reduce the share count and debt – two smart moves. While there is more work ahead, Brinker’s recovery is headed in the right direction. Investors may want to begin putting this turnaround stock on their plate.
Cheesecake Factory (CAKE) – Cheesecake Factory basically created the upscale casual dining concept when it opened its first restaurant in 1978. Today, although the company is struggling to rebuild profit margins at its 202 highly popular owned restaurants in the Unit- ed States and twenty-one licensed restaurants internationally, the management wants to continue to expand to new locations and spend on new dining concepts. Investors seem to prefer that Cheesecake Factory concentrate on cutting its bloated overhead to help reverse two years of declining earnings and prioritize returning more of its strong and steady free cash flow to shareholders. Should management concede even partly to this view, investors could regain their appetite for Cheesecake Factory shares.
Papa John’s International (PZZA)– As the world’s third largest pizza chain, with over 5,000 locations in 45 countries, Papa John’s is working to recover from the reputation-damaging behavior of its former chairman/CEO. Central to this effort is the role of Starboard Value. This successful activist holds the board chair and the loyalty of several other directors. With a total of six new directors this year (including basketball star Shaquille O’Neil) and new operating leadership, the company is essentially under new control. The founder’s influence has faded, and he has been an aggressive seller of his shares. Near-term results will likely remain tepid, highlighted by the -6.9% comp in the most recent quarter, and so investors will want to pick their spots to get in. However, with the shares already down 50% and selling well-be- low Domino’s Pizza’s 21x EV/EBITDA multiple, Papa John’s shares could really deliver.
Red Robin Gourmet Burgers (RRGB)– Red Robin has its roots in a 1940’s tavern in Seattle and now has 560 restaurants across the United States and Canada. Following its 2003 initial public offering at $12, the shares surged to over $90 by mid-2015. Yet, today, the shares sell for only a third of that peak price, as lower prices at competitors and overly aggressive cuts in labor and service levels have turned off customers. Already worried investors were further rattled by the sudden departure of CEO Denny Marie Post in April. However, the company will likely continue to pause its unit growth to concentrate on improving its existing stores and expand its successful off-premises business. Red Robin’s balance sheet remains sturdy, and the company generates free cash flow, providing some breathing room. At a highly discount- ed 4.8x EBITDA multiple, the shares are worth a visit.
TURNAROUNDS IN AUSTRALIA
With the longest running economic expansion in modern history, at 28 years, Australia’s economy has truly been a wonder. The Land Down Under has benefitted from the relent- less expansion of its neighboring giant China, as well as growth in other Asian and global trading partners. This growth has also produced decent Australian equity returns over the past five years. While lagging the impressive 11.6% annualized returns of the S&P500, the benchmark ASX 200 index has generated a respectable 7.5% rate of return. This is particularly impressive as the index contains almost no technology companies (only about 2% weight) and is heavily tilted toward financials (32%) and materials/mining (18%). Investors who want broad Australian exposure can buy the iShares MSCI Australia ETF (ticker EWA). Turnaround investors can also find individual Australian stocks with strong rebound potential. Moreover, should the U.S. market suffer a downturn, particularly one led by tech stocks, these shares might provide diversification to dampen its effect. Plus, any weakness in the recently strong U.S. dollar against the Australian dollar (A$) would likely further boost returns. Listed below are five major Australian stocks that have lagged both the local market and the S&P500 yet have company-specific changes that could produce strong recoveries. All of the stocks are listed on the Australian Securities Exchange (ASX), and trade in the United States as ADRs. Most have sizeable trading volumes although Origin Energy has lower volume that may require investors to buy patiently. The stocks pay sizeable dividends, too. As with most foreign dividends, there may be local and tax treaty effects on some of these payouts, and so investors may want to seek advice on the possible effect on their specific tax situation. 
