DFRG: THOUGHTS INTO THE PRINT

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DFRG reports on Tuesday, July 22nd BMO.

Takeaway: DFRG remains on the Hedgeye Best Ideas list as a short.  We expect weak casual dining trends and cost of sales inflation (beef, shrimp, milk, cheese) to pressure margins in the Q.  While Del Frisco's may have pricing power at the Double Eagle concept, we doubt they have any at the other two concepts.  That said, same-store sales estimates at Grille (+2.9%) and Sullivan's (-0.1%) continue to look aggressive.

Investment Thesis

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.  We believe 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're confident the stock is dislocated from its intrinsic value as our sum-of-the-parts analysis suggests notable downside.  You can review our full thesis here.

Earnings Expectations

For 2Q14, the Street expects revenues of $69.10 million (+14% YoY), adjusted EPS of $21.00 (+4% YoY), and system-wide same-store sales of +2.3% (led by +3.6% growth at Del Frisco's Double Eagle).  We see downside to earnings driven by disappointing comps at Grille and Sullivan's as well as margin pressure due to significant food inflation.

Same-Store Sales Trends

Two-year same-store sales trends are plain ugly, but the Street is baking in a recovery in 2Q14.  We're slightly less optimistic.  Grille is still defining its target market and Sullivan's hasn't yet proven its capable of a turnaround.  We believe any potential upside will be driven by the Double Eagle concept, in which case management would need to be able to take ample pricing in the Q.  Certainly a risky proposition given the discounting trends we're seeing across the industry.

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Margins

The Street expects slight restaurant level and operating margin deterioration in the quarter, mostly due to food cost pressures.  The real disconnect, however, comes in back half of the year with the Street assuming restaurant level margin expansion in 3Q14 and operating margin expansion in 4Q14.  We continue to expect restaurant level and operating margin deleverage as Grille (lower margin concept) becomes a larger percentage of the portfolio.  Recall that DFRG plans to build 5 new Grille's this year and only 1 new Del Frisco's.

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Valuation

DFRG is currently trading at 24.96x P/E and 11.58x EV/EBITDA on a NTM basis.  This is well ahead of its casual dining peers which, on average, trade at 17.1x P/E and 9.4x EV/EBITDA on a NTM basis.

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Sentiment

77.8% of analysts rate DFRG a buy, 11.1% a hold and 11.1% a sell.  Furthermore, short interest comprises 6.59% of the float.

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Risks

Immediate-term risks to the bear case include strong same-store sales trends across the board and management's ability to take ample pricing to protect margins.  Longer-term risks to the bear case include continued strength in the high-end dining category, system-wide same-store sales acceleration, a quicker than expected turnaround at Sullivan's and Grille's ability to prove itself as a legitimate growth concept in 2014. 

Howard Penney

Managing Director

Fred Masotta

Analyst