Real estate, alternative real assets and other diversions

The Restaurant Group: Weak profitability, long leases and high debts

The Fund Manager

The Restaurant Group (which I’ll shorten to TRG) joined the model portfolio in early 2016, shortly after the company published some very upbeat 2015 results.

Revenues were up 8% while earnings and dividends per share were up 13%, continuing the company’s long track record of impressive results.

But then things started to go wrong in its core restaurant business (TRG also runs pubs and airport concessions, and these continued to perform well).

Initially this was put down to operational issues, such as a lack of focus on value and service. But despite operational improvements over the next couple of years, like-for-like sales continued to fall. 

By mid-2018, management admitted that TRG’s problems were structural rather than cyclical.

Key problems included reduced footfall at restaurants in out-of-town retail parks (thanks to the shift to online shopping), increased competition from other branded restaurants, new food delivery aggregators (e.g. Just Eat) and increasing costs such as the minimum wage, rent and business rates.

Management’s solution was to acquire Wagamama, a high growth pan-Asian restaurant chain. This would bring economies of scale and allow TRG to convert underperforming sites into Wagamamas. 

However, Wagamama does not solve TRG’s fundamental problems which are, in my opinion, a lack of competitive advantages, a tendency to sign long leases and (thanks to Wagamama) high debts.

For these and other reasons I have decided to sell TRG this month, with the following less than stellar results:

Investment results

Purchase price (adjusted): 257p on 11/04/2016

Initial position size: 3.9%

Sale price: 137p on 05/11/2019

Holding period: 3 years 7 months

Capital gain: – 46.9%

Dividend income: 15.7%

Annualised return: – 12.0%

The slowing UK economy revealed TRG’s underlying weaknesses

Note: You can download the original pre-purchase review (PDF) which was published in the April 2016 issue of my monthly newsletter.

Obviously this is not a great result, so in the rest of this post-sale review I’ll focus on TRG’s underlying weaknesses and how they became much more visible after I began lease-adjusting ROCE (returns on capital employed) a couple of months ago.

But first, here’s a quick review of this investment from beginning to end.

Up to 2015, The Restaurant Group had producing rapid and extremely steady growth

When TRG joined the model portfolio in early 2016, its track record was almost second to none. Revenues, earnings and dividends had increased almost every year over the previous decade, giving the company an average annual growth rate of 10%.

This growth had been driven primarily by an increase in the number of restaurants, food-focused pubs and airport concessions operated by the business, from a total of 284 in 2006 to more than 500 in 2015.

Overall TRG looked like a very strong business, with high profitability (average returns on capital of 19%), well-known brands, very little debt and no pension liabilities. The valuation multiples looked attractive too, with a 4.4% dividend yield to go along with its ten-year average dividend growth rate of 12%.

This is what impressively consistent growth looks like

Of course, it wasn’t all good news otherwise the dividend yield wouldn’t have been so high. 

The company’s 2015 results mentioned economic uncertainty from the Brexit referendum, an increase in competition from other branded restaurants and pubs, and a decrease in footfall at some of its out-of-town retail park sites thanks to the growing trend for online shopping. 

Another headwind was costs, with above-inflation increases to the National Minimum Wage and the introduction of the higher National Living Wage. These negative factors had already led to a like-for-like sales decline of 1.5% and a near-50% decline in TRG’s share price (before it joined the portfolio). 

Management’s opinion was that most of these factors were either short-term or could be dealt with by providing a better service, improved menus, improved efficiency and reduced costs through technology.

At the time, my opinion was that people weren’t going to stop eating out, so any revenue or cost pressures would be reflected across most of the restaurant and pub industry. In fact, given TRG’s impressive track record, I though these pressures might squeeze some of its competitors out of business which, in the long-run, would be good for TRG.

But that isn’t how things turned out.

A surprisingly rapid decline, bordering on collapse

Less than a month after TRG joined the portfolio, management announced that they expected 2016 like-for-like sales to be down by 2.5%. This was due to ongoing challenges in revenues (from declining footfall at out-of-town retail parks) and expenses (from increasing rents, wages and other costs). 

At this point the company launched a comprehensive review of its strategy and, somewhat surprisingly, the CFO left with immediate effect. This was surprising, to me at least, because CFO and CEO “resignations” usually occur after much more than a 2.5% like-for-like sales decline.

