We are removing RRGB from the Hedgeye best ideas list as a short.
We remain cautious on the Casual Dining segment and feel RRGB is one of the weaker players in the space. Our short thesis was predicated on the company not delivering on improving traffic (which happened) but misjudged the potential for a significant increase in average check.
For the intermediate term, we no longer see Red Robin as one of the most attractive shorts in the space. Improving 2-year traffic trends make it difficult to remain short the stock. Given yesterday’s results we can no longer defend our bearish case.
Conclusion
The 2Q13 numbers support the notion that RRGB’s brand transformation and new menu initiatives have impacted traffic trends sooner than anticipated. We adopted a bearish stance on RRGB back in early June as we believed the stock had gotten ahead of the company’s fundamentals and future growth prospects.
The bear case was led by the three main deterrents to growth that we expected the company to face in FY13. The first was a decline in traffic. The current casual dining environment suggests a slowing sales and traffic environment, and we viewed a second quarter uptick in traffic for RRGB as unlikely. The second issue we had was with the near-term expectations of the brand transformation. While we agreed RRGB was desperately in need of a brand transformation, we believed this initiative would be a negative in the short-term. The last component of our bear case consisted of a dreadful outlook for 3Q13, a quarter which we have previously referred to as “RRGB’s Waterloo.”
Below we break down the three main tenets of our previous bear case and explain why we have backed away from our short thesis.
Traffic
While traffic did contract -0.7% in the quarter, the 2-year trend turned positive for the first time in six quarters as the company outperformed its casual dining peers by 240 bps. This suggests that RRGB was able to gain market share during the quarter – a feat that we viewed as unlikely. There’s no way to spin it. A positive 2-year average trend in traffic growth, particularly in a sluggish environment, is a bright spot for the company and portends the largest hole in our thesis.
Brand Transformation
The company’s brand transformation is still in its early stages and will take time to fully materialize. However, their efforts to-date have translated into a higher perceived value, allowing them to efficiently take +2.3% pricing in the quarter. This, combined with menu enhancements and a renewed focus on higher margin items – alcohol, appetizers, and dessert – led to a +5% increase in average guest check during the quarter. Whether or not this is sustainable is another question. Price is expected to roll off in 3Q and the lift seen from menu enhancements will be difficult to match moving forward.
Several initiatives proved beneficial to 2Q13 results, but it will take time before we can determine the true, long-term impact of the brand transformation. While early results have impressed, it is not a guaranteed success. Moving away from the core customer always carries risk and Bar Works remains a fairly large question mark.
RRGB’s Waterloo
We previously wrote that 3Q13 is RRGB’s Waterloo for the following reasons:
- Difficult SRS comparisons
- Lowest revenue quarter of the year as incremental expense continues to build
- Expenses in 2H13 likely to grow significantly thanks to new costs
Though we expect 3Q13 to be a difficult quarter for the casual dining industry in general, we now have no reason to believe it will be worse for RRGB than others.
The company has shown it can grow sales in a slowing environment and has managed expenses, in midst of a brand transformation, better than we had anticipated. We would heed caution, however, on a couple of counts. First, 2Q13 restaurant-level operating profit margins of 23.3% are unsustainable, particularly when you factor in the 3Q13 roll off in price. Second, brand transformation expenses are likely to pick up in 2H13, leading to more margin pressure than the first half of the year.
Overall, our thesis for 3Q13 has changed marginally. The one difference is that RRGB has responded to the current environment better than we anticipated. The street seems to have modest expectations for 3Q13, but we continue to believe the casual dining group is likely to see multiples revised lower in the current quarter.
Final Thoughts
At 8.6x EV/EBIDTA, RRGB is trading in-line with its Casual Dining peer group at 8.7x. And while valuation is at peak levels, it is not a catalyst – and never will be. Though we still have conviction in some of the core tenets of our short thesis, we have lost conviction in the others. Without these, we can no longer make a compelling bearish case.
Howard Penney
Managing Director
