Cabot Turnaround Letter Issue: February 22, 2023

Turnarounds in Small-Cap Restaurants

Operating a restaurant is clearly a difficult task. Competition is fierce, customers can have fickle loyalties, good workers demand higher wages but can be difficult to train and retain, while food and energy costs continue to escalate in the current inflationary environment. A downturn in the economy can drain revenues as consumers trim their spending.

However, restaurants can be great businesses. Successful restaurants with capable leadership continue to stay successful. Customers generally are creatures of habit and will continue to come back again and again. Success helps keep employees motivated and engaged, which improves service and food quality while reducing costs. The opposite is true as well. Weak management drives out customers – by providing lousy food, grumpy service, dirty stores and high prices. If any business embodies the gap between a “virtuous cycle” and a “vicious cycle,” restaurants fit the bill.

While large, well-run restaurant companies like McDonald’s cruised through the pandemic almost unscathed, smaller companies struggled. Less capable leadership or other weaknesses, combined with their limited financial and other resources, left them ill-prepared.

Today, however, with the pandemic in the rear-view mirror, several small-cap restaurants are starting to turn the corner with emerging fundamental recoveries. We uncover four new ideas and provide updates on two others (Red Robin Gourmet Burgers and El Pollo Loco) that we wrote about last year. All six look promising. Also, they have very limited Wall Street coverage and are off the radar screens of most investors. These are not low-risk stocks, and they remain vulnerable to inflation, competition and recessions, but for investors with an appetite for risk, they may provide tasty returns.

Carrols Restaurant Group (TAST) – Carrols is the largest Burger King franchisee in the U.S. with 1,022 restaurants across 23 states. It also operates 65 Popeyes restaurants. Both chains are owned by publicly traded Restaurant Brands International (QSR). A long-standing member of the Burger King family, the company opened its first Burger King in 1976. While its acquisition of 166 Burger King and 55 Popeyes restaurants in 2019 added heft, it came right before the pandemic. The all-stock deal also made Cambridge Franchise Partners a major (now 29%) shareholder. Other more recent and smaller deals have absorbed needed cash. Carrols is struggling with weaker store sales while labor and food costs continue to increase, so profits have turned negative. While it struggles with the difficult operating environment, Carrols’ board and management team are being refreshed with new capabilities to execute a turnaround. While the unexpected passing of the new CEO in January was a setback, we anticipate that a new chief will soon be appointed to lead the effort. Priorities include raising prices to offset rising costs, using cash flow to trim its unwieldy debt burden, and making other changes to attract more customers. It would seem that all parties involved, including Restaurant Brands (which recently replaced its CEO), want Carrols to survive and prosper. The shares trade at 6.7x depressed cash operating profits.

Closing prices on February 17, 2023.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar/fiscal years ending in 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Dave & Buster’s Entertainment (PLAY) – Dave & Buster’s is a dining and entertainment company. Its Dave & Buster’s segment includes 150 stores in 41 states, Puerto Rico, and Canada that offer a full dining and beverage menu in an environment centered around playing games and watching live sports and other televised events. The company recently acquired the Main Event business, adding over 50 locations in 17 states that offer state-of-the-art bowling, laser tag, arcade games, and virtual reality. After a strong post-IPO (October 2014 at 16/share) growth streak, the company’s aggressive expansion led to weakening same-store sales and narrowing margins. The pandemic clearly inflicted financial damage on the company, and even though the shares have bounced back, they remain stagnant relative to their late-2015 price. However, the company is arguably in better shape than it was pre-pandemic. Its margins and profits already exceed the pre-pandemic level, as it is more than offsetting wage and cost inflation with higher pricing. This is before including the favorable effects from its all-cash $835 million acquisition of Main Street last year. This deal looks like a winner, as it not only fits well with the Dave & Buster’s business model and brings $25 million in synergies (mostly realized already), but also it brought Main Street’s impressive CEO to lead all of Dave & Buster’s. Leverage is modestly elevated at 2.1x net debt. We note the presence of activist Hill Path Capital with a 14.7% ownership stake, which will likely keep management focused on shareholder returns. The company reports earnings on February 28.