Coca-Cola Amatil (CCLAY)– With 2018 sales of US$3.3 billion, this company is one of the largest bottlers and distributors of soft drinks and other non-alcoholic beverages in the Asia Pacific region. About 30% of its shares are owned by the Coca-Cola Company. Like most Coke bottlers, Amatil has healthy operating profit margins (about 15%) and returns on equity (about 33%), a sturdy balance sheet, and pays an attractive dividend. Similarly, however, it also is struggling to maintain its revenue and profit base as consumers migrate toward water and other healthy beverages. Last year, revenues fell 1% while operating profits fell nearly 7%. Amatil is working to rejuvenate its core soda and water businesses while investing heavily in promising beverages like energy, value-added diary and coffee drinks. It is also divesting SPC, the nation’s leading fruit and vegetable processor but also a non- core albatross. The turnaround may take a while, but patient investors may find this solid company worth the wait.
Lendlease Group (LLESY)– Listed on the ASX since 1962, Lendlease is a leading inter- national real estate development, construction and investment company with $11 billion in revenues. Some of its notable projects include the Sydney Opera House, National 9/11 Memorial and Museum in New York City, and the Athletes Village in London for the 2012 Olympics. Its presence in major global cities makes it well-positioned to benefit from the secular trend toward urbanization. While Lendlease is generally a well-managed company with sound capital and operating practices, investor confidence was rattled last November when it acknowledged deep problems in its Engineering & Services businesses. This news, plus the related weak earnings guidance and increase in its debt, drove Lendlease shares down 27%. Additional concerns over a slowing construction outlook also weigh on the shares. However, while the E&S problems cloud the near-term outlook, the company will be either winding down or closing these operations, leaving it in a lower-risk and stronger position long term.
National Australia Bank (NABZY)– One of the four largest banks in Australia, this company offers a full range of banking services. Recent missteps, including a compliance issue that is requiring costly remediation payments, along with sagging results in its consumer banking and wealth management businesses, has led to the dismissal of its CEO and his forfeiture of up to A$21 million in compensation. The bank reduced its dividend by 16% to help fund its remediation payments and further lift its already-healthy capital levels. Its three-year transition plan to higher profitability remains broadly on track. Despite the bank’s issues, its profits remain steady and its loan quality continues to be sound. Its valuation relative to peers seems to overly discount its improving prospects. Like all banks, National Australia Bank faces numerous economic, regulatory and competitive headwinds, but its turnaround program makes this bank a potentially appealing stand-out.
Origin Energy (OGFGY)– Origin is Australia’s largest energy retailer, providing electricity and natural gas services to over 4 million customers. While this business is growing and comprises about 56% of cash operating profits, the Integrated Gas segment is rapidly be- coming a major cash producer. This segment explores for oil and natural gas and is a partner in the Australia Pacific LNG joint venture with ConocoPhillips and Sinopec. The already sizeable cash distributions from this operation, which has allowed Origin to initiate a dividend and continue to pay down its debt balance, are poised to increase another 15% later this year. Investors don’t appear to be fully appreciating the merits of this successful venture.
Telstra (TLSYY)– Founded in 1854, Telstra is Australia’s largest telecom company, providing a full spectrum of telecom services across the Asia Pacific region. Competitive pressures have weighed on recent results, illustrated by weak first half 2019 when EBIT- DA fell by over 11%. While an outsider was brought in as CEO nearly four years ago, the turnaround effort took a more serious turn with the change-over of nearly the entire senior leadership team late last year. Part of the new team is Robyn Denholm, the highly regarded former CFO and architect of tech firm Juniper Networks’ impressive turnaround. The T22 Strategy (or “Telstra 2022”) is to simplify its service offerings, streamline its businesses, sell up to $2 billion of its infrastructure, and invest $3 billion to upgrade its network. Telstra also has several private-equity and other initiatives that could germinate into valuable assets. With time, this company’s efforts could lead to much better share price performance along with attractive dividends.