Clearly there must have been more going wrong than just a minor sales decline.

Despite all this, management still expected to open around 30 new sites in 2016, reflecting their continued belief that TRG’s ultimate goal of 850+ UK sites was still achievable.

And then, in August 2016, the CEO left with immediate effect.

Investors found out why in the company’s 2016 interim results: Like-for-like sales were down 4%, 33 sites had been identified for sale or closure and the balance sheet value of another 29 sites was being written down (leading to a significant loss for the year).

The strategic review was ongoing, but eventually it would evolve into a plan to:

Re-establish the competitiveness of the restaurant brands

Serve customers better and more efficiently

Grow pubs and concessions

Build a leaner, faster more focused organisation

The replacement CEO reiterated this turnaround plan in the 2016 annual results and again in both the 2017 interim and annual results.

By the end of 2017, results from the turnaround plan were minimal. The number of meals served had gone up, but revenues from the restaurant business were down, and good results from pubs and airport concessions were not enough to offset the decline.

Related:  2018 Performance review and lessons learned

Management continued to execute on the turnaround plan throughout 2018 and like-for-like sales continued to fall. With ongoing cost pressures and a focus on value (i.e. lower prices), margins were squeezed and profits remained at less than half their 2015 highs.

Despite all the hard work, it looked like the turnaround plan was not working.

Management throw in the towel and acquire Wagamama

Shortly after the 2018 interim results, management effectively threw in the towel and announced that TRG was to acquire Wagamama, a fast-growing pan-Asian restaurant.

The price tag was £357 million, or £559 million including Wagamama’s debts, and the acquisition was funded primarily by shareholders via a rights issue (I chose to sell the allotted rights rather than take them up).

I say management “threw in the towel” because once the Wagamama acquisition had been announced, they stopped focusing on turning the existing restaurant business around. Instead, the turnaround plan was replaced with a plan to:

Convert suitable existing restaurants into Wagamamas

Close at least 50% of the company’s restaurants as their leases expired

Grow Wagamama

Grow pubs and concessions

Wagamama, with its healthier menus, better locations, existing links with delivery aggregators (e.g. Deliveroo) and generally “trendier” brand, must have looked like a get-out-of-jail-free card to TRG’s management.

However, the combination of TRG and Wagamama is not something I want to be invested in, and here’s why:

An alternative history: The Restaurant Group as a company with little or no competitive advantage

In the late 1990s, TRG (or City Centre Restaurants, as it was then) had most of its restaurants in high footfall locations such as high streets and tourist centres. It had 45 Garfunkel’s restaurants (with about half in airports), a handful of other brands and was the UK’s leading Mexican restaurant operator.

The economic boom of the late 90s saw the casual dining market explode, with new restaurants opening up left, right and centre. When the bust of the early 2000s arrived, the combination of an oversupplied market and an economic downturn gave TRG two years of losses.

At this point, the company decided to focus on out-of-town retail and leisure parks.

In theory, these parks had significant barriers to entry. For example, a retail/leisure site might have five retail stores, two restaurants (one run by TRG), a cinema and a gym. Once these tenants are in place, the ability of additional restaurants to appear on site is very limited compared to a high street, so TRG would have a captive market of shoppers and cinema-goers.

This sounds good in theory, but my revised interpretation of this strategic switch is that TRG did not have a meaningful competitive advantage on the high street, so it moved to where there was less competition.

This strategy worked from around 2001 to 2015. During that time the company expanded enormously, putting restaurants in dozens of new retail parks and leisure parks that were springing up left, right and centre.

Eventually sites for new out-of-town parks became limited, so developers expanded existing parks. Where there was one restaurant, suddenly there would be two more.

TRG leased many of these new sites, sometimes having two or three of its restaurants in a single retail/leisure park, competing against each other. This kept headline growth going, but it also reduced profit margins and returns on capital.






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About John Kingham

John Kingham

John Kingham is the editor of UK Value Investor, the investment newsletter for defensive value investors. With a professional background in software analysis, John's approach to high yield, low risk investing is based on the Benjamin Graham tradition of being systematic and fact-based, rather than speculative. John is also the author of The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio. His website can be found at: www.ukvalueinvestor.com.

Articles by John Kingham

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