El Pollo Loco Holdings (LOCO) – Based in Los Angeles, this company is the nation’s leading fire-grilled chicken quick-service restaurant chain, with 485 company-owned and franchised locations in the western United States. It is recognized as the #1 quick-service Mexican restaurant among national Mexican QSR and fast-casual chains. While the shares have jumped this year, they remain 25% below their pre-pandemic price and 40% below their early 2021 peak. The new CEO, previously the company’s CFO and a former senior executive at KFC and Pizza Hut U.K., appears to be making progress. Revenues, same-store sales, and earnings are moving ahead of investor expectations. Incremental price improvements should help further offset rising costs. The balance sheet holds only $20 million of debt which is offset by cash. Trading at 7.6x cash operating profits, the shares remain undervalued, particularly if the turnaround continues.

Fiesta Restaurant Group (FRGI) – Based in Dallas, this company owns 138 Pollo Tropical restaurants, all in Florida. It also franchises 24 restaurants outside the U.S. The company sported healthy margins prior to the pandemic and engineered a minor pandemic-era turnaround in its Taco Cabana segment that allowed it to sell this business for $85 million in 2021. The proceeds fully repaid Fiesta’s total debt balance of $75 million. Now with a single business, the company is focusing on restoring its former profits, which have become elusive. Yet the fundamental trends are incrementally improving. In the third quarter, same-store sales rose 9% while store-level profits ticked up. Then, last December, the recovery effort took a step forward as the CEO stepped down, opening the path to a more effective turnaround. The balance sheet remains debt-free, and the company is likely to be at least marginally free cash flow positive. Trading at only 4.3x cash operating profits, the shares have a wide margin for safety.

Potbelly Corp (PBPB) – This chain of 429 quirky sandwich shops was originally a one-restaurant company in the Lincoln Park area of Chicago (full disclosure: I was an occasional customer in the late 1990s). Overzealous expansion, plus the pandemic, nearly led to the company’s demise in 2020. However, that year also brought on board an entirely new and exceptional leadership team: Robert Wright (formerly chief operating officer for Wendy’s) as CEO and Steven Cirulis (former senior executive at Panera and McDonald’s) as CFO, along with impressive new talent in the COO, chief legal officer, and other roles. The team is focusing on all aspects of the business: improving food quality, better tailoring promotional activity, updating its back-office and user-facing technology, boosting margins and streamlining the cost structure. It is also increasing its franchising program which should add to profits without tying up capital. Results so far have been highly encouraging, with pre-announced fourth-quarter results showing strong revenue and margin performance. Earnings are now positive and poised to surge. The balance sheet is clean, with its small $10 million in debt fully offset by cash. While the shares jumped following the fourth-quarter update, at only 8.4x cash operating profits, they still appear to greatly underestimate this company’s potential.

Red Robin Gourmet Burgers (RRGB) – Red Robin is a major quick-service restaurant company with 511 stores in the United States and Canada. Following its IPO in 2002 at 12/share, the shares have followed a roller-coaster path, surging twice to above 60 and tumbling three times to below the IPO price, and currently sit near all-time lows. Red Robin has struggled with weak execution and rising costs, made worse by frequent turnover in its executive suite. However, a highly capable new CEO, along with other talented senior management, could bring both permanence and improvements. While too early to ascribe to this new team, profits and same-store sales trends are now moving in the right direction. An innovative partnership with Donatos pizza is showing early promise. Trading at 4.4x cash operating profits, the shares discount almost no turnaround. The company reports fourth-quarter earnings on February 28.

High Free Cash Flow Yields

For struggling companies, cash is their lifeblood. Theoretically, as long as a weak business generates positive free cash flow, and can service its liabilities, it will have an infinite amount of time to work on its turnaround. Theory and reality are, of course, very different. Most struggling companies face eroding revenues and profits (and thus cash flow) and often have leveraged balance sheets that become more onerous with rising interest rates and tighter refinancing terms. Also, struggling companies usually want to spend on new initiatives, further draining cash flow.

In this search for turnaround opportunities, we looked for struggling companies with generous free cash flow, both on an absolute basis and relative to their market value. Strong free cash flow provides a margin of safety should profits sag. Free cash flows relative to market value, which becomes free cash flow yield, suggest a low stock valuation. We define free cash flow as Adjusted EBITDA less interest, taxes and capital spending, and use 2023 estimated results as our base case.¹

Listed below are three companies with free cash flow yields of 10% or greater. Our feature recommendation this month, Kohl’s Corporation (KSS), was initially developed from our search for high free cash flow yield stocks.