Purchase Recommendation: The Kraft Heinz Company
Background: The Kraft Heinz Company is among the world’s largest packaged food companies. With its century-plus roots in cheese (Kraft) and ketchup (Heinz), the company today holds a remarkable portfolio of over 200 brands, including the iconic Kraft- and Heinz-branded foods, Oscar Meyer meats, Ore-Ida potatoes and Planters nuts. About 31% of sales are outside of the United States. Following the 2013 acquisition of H.J Heinz Company by Berkshire Hathaway and Brazil’s 3G Capital, Kraft Foods and Heinz merged two years later in a giant $49 billion deal. At first, the combination looked promising, winning praises from investors. Aggressive cost-cutting helped boost its EBITDA margin to an industry-leading 29%, propelling the shares to over $95 by early 2017, nearly 30% higher than its opening post-merger price. Its zero-based budgeting approach became the envy of the industry, leading peers to adopt a similar strategy. However, flaws began to emerge in early 2018, as the company struggled with weak revenue and profit growth. The issues culminated on February 22, 2019, with a remarkable five-point roster of bad news, as the company: 1) missed the 4Q18 consensus earnings estimate, 2) offered weak guidance, 3) wrote-off $15.4 billion of goodwill, 4) cut its dividend by 36%, and 5) announced an SEC investigation into its accounting. Investors were shocked (even part-owner Warren Buffett expressed his surprise), sending KHC shares down 27%. Rather than creating value, the KHC merger has produced lower revenues and profits, more debt and a much lower share price. Investors see a company whose dated product line has limited appeal to today’s consumers (who want fresh, healthy, less-processed foods), has weakened bargaining power relative to its grocers and other distribution channels, carries an elevated debt burden, is led by a management that lacks credibility, and hasn’t filed clean financial statements since last October. It’s little wonder that the shares trade 57% below their post-merger opening price in a stock market that has gained nearly 40%.
Analysis: While disdained by investors, Kraft Heinz is by no means a lost cause. The company’s revenues remain stable (if not growing), backed by still-popular brands and products. Its profit margins are still robust, and it generates sizeable cash flows. Most of the problems are centered on the U.S. operations, as international results have been stronger. The sharp drop in its stock price has increased the pressure on Kraft Heinz to improve. We expect that Warren Buffett, as the largest shareholder (with 26.7% ownership) will work behind the scenes to rebuild the value of his now-$10 billion holding. An important first step will be the arrival on July 1st of new CEO Miguel Patricio, who brings needed expertise in rejuvenating products and brands. Kraft Heinz also has reportedly begun selling part of its trove of valuable brands, including its Maxwell House coffees, Breakstone sour cream/cottage cheese and Plasmon baby food businesses, to streamline its operations and reduce its debt. Other initiatives under way include more investment in its supply chain, warehouse system and sales force. We anticipate better product innovation ahead. Kraft Heinz’s accounting issues, while unnerving, appear to be contained at about $200 million, which is less than one percent of revenues. We would expect the company to be current on its financial filings by the end of the summer. Despite this issue and the company’s elevated debt level, the bond market, which can be an early indicator of deeper problems, remains unfazed: Kraft Heinz bonds currently trade around par. While the $0.40/share quarterly dividend is well-covered and produces an over five per- cent yield, investors should recognize that the company might choose to cut it further in order to accelerate its debt paydown. With low expectations, even moderately positive news might help lift the shares. As Kraft Heinz makes more substantial progress toward meeting its combined challenges of producing revenue growth and margin expansion, its stock price will likely produce meaningful gains. We recommend the
PURCHASE of shares of The Kraft Heinz Company (KHC) with a $45 price target.
News and Notes
While Globalstar’s share performance has been disappointing so far, the company has started down a more promising path. Three of the seven board members are new and independent from the chairman/majority shareholder, which should bring more focus on increasing the company’s value. A possible upcoming dilutive equity raise could actually boost the share price as it extends the company’s life expectancy. These shares are speculative in their risk level but have the potential for outsized returns given their very low valuation relative to the value of their telecom spectrum assets. We continue to rate them “Hold”
Performance
The tables below and on the next page show the performance of all of our currently active recommendations, plus recently closed out recommendations.
