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Subject:  C'mon baby lite my fire--Ignite! Date:  2/24/2013  10:16 PM
Author:  LeKitKat Number:  13787 of 19776

Ignite Restaurant Group is a recent IPO listing in May 2012. The business has two separate concepts: Joe’s Crab Shack and Brick House Tavern + Tap. Joe’s is the biggest part of IRG’s business with 129 restaurants and Brick House has 15 restaurants. Both of them are casual dining.

IRG hit a high of just over $19 shortly following the IPO. By mid-July it dropped to $13 on accounting irregularities in the SEC filings that had to be restated. Most of the trouble was with lease accounting and lease recognition expense. IRG leases 100% of its properties and the restatement was significant but non-cash in nature. Lease expense is recognized on a straight line basis and that must include CPI adjustments and economic penalties from cancelable options that the company failed to include. The market seldom takes kindly to restatements and Ignite has yet to recover to its post-IPO highs. The restatements coupled with disappointing third quarter results took IRG to its short history’s low under $12 in October and November. It recovered briefly only to be hit again after the early February announcement they would acquire Romano’s Macaroni Grill that did not seem to set well with investors.

Joe's Crab Shack

Joe's has a narrowly defined new restaurant development strategy that targets specific locations with high population density and a love for seafood in close proximity to regional and national tourist attractions. Since Joe's middle name is crab and the business centers around seafood offerings, this makes sense. Twenty-one of the twenty five top performing Joe's generated average unit volumes (AUV) of $4.7 million in 2011 well in excess of AUVs across the chain of $2.97 million.

Brick House Tavern+Tap

IRG plans to expand Brick House targeting the top 50 designated market areas (DMA) nation-wide. There are now 16 locations. They initially opened a limited number of Brick House restaurants across a broad range of geographies with the intent of creating some brand recognition prior to continued build out. With the acquisition of Mac Grill, some of the prerequisite DMAs have been acquired and can be used to move Brick House in to failing Mac concepts.

Restaurant economics

The average investment, including build-out costs and pre-opening costs, for Joe’s was $3.3 million and for Brick House was $2.8 million. The new prototypes Joe’s have AUVs of $4.9 million and Brick House does $2.9 million. Conversions require less capital and management estimates conversions of Mac Grills will cost around $500,000. New-builds going forward should be less costly and IRG is looking at decreases to $3.1 million for Joe and $2.6 million for Brick House. The Mac Grill units average cost at the $55 million acquisition price works out to $2.96 million per unit. If the Mac Grill restaurants are in great DMAs under favorable leasing, the real estate aspect of the deal by itself looks reasonably good. The cost to convert will not necessarily be cheaper than a new build, but the location may be worth the premium. It’s unlikely that they will convert all the Mac Grills to Joe’s and Brick House and future success depends on rehabilitation of a portion of the Mac brand itself.

The Big Mac Deal

Ignite will acquire Romano’s Macaroni Grill for $55 million in an all-cash deal and the deal will be complete in the back half of 2013. This brand operates in the polished casual segment and is same niche that Joe’s Crab Shack and Brick House Tavern + Tap pulls consumers from.

Mac Grill for the real estate alone looks cheap-ish. The deal brings 186 RMG restaurants for $55 million working out to $2.96 million per unit. That does not include franchises. By management’s account, most of the MRG restaurants are in good quality designated market areas with favorable long-term leases and the boxes' interiors are in good shape. Considering it takes several million dollars to build and open a polished casual restaurant, the real estate makes some sense. The Brinker team of years past was careful to pick quality locations and negotiate favorable leases that Ignite feels could not be replicated today. The locations are at the signalized corners or power centers with draws like a movie theater behind it and all the retail support. Around 84% of the Mac portfolio is in the top 50 DMAs in the country.

What is less likely to make investors and management happy is the inevitable negative impact the overshadowing presence of the struggling Mac Grill units will have on margins, growth in average weekly sales and average unit volumes. Ignite predicts the acquisition will be dilutive in 2013. The hard-won improvements at Joe's and Brick will lose ground as Mac Grill’s results are consolidated.

Mac Grill is a damaged concept and will require a massive turnaround effort in the crowded Italian casual dining space dominated by Carraba’s, Maggiano’s and Olive Garden. Competition cannot be easily dismissed and Mac Grill will have to fight for a place at the table. The Mac Grill average unit volume has been declining from $3.4 million 6 years ago to $2.1 million in 2012. The concept has fallen out of favor and relies heavily on discounting to bring customers in. Restaurant operating margins* are lower than IRG’s with almost 70% of the units at margins below 15% and 32% of these are less than 10%. IRG’s restaurant operating margins are 20%. While this offers opportunity for improvement on the Mac Grill concept, it’s going to reverse improved numbers on the Joe’s/Brick profit and loss for a few quarters.

*Restaurant operating margins does not include interest, marketing and depreciation.

With Mac Grill restaurant operating margins below 15% for a majority of units, it is unlikely there is much profit on the bottom line. By this metric, Joe’s/Brick may not have made a great investment. Mac Grill does have positive cash flow at all but 7 units at the time of the merger.

Ignite sees the acquisition offering the same potential as the turnaround at Joe’s and will follow the same strategy making changes in the menu, marketing, service and real estate.

The Joe’s story in numbers

The following table for Joe’s shows the slow improvement in growth over four years. Note the most recent year is on the right side of the table for annual numbers and left for quarterly.

Annual Growth and Margins

Growth

2008 2009 2010 2011
=============================================
Revenue 0.0% 12.6% 14.1% 15.3%
Gross#1 -2.5% 13.1% 13.5% 12.2%
Gross #2 1.6% 15.9% 14.7% 11.2%
Operating -61.7% 404.3% 26.2% 20.3%
Net -19.7% 407.4% 20.0% -5.0%
==============================================
AWS 2.3% 13.3% 5.9% 9.3%
AUV 2.6% 10.4% 8.1% 5.7%
Comps 1.9% 9.5% 4.9% 6.9%

Gross#1 includes consumables
Gross#2 is both consumables and labor
AWS is average weekly sales
AUV is average unit volume

Operating and net margins have improved over 5 years annually even with no improvement in gross margins. The company has not been able to improve costs of consumables and labor. The values are in line with other chains. Where they have shone is through better management of operating costs including low occupancy costs. This trend is better appreciated in the first 9 months of 2012.

Margins

2007 2008 2009 2010 2011
=====================================================
Gross#1 72.3% 70.5% 70.8% 70.4% 68.5%
Gross #2 40.4% 41.0% 42.2% 42.5% 40.9%
Operating 2.4% 0.9% 4.2% 4.6% 4.8%
Net -1.5% -1.2% 3.2% 3.4% 2.8%
=====================================================
Occupancy/revenue 5.5% 7.9% 8.2% 7.8% 7.5%


Revenue growth is not as impressive as the favorites in the sector including Chipotle, Panera and Buffalo Wild Wings that can manage 20% growth or better. All three have consistently higher same store sales than Ignite. Ignite’s net and operating margins are lower than Chipotle and Panera but compare favorably to BWLD. Gross margins are competitive and occupancy costs are very much in line. Operating margins were low and trailed some of the better chains by nearly 50%. The last three quarters have seen much-improved margins and it’s this improvement that is at risk with the consolidation of Mac Grill. By the numbers, it does look like management is good at turnarounds, but Mac Grill may be more difficult than Joe’s was. The polished casual Italian space is crowded and Mac Grill customers have grown accustomed to discounts and may not take kindly to a full-priced menu. The average check at Mac Grill is $18 compared to $24 at Joe’s.

Quarterly margins

09/2012 06/2012 03/2012
========================================
Gross#1 68.7% 69.0% 68.2%
Gross#2 42.9% 42.3% 41.1%
Operating 9.8% 7.9% 5.2%
Net 6.9% 4.6% 2.4%

While margins were improving in the last nine months, same store sales slowed to 0.4% and traffic dropped into negative territory of (1.5%) for Q3 2012. The 0.4% increase in comps was made possible by a 1.9% in prices -- average Joe’s check was $24 compared to $23 in Q3 2011. There are rumblings across the restaurant industry that polished casual is suffering from consumers with less money to spend looking to trade down to value menus. Pizza and beer casual chain BJ’s Restaurants’ fourth quarter was disappointing with flat EPS, 3% positive same store sales, continuing high percentage occupancy costs (21% of revenue), and lower net margins. Of more concern were BJ’s comments that comps for the first seven weeks of 2013 were (0.5%) and trends were softening as consumers pull back on spending. For Joe’s, the BJ’s comments have a canary in a coal mine flavor since they occupy the same polished casual space and have similar average check amounts. If Ignite was still mainly Joe’s Crab Shack and a tiny amount of Brick House, this trending down would be less concerning and more easily weathered, but taking on the turnaround at Mac Grill at this particular time presents a bigger problem.

Quarterly growth

09/2012 06/2012 03/2012
=======================================
Revenue 14.0% 16.2% 18.3%
Gross#1 15.0% 16.2% 17.7%
Gross#2 14.8% 18.2% 19.9%
Operating 17.9% 42.0% 28.5%
Net 8.4% 27.9% 114.7%
=======================================
Stores 7.4% 7.5% 7.0%
AWS 7.1% 7.6% 10.5%
AUV 0.4% 3.5% 6.1%
Comp 0.4% 3.0% 5.3%
=======================================
Joe's avg check $23.94 $23.69 $23.79

Average weekly sales (AWS) continue to increase but at a slower pace as comps decline. Same store sales at Ignite were decelerating with negative traffic numbers in Q3 and by inference Mac Grill is not doing much better. Average unit volume (AUV) was flat and while some of the new Joe’s prototypes were doing better than average AUVs the older units are probably falling off as traffic declines. The turnaround from 2007 is convincing, but Ignite appears to be pausing at least in Q3-Q4 2012 and guidance for Q1 2013 is not much better.