Closing prices on February 17, 2023.
* Enterprise value/earnings before interest, taxes, depreciation and amortization. Based on consensus estimates for calendar/fiscal years ending in 2023.
Sources: Company releases, Sentieo, S&P Capital IQ and Cabot Turnaround Letter analysis.

Dell Technologies (DELL) – This iconic company was started by Michael Dell in 1984 in his college dorm room. It fully participated in the worldwide adoption of PCs, then became a private company in 2013 with Michael Dell remaining a major shareholder and head of the company. In a complicated series of transactions, Dell acquired EMC in 2016, then returned to public ownership in 2018, and later spun off VMWare. Today, the company is a leading technology company with among the broadest portfolios of cloud, networking, PC, storage and other equipment, with an array of related software and services. Management is proven and capable. Sensibly, the company recognizes that its growth prospects are limited, so it emphasizes returning half of its free cash flow to shareholders, with the balance being allocated to new investments, targeted acquisitions and debt paydown. Dell’s business is cyclical, leading many investors to avoid its shares in anticipation of a further downturn in the tech industry. But the company will likely remain well-positioned for a recovery and is supported by a plenty-strong balance sheet.

Dropbox (DBX) – Founded in 2007, Dropbox provides cloud-based storage for businesses and consumers. The intuitive ease of use has led to widespread adoption, with over 17 million paid users and over 700 million registered users. While its concept is simple and seemingly vulnerable to competition, Dropbox continues to generate steady if incremental revenue and profit growth. We see Dropbox as a tech company with two traits that are rarely seen together: a stable franchise that is shareholder friendly rather than grow-at-all-costs. Management is focused on maintaining the product’s relevance with a clear eye toward shareholders. The company has set clear performance targets (including 30-32% non-GAAP operating margins and $1 billion in free cash flow). Stock-based compensation is reasonable, even as the company has reduced its share count by 17% in the past three years. The balance sheet is debt-free. The recent share price drop following its quarterly results offers a chance for value investors to participate at a reasonable valuation.

Gulfport Energy (GPOR) – Gulfport is like many other energy companies: it generates considerable free cash flow, its fate remains somewhat captive to commodity prices, and it took a trip through bankruptcy (exiting in May 2021 with a cleaner balance sheet, reduced pipeline volume obligations, and new leadership). Based in Oklahoma City, Oklahoma, Gulfport focuses on natural gas, with its production fields concentrated in southeastern Ohio and mid-Oklahoma. Since its bankruptcy exit, the company has further trimmed its net debt to 0.9x EBITDA and repurchased $233 million of common and preferred shares, even as it has maintained its production volumes. It has no major debt maturities until 2025. In January, the company hired a capable new CEO, possibly signaling a more aggressive approach to acquiring beaten-down natural gas assets, which adds a new dimension to the story. The company reported a disappointing quarter and investors worry about a return to chronically low commodity prices, leading the shares to plumb their post-Chapter 11 exit low. For investors looking for a small-cap natural gas levered company with a solid business and an under-appreciated stock, Gulfport Energy could fit the bill.

Note 1: Our free cash flow estimates generally ignore stock-based compensation costs, as these are non-cash expenses and provide the company with alternatives for using that avoided cash outflow. We readily acknowledge that stock options are not free, and that either the share base expands (diluting existing shareholders) or the company must repurchase those shares, or both. For our analysis here, we accept this limitation.

RECOMMENDATIONS

Purchase Recommendation: Kohl’s Corp. (KSS)

Kohl’s Corp. (KSS) N56 W17000 Ridgewood Drive, Menomonee Falls, Wisconsin 53051 https://investors.kohls.com

Symbol: KSS Market Cap: $3.6 billion Category: Mid Cap Business: Retail Revenues (FY2022e): $17.5 Billion Earnings (FY2022e): $330 Million 2/17/23 Price: 32.43 52-Week Range: 23.38-63.74 Dividend Yield: 6.20% Price target: $50

Background: Kohl’s Corporation operates over 1,100 department stores in 49 states and the kohls.com e-commerce business. Founded in 1927 as a corner grocery store by Maxwell Kohl in Milwaukee, Wisconsin, the company expanded in 1962 into the department store format. Owned by British American Tobacco from 1972 to 1986, Kohl’s was subsequently purchased by an investor group and completed an initial public offering in 1992. As a public company, it expanded to a nationwide presence through both new store openings and acquisitions of locations from other retailers. In 2019, Amazon purchased company-issued warrants to acquire 1.7 million shares at an exercise price of $69.68/share, expiring in 2026, although this deal has not led to any further relationship other than a merchandise-return cooperation.

