Thrice well done in the USA

Introduction 

The Kempen (Lux) Global Small-cap Fund has invested in US restaurant chain Del Frisco's Restaurant Group (DFRG) since October 2015. When we first bought this stock, the price had halved within a period of over a year: from a peak of 28 dollar per share in the first half of 2014 to 14 dollar per share. This drop was reason enough for us to conduct a detailed analysis.

Three types of steakhouse 

Del Frisco's owns around fifty steakhouse restaurants in the United States, divided over three chains. The Del Frisco's Double Eagle Steak House label serves the upper end of the market. The company also owns a chain in the middle segment under the brand name of Del Frisco's Grille. The third label is called Sullivan's Steakhouse. Like Double Eagle, this concept is aimed at the upper end of the market, but the restaurants are often located in smaller US towns. Prices are slightly lower than those at the Double Eagle restaurants, which means that Sullivan’s complements the Double Eagle concept.

Growing pains 

When we first examined Del Frisco's in the summer of 2015, we noticed that the company had grown substantially. In particular the relatively new Grille chain had been rolled out quickly, from two branches at the end of 2011 to seventeen in the summer of 2015 (as of the end of 2016, there were 21 Grille restaurants). In early 2015, it became clear that a number of the new restaurants, and in particular those that had opened in 2014, were performing less well than management had initially expected. Moreover, the existing restaurants of the two other chains were also displaying slightly poorer results.

Plummeting price 

The above triggered a huge drop in the price of the DFRG shares. The fact that several members of the DFRG management bought shares in their company in the summer of 2015, a highly positive sign in our eyes, was apparently of no interest to the average investor. Our interpretation of the drop in price is that it was mainly growth investors who wanted to divest themselves of these shares, whatever the cost. Such moments can be of great interest to long-term investors such as ourselves.

Three chains, three profiles 

We decided to analyse each of the three chains separately as they each have different growth and profitability profiles. The Double Eagle chain is highly profitable and we believe this to be a very attractive and valuable asset. Sullivan's is less interesting, given that this chain generates much lower revenue than Double Eagle and enjoys a considerably lower level of profitability. Nevertheless, we viewed - and still view - Sullivan’s as a positive asset. The Grille chain is the most difficult to analyse and value. In the past, the management has indicated that the potential for the Grille concept in the United States is at least 170 restaurants. Given the issues with the restaurants that opened in 2014, there is reason to doubt this claim. Furthermore, it is tricky to estimate the ultimate margin structure of this concept. We prefer to adopt a cautious forecast where such uncertainty exists.

‘No growth scenario’ 

At the end of the summer of 2015, we assessed the financial implications of a scenario in which DFRG were to open no new restaurants. In general, growth is at the expense of a company’s short-term profits and cash flows and DFRG has grown sharply. Our scenario showed that DFRG was expected to generate 11 percent free cash flow per year for shareholders: a return we find highly attractive for a healthy company with a robust balance sheet (two characteristics of DFRG). 

What else is in its favour?  

In addition to the abovementioned analysis, we look at other elements before deciding whether to include a stock in the portfolio. For instance, we always examine the company’s history. DFRG was listed on the stock exchange in 2012, but had previously formed part of a listed company in the distant past. We also chart the backgrounds of the individual directors. The role of management is very important, especially at a relatively small restaurant chain. DFRG has an experienced and highly regarded management. Another standard part of our process is an extensive analysis of the company’s balance sheet. We are long-term investors and do not like companies with high or excessive levels of debt. DFRG has a very robust balance sheet that contains zero to minimum (net) debt.

All in all, as a team we agreed that DFRG is a very attractive investment and for this reason decided to buy a position in October 2015. 

Update 

We have now invested in DFRG for over five quarters. The restaurant chain’s underlying performance has recently improved slightly, as can be seen from this press release. The most noteworthy event since we started to invest in this company is in our view the change of CEO announced on 21 November 2016. As of that date, Director Norman Abdallah took over the role of CEO from Mark Mednansky. We have great admiration for the work done by Mednansky, who headed the company for 18 years. At the same time, we believe that Norman Abdallah will be able to take the company to the next level. He has a very impressive CV in the restaurant industry, including running restaurant chains on behalf of several leading private equity companies. We had the opportunity to meet Abdallah and CFO Tom Pennison in Orlando on 10 January 2017. The management has tangible plans to accelerate organic growth and increase margins. As a result, our confidence in this management team and company has only increased. We therefore expect to hold DFRG in our portfolio for a long time.

Previous cases 

  • Spotless
  • Safestore
  • Select Comfort
  • Kronos Worldwide
  • Fujitec
  • Steiner Leisure  

 

Date: 6 February 2017 

Disclaimer:
This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’), managed by Kempen Capital Management N.V. (‘KCM’). The Fund currently holds shares in the subject company.  The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. The information in this document is solely for your information. This document should not be considered to constitute an investment recommendation and it is not intended as an offer or a solicitation to buy or sell any financial instrument mentioned in this document.  This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM.