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Key Takeaway

4Q sales and earnings fell well short of estimates, but the stock has been resilient as the street has found solace in a solid guide.  This, however, doesn’t mean the guidance was right – in our view, 2015 and 2016 estimates remain far too aggressive.  We’d short DFRG on this pop and continue to see downside to the $10-14 range.


DFRG: THESIS CONFIRMED, DESPITE THE POP - 1

EPS down $0.12 since 2012.   Is management’s growth strategy working?  You know where we stand on this, but let’s take a step back for a second and recognize the divergent trajectory between unit growth and earnings growth over the past two years.  DFRG’s earnings per share have decreased 15% from $0.94 in 2012 to $0.82 in 2014, while units have increased 35% from 34 in 2012 to 46 in 2014.  We understand the costs associated with aggressive unit expansion, the time it takes to reach normalization, etc., but to show such a significant level of earnings deterioration over this time on the back of 30% sales growth must tell you something’s wrong – DFRG doesn’t have a legitimate growth algorithm.  For a company that touts itself as a “one of the growth leaders in [the] industry,” this is a serious issue.

DFRG: THESIS CONFIRMED, DESPITE THE POP - 222

Management commentary proved the Grille is not ready to grow.  With restaurant level margins at the Grille down 200 bps y/y, management is scrambling to right the ship.  In other words, they should be taking their foot off the proverbial growth pedal, but they’re not.  Instead, in conjunction with this growth comes an effort to improve its training program, recipes, cooking methods, kitchen prep times and technology (speed up service, reduce labor costs).  While this can be viewed as a positive, on the margin, it’s important to understand why management is in this predicament in the first place.  What’s more bothersome than this, however, is that they have not identified the concept’s optimal target market and, as a result, are currently conducting market research to do so.  This is the same issue that is plaguing the underperforming NDLS.  You shouldn’t be growing an asset base by 38% if you don’t even know its target market.  It’s inevitable that a certain percentage of their new units will be underperformers and, ultimately, need to be relocated or closed.  Management better hope they’ve found all the answers in a short period of time – if not, they could be looking at another year of negative earnings growth.

2015 is set up to be another disappointing year.  Guidance was solid, and perhaps that’s why the stock has held up, but that doesn’t mean it’s right.  Considering the lower full-year EPS base of $0.82, management’s 2015 guidance of 15-18% EPS growth implies a range of $0.94-0.97 – a far cry from the $1.02 the street expected heading into the print.  And, at this point, $1.26 in EPS in 2016 is completely out of the question.  We have no doubt comp and cost of sales guidance is on the money, because the revenue growth is there and they have the benefit, or as they call it “natural hedge,” of the Grille working in their favor on the food cost line.  Our concern lies within the operating, marketing/advertising, and G&A which we believe will call for incremental investment over the course of the year.  The street expects other restaurant expenses to delever ~59 bps y/y to 47.31% of sales.  Given the current initiatives going on around the labor line, we have a hard time getting there.  We’re looking for closer to 5-10% EPS growth this year, but it could be much worse than that. 

DFRG: THESIS CONFIRMED, DESPITE THE POP - 3