From mid-2000 through today, the shares generally traded in the 40-80 price range. Revenues have remained essentially unchanged since 2011 while operating profits have stagnated since 2014. Frustration with this lackluster performance spawned an aggressive activist campaign by Macellum Capital in February 2021. This led to an agreement to add three new independent directors to Kohl’s board, an authorization for Kohl’s to repurchase $2 billion of its shares, and the formation of a new capital allocation committee. Other groups saw value, as well, leading to numerous reported buyout efforts last year, including Hudson’s Bay/Sycamore Partners (at high 60s/share), Simon Property Group/Brookfield Asset Management (at 68/share), and Franchise Group (at 60/share). Under pressure from the turmoil, Kohl’s CEO Michelle Gass resigned in December 2022.

Investors see Kohl’s as a broken company left behind by time, trends and technology, with unsettled leadership, further pressured by bloated inventory, a possible recession, and rising labor and goods costs.

Analysis: Significant changes are ahead to restore at least some of the company’s prosperity. After a series of unimpressive leaders, Kohl’s appears to finally have a proven retailer at the helm. New CEO Tom Kingsbury led Burlington Stores through a prosperous era from 2008-2018 and is widely regarded as a highly capable leader. He became permanent CEO on February 2, 2023, following his joining the board in 2021 and stepping in as interim CEO last December. His mandate and expertise are to restore and upgrade rigor and discipline in the company’s operational performance, including inventory management. Unlike other retailers like JCPenney and Bed Bath & Beyond that chose to radically change their merchandising strategy, Kingsbury may tweak the merchandising, but the overall strategy should remain unchanged – just executed better. About two-thirds of Kohl’s merchandise is national brands, and we anticipate this mix to remain unchanged. Kingsbury is supported by a refreshed board, with six of its twelve members new since 2019.

The company has a target operating margin of 7-8%, up from about 4.5% this year. Kohl’s routinely met or exceeded this level in most years prior to 2019 and earned a 9.1% margin in 2021. We believe this goal is achievable, but our thesis is based on the company reaching only a 5.5% margin.

While most investors dismiss Kohl’s as lacking growth, we see its revenues and profits as relatively stable and durable. Sales have remained steady at about $19 billion. Operating profits have ranged from $1.3 billion and $1.7 billion every year since at least 2013, excluding a modest $200 million loss in pandemic-stricken 2020. Operating profits for 2022 will clearly be below this range, at about $800 million, due to costs to offload the company’s bulging inventories as well as elevated shipping, product and shrink costs. We anticipate a rebound to over $1 billion in operating profits by 2024 as these issues are unwound and as the new leadership restores operational rigor.

We see the Sephora partnership, launched in 2020, as an additional source of retailing strength. Kohl’s has rolled out these shops-within-a-shop to 600 stores, which have produced roughly 7% uplift in sales for these stores. The company will continue to expand this successful concept in 2023.

Historically, Kohl’s generates considerable free flow of around $800 million a year. While free cash flow will likely dip to roughly breakeven in 2022, we estimate that close to $800 million in cash flow was absorbed by a build-up of excess inventory. This build-up should fully reverse in 2023, releasing considerable cash. We anticipate that Kohl’s will return to generating $800 million or more of annual free cash flow in future years as profits and working capital stabilize.

Despite its reputation for being unfriendly to shareholders, Kohl’s has recently directed much of its free cash flow toward repurchasing its shares. Since early 2021, the company, albeit under pressure from the activist, has bought back 30% of its share count. And, management recently raised its dividend to $2.00/share (for a 6.2% yield), backed by its firm commitment and ample free cash flow coverage.

Kohl’s debt burden isn’t overbearing at 3.0x adjusted EBITDA. Nevertheless, the company rightfully wants to trim it to 2.5x to help maintain its investment-grade credit rating. This reduction should also lighten its interest costs by paying off its expensive line of credit. Most of its other debt is fixed-rate, but some carry rates as high as 9.5%. Kohl’s maturity profile is manageable and following its planned retirement of $275 million in debt due this year, the next maturity is 2025.

