• [WEBCAST] Raoul Pal & Neil Howe: A Sobering U.S. Economic Reality Check

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I have communicated three main concerns about RRGB’s business model in the last year or so. First, I thought the company was continuing to grow too fast. Second, I was concerned about the company’s increased contribution to its national advertising fund as management would never quantify the return being generated from the company’s investment. RRGB’s campaign focused only on brand-building advertising, which is never as effective as promoting products at specific price points. Additionally, the expense associated with a national T.V. advertising campaign does not seem warranted for a 400-unit restaurant company. Third, I was bothered by the company’s capital allocation decision to borrow money to buy back stock. RRGB spent $50 million in FY08 to buy back about 1.5 million shares at an average purchase prices of $33.76 while increasing its debt by nearly $70 million.

RRGB addressed all of my concerns on its earnings call last week. The company lowered its FY09 new unit growth to 13-14 new units, down from its initial guidance of 20 and cut its FY09 capital spending expectations by more than 45% from its FY08 level. Management also stated that it has not yet made any decisions about its development plans for FY10, which highlights that the company recognizes the need to be cautious in this environment (20% company-operated unit growth will no longer yield the necessary returns).

The company also announced its intention to lower its contribution to its National Advertising Fund to 0.25% of restaurant revenue in FY09, down from 1.5% in FY08, which depending on sales could result in a $11 million reduction to FY09 marketing expenses. Specifically, RRGB does not plan to run any national cable advertising. Management justified this decision, saying “In the second half of 2008 while we continued our brand building campaign on national cable TV we began to see a slowdown in incremental traffic so to help form our 2009 plan we tested both pricing and product news on TV in two markets in Q4. Based on this test and the overall results of our advertising in the second half of 2008 we concluded that in this current economic environment it would be more prudent to capitalize on the awareness gains and focus our marketing dollars on more targeted traffic driving and retention initiatives in 2009.” Although I am not sure whether the company’s advertising was ever yielding the necessary returns, I am encouraged to see that the company was evaluating the effectiveness of its marketing spend and decided to lessen its investment at this time. Going forward, the company is going to allocate more of its marketing dollars to its national online advertising and loyalty initiatives.

Regarding share repurchases, RRGB still has a $50 million authorization in place and said that it may make opportunistic purchases of common stock in FY09. The company does not, however, plan to increase its debt to execute these share repurchases. Instead, management stated that it expects to use its free cash flow to pay down outstanding debt during the year.

RRGB, like its competitors, will continue to face margin pressure in 2009 as it expects both same-store sales and traffic to remain negative. Due to the uncertainty around sales, the company decided not to provide either FY09 sales or earnings guidance. That being said, in this environment, it is encouraging to see companies that are working to manage the things they can control and RRGB seems to finally be heading in the right direction on that front.