Last week, an activist investor took a position in Del Frisco’s Restaurant Group and came out firing.
As my colleague Heather Lalley reported, Engaged Capital said that a sale of the company would be a less risky option for Del Frisco’s going forward, given “strategic missteps” and sales and traffic challenges at Del Frisco’s Double Eagle Steak House and Del Frisco’s Grille.
“Simply put, DFRG’s performance as a public company has been abysmal,” Glenn Welling, chief investment officer with Engaged, said in a letter to the board.
“The environment for M&A in the restaurant industry has rarely been more active than it is today,” Welling added.
He’s right. There are lots of buyers out there. As Engaged noted, Del Frisco’s has some strong assets, notably its flagship Double Eagle as well as its recently purchased growth chains Barcelona Wine Bar and Bartaco.
Hedgeye Risk Management analyst Howard Penney in particular believes the real value of Del Frisco’s is double its current stock price of just more than $7 a share.
But there are challenges in a sale process, and risks for investors who push for a sale.
The issue with Del Frisco’s highlights the odd world of public restaurant M&A. Anybody who sells a company or a house or something else typically waits until the value of that asset is highest before selling. Sales of chains such as Popeyes Louisiana Kitchen and Panera Bread show what happens when that works.
But pressure tends to increase on public companies to sell when their valuations hit low points. As a result, it’s common to see chains get sold when their values are low, only to see the private buyers reap the benefits.
Del Frisco’s stock was down nearly 60% going into trading on Thursday after the Engaged letter was first published.
The performance, especially considering that rivals such as Ruth’s Chris Steak House are up, probably made an activist inevitable, said Nick Mazing, director of research for the financial research firm Sentieo.
But that also means there are a lot of shareholders in the company who bought Del Frisco’s at $12, $13 or $14 per share and risk getting less than that in a sale.
“There might be shareholders who are not interested in a quick sale here as the company is trying to get its house in order,” Mazing said.
In addition, Del Frisco’s valuation is tricky.
As it is, its enterprise value is more than 14 times earnings before interest, taxes, depreciation and amortization. But much of that enterprise value is in the form of the company’s more than $300 million in debt.
A buyer could certainly step in and pay a higher multiple to get Del Frisco’s, but in general the higher into the teens a valuation gets, the more skittish buyers get. High-teens multiples are usually reserved for limited-service chains and especially those with relatively safe track records.
That makes it more likely that a strategic buyer would take on Del Frisco’s. Private-equity buyers typically hate to pay such high multiples because they’d want a quick exit. A strategic has no such qualms.
Still, the buyer would have to satisfy investors who’ve seen their valuations drop while paying a price they can stomach.
For the activist, however, Del Frisco’s is too much of a risk not to sell.
“DFRG’s high leverage, weak and inconsistent operational performance and value destruction under the current strategy demand quick and decisive action by the board,” Welling, of Engaged Capital, wrote. “It is unacceptable for the board to ask DFRG shareholders to bear the risk of additional declines in traffic and profitability at Double Eagle and the Grille while hoping that current management will successfully integrate and operate the Barteca concepts (defying a long history of doing otherwise) when we believe there is a far less risky option available: a sale of DFRG today.”
Del Frisco’s debt load and the performance of its onetime growth chain Del Frisco’s Grille are deep concerns. The company’s stock price over the past year makes it clear something needs to change. Maybe a sale is the only way to bring that about.
But by doing so, the buyer would get the benefit of turning those brands around. And remember: Del Frisco’s only bought Barteca earlier this year and hasn’t yet fully integrated the brands. In addition, the environment remains remarkably friendly for steak chains, which could fuel the Double Eagle’s turnaround.
That could be a tough choice for investors.