Preliminary fourth quarter results

Total revenues were $112.5 million, an increase of approximately 11% compared to revenues of $101.4 million in Q4 2011. Revenues were negatively impacted by approximately $1.0 million (0.9%), due to lost operating days during Hurricane Sandy. Comps increased 0.8% excluding a 0.1% impact from Sandy. Increased media spend and the launch of a new winter menu helped push sales.

For the full year 2012, total revenues increased approximately 15% to $465.0 million compared to $405.2 million in 2011 and comps increased 2.2%. The restaurants that I consider the Big Three – Chipotle, Panera and Buffalo Wild Wings—all had better numbers and comps through 2012 than IRG with higher revenue growth. Ignite’s net margins compare favorably to Panera and are better than BWLD. Nobody beats Chipotle.

The future and guidance

Over the long-term, management may be able to repeat their success with Joe’s, but the timing of the acquisition of a damaged polished casual is not optimal. Not only will Ignite be attempting to refurbish the Mac image; they will be doing it in a macro-environment unfavorable to restaurants in this price niche between premium and value.

Ignite does have the latitude to move between brands and put Joe’s or Brick into underperforming Mac Grills, taking advantage of the real estate they acquired by converting a Macaroni Grill to Joe’s or Brick House and save roughly $500,000 in build-out costs. They have already converted a Macaroni Grill into a Joe’s Crab Shack prior to the deal and know it can be economically feasible.

The plans to reinvigorate the brand are ambitious and there will be an overhaul of the menu and the service. They will also attempt to spend marketing dollars more effectively across cable and concentrate less on local markets. Part of their challenge will be weaning customers off coupons and make the menu, the ambience and the amenities enticing enough to convince consumers to pay full price.

In Q1 2013, Joe’s and Brick House same store sales will be around 1%. They are comping against a strong 15.2% compounded two-year average same store sales increase in Q1 2013 making it difficult to post impressive numbers. The best growth stories seem to be able to defy the numbers. Chipotle had a string of double-digit comps extending for six quarters that just ended in June 2012.

Mac Grill will become part of the financial statements in the late to mid-second quarter with projected revenues at $180 to $190 million including $1.4 million in franchise fees. That is a 0.7% increase in comps. The good news is comps will not be negative, but less than 1% is anemic.

For the existing Ignite business, 2013 cost of sales is projected in the 31.1% to 31.3% range, labor at 27.3% to 27.5% and gross margins could decline slightly from Q3 2012 down to 41.2%.

Restaurant-level profit comes in at the 16.4% to 16.8% range and is a decrease from Q3 2012 (last reported result available) of 19.7%. Restaurant level margins for the Mac Grill based off their prior-year run rates are estimated at 6%. Ignite has a lot of work to do.

What this comes down to is a disappointing 2013 if guidance is accurate. The Ignite legacy restaurants appear to be stalling and even giving back some of the margin gains established in 2012. Mac Grill operates at a level far below Ignite and is going to be a huge project to take on with the current trend of slowing sales in the casual concept sector. They believe 2014 will be the turning point for the consolidation. There is an opportunity to wait for the back half results that would let the investor form some picture of just what Mac Grill’s financials look like. The price of the stock is unlikely to run away before then.

Relative valuations to the best in the business and BJ’s

IRG

Trailing P/E 23.81
Forward P/E 20.69
Price/Sales 0.76
Price/Book 3.02
Enterprise Value/Revenue 0.82
Enterprise Value/EBITDA 7.78

CMG

Trailing P/E 36.06
Forward P/E 25.63
Price/Sales 3.50
Price/Book 7.69
Enterprise Value/Revenue 3.41
Enterprise Value/EBITDA 17.10

BWLD

Trailing P/E 24.82
Forward P/E 17.71
Price/Sales 1.36
Price/Book 3.70
Enterprise Value/Revenue 1.38
Enterprise Value/EBITDA 9.35

PNRA

Trailing P/E 26.68
Forward P/E 19.40
Price/Sales 2.13
Price/Book 5.51
Enterprise Value/Revenue 2.02
Enterprise Value/EBITDA 11.47

BJRI

Trailing P/E 28.54
Forward P/E 20.60
Price/Sales 1.21
Price/Book 2.36
Enterprise Value/Revenue 1.2
Enterprise Value/EBITDA 8.1

By these relative valuations Ignite is a better value than the premium names in the restaurant universe. Chipotle sells at the highest premium and its long history of superlative performance supports the price. Investors may need to look at the consolidated Ignite Mac before deciding whether it’s a bargain.
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