The Hedgeye Macro Team gave us the honor of penning this morning’s Early Look. We decided to write on our most recent best idea, short Del Frisco’s Restaurant Group (DFRG), in a note we believe is appropriately titled “A Castle-in-the-Air.”
EARLY LOOK: A Castle-in-the-Air
“Dreams of castles in the air, of getting rich quick, do play a role – at times a dominant one – in determining actual stock prices.”
-Burton G. Malkiel
For the past several days, I’ve been reading a gem of a book recommended by my colleague, Howard Penney. Malkiel’s “A Random Walk Down Wall Street” is a timeless, thought provoking piece that most curious investors would enjoy reading poolside on a beautiful summer day. I certainly did. After all, restaurant research isn’t limited to cheeseburgers and fries. In fact, a large part of our job pertains to understanding both human and market psychology. The castle-in-the-air theory, which concentrates on the psychic values of investors, serves as a constant reminder of this fact.
For those unfamiliar with its origin, the castle-in-the-air theory was popularized by John Maynard Keynes in 1936. While we tend to disagree with Keynes’ and his disciples on a number of economic issues, the notion that stocks trade off of mass psychology is widely appealing. Accordingly, some investors attempt to front run this onslaught of groupthink, not by identifying mispriced stocks, but rather by identifying stocks that are likely to become Wall Street’s next darling. All told, this can be a profitable strategy – until it’s not.
Back to the Global Macro Grind...
We believe we’ve identified one of Wall Street’s current darlings and recently added it to the Hedgeye Best Ideas list as a short. Del Frisco’s Restaurant Group (DFRG) owns and operates three distinctly different high-end steak chains. After coming public in July 2012, the stock has gained over 114%; quite impressive, by any measure. More importantly, however, we believe cheerleading analysts and the subsequent madness of the crowd have propelled the stock during this time. Is it reasonable to call a company whose adjusted EPS declined 7% in 2013 one of the greatest growth stories in the restaurant industry? We think not.
As Malkiel goes on to say:
“Beware of very high multiple stocks in which future growth is already discounted, if growth doesn’t materialize, losses are doubly heavy – both the earnings and the multiples drop.”
The truth is, the company currently screens as one of the most expensive stocks on both a Price-to-Sales and EV-to-EBITDA basis in the casual dining industry. While we’re not insinuating DFRG is the beneficiary of a “get-rich quick speculative binge,” we are confident the stock is severely dislocated from its intrinsic value.
Part of the hype has been driven by the company’s positioning within the restaurant industry. Del Frisco’s caters to the high-end consumer; a cohort that the stock market would suggest is doing quite well. While this may be true, we believe the high-end consumer has been slowing on the margin as inflation in the things that matter (food, energy, rent, etc.) continues to accelerate. Contrary to popular belief, high-end consumers can feel the pinch too and two-year trends at the company’s hallmark concept, Del Frisco’s Double Eagle Steakhouse, would suggest the same.
Admittedly, the Double Eagle Steakhouse, though slowing, is a healthy concept. But it’s only 25% of the overall portfolio. The other 75% consists of a fundamentally broken concept (Sullivan’s) and an unproven growth concept (Grille). Naturally, the Street is discounting an immediate turnaround at Sullivan’s and a flawless rollout of the Grille, neither of which we see materializing. In fact, we continue to expect restaurant level and operating margin deterioration throughout 2014. This has less to do with all-time high beef prices (32.8% of Del Frisco’s 2013 cost of sales) and the recent wave of minimum wage increases (25% of Del Frisco’s restaurants have exposure), than it does with the fact that the company is systematically growing at lower margins and, consequently, returns.
More broadly, there are a number of red flags that the Street is unwilling to acknowledge right now including decelerating same-store sales and traffic trends, declining margins, declining returns, increasing cost pressures, expensive operating leases, peak valuation, positive sentiment and high expectations. We simply refuse to give the company credit for what it has not proven and while we can’t hit on all the minutiae of our thesis in this note, we do have a 67-page slide deck that does precisely that (email for more info). In short, our sum-of-the-parts analysis suggests significant downside.
You can delay gravity, but you can’t deny it. Needless to say, we don’t expect this particular castle-in-the-air to stay there much longer.