Helping bolster its financial strength is Kohl’s ownership of much of its retail asset base. It currently owns 410 stores, or 35% of its total stores, as well as 88% of its 1.2 million square feet of distribution facilities and essentially all of its corporate offices. This ownership provides considerable relief from rent costs, protection from rent increases and can be a source of capital if it chooses to sell/lease back some of this property. This high degree of ownership of its asset base is somewhat unique in the retail industry, which usually leases its store and distribution space.

While the Kohl’s turnaround carries risks, the deeply undervalued shares provide a margin of safety. On depressed 2022 results, the shares trade at only 3.7x EV/EBITDA. The free cash flow yield on likely 2023 results is an attractive 13%. Any meaningful fundamental improvements could produce a significant lift to these shares.

Prospective investors will want to know that the company reports earnings on March 1, before the market opens. Management previously withdrew its guidance, so the report could produce sizeable share price volatility in either direction.

We recommend the purchase of Kohl’s Corporation (KSS) shares with a 50 price target.

Ratings Changes

On February 3, we moved shares of Meta Platforms (META) from BUY to SELL following their surge above our 180 price target. The company reported a strong quarter, tempered its plans for 2023 spending and announced a $40 billion increase in its share repurchase program. Also, the U.S. government lost its anti-trust case, allowing Meta to acquire Within, a company that will help Meta with its metaverse build-out. The change in management’s mindset from all-out growth to “the Year of Efficiency” helped drive the shares above our 180 price target.

We did not raise our price target, as the company’s valuation and fundamentals didn’t justify new money, and we generally avoid HOLD ratings. One way to think about the Meta investment is that it isn’t quite a cigar butt in the Ben Graham/Warren Buffett sense, but not a “great company” in the Charlie Munger sense. The Meta investment produced a 58% gain since our late December 2022 recommendation at 118.04.

On February 6, we moved shares of Dow (DOW) from BUY to SELL. As the shares reached our 60 price target, and as part of our effort to reduce the number of names on our recommended list to focus only on the most attractive turnarounds, the shares no longer belonged in the turnaround portfolio.

Dow remains a fundamentally strong company with a valuable market position, healthy profits and free cash flow, a solid balance sheet and is led by capable management. However, we see little reason to raise our price target and the shares’ risk/return trade-off is not favorable enough to justify holding the position in a turnaround portfolio.

Since our initial recommendation in the October 2022 Cabot Turnaround Letter, DOW shares have generated a 38% total return. In the comparable period, the S&P 500 total return was 12%.

On February 16, we moved shares of Conduent (CNDT) from BUY to SELL. The company reported another mediocre quarter and year and offered a mediocre outlook for 2023. There is little reason to believe that this company can implement any meaningful improvements in its profit structure, even with the pressure from 18% owner Carl Icahn¹. Conduent is breakeven on free cash flow and carries $1.3 billion in debt. While it holds nearly $600 million in cash, we believe that this is effectively not available for debt reduction as it provides vital confidence to customers that Conduent has financial durability.

Since our initial recommendation in the February 2017 Cabot Turnaround Letter following the spin-off from Xerox, CNDT shares have generated a (72%) loss. Unfortunately, not all turnarounds, nor turnaround investments, are successful. This one clearly was a dismal failure. We are disappointed in this outcome, but thankfully it is a rare exception to our otherwise favorable track record.

1. The $154 million position is a tiny 0.7% of Carl Icahn’s estimated $22 billion portfolio and apparently a low priority.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every company on the Current Recommendations List. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may currently hold and may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time.

Performance

The following tables show the performance of all our currently active recommendations, plus recently closed-out recommendations.

Large Cap¹ (over $10 billion) Current Recommendations

Mid Cap¹ ($1 billion - $10 billion) Current Recommendations

Small Cap¹ (under $1 billion) Current Recommendations

Most Recent Closed-Out Recommendations

Notes to ratings:
1. Based on market capitalization on the Recommendation date.
2. Total return includes price changes and dividends, with adjustments as necessary for stock splits and mergers.
* Indicates mid-month change in Recommendation rating. For Sells, price and returns are as-of the Sell date.
** BNRE return includes spin-off value of BAM shares.
*** GE total return includes spin-off value of GEHC shares at January 6, 2023 closing price to reflect our sale.

The next Cabot Turnaround Letter will be published on March 29, 2023.