Seeking Alpha • Sep 26
Carrols Restaurant Group: Valuation Starting To Improve
Summary
Carrols Restaurant Group is down 80% from its 2021 highs, with the recent leg down attributed to a sharp decline in profitability in Q2.
However, it's possible that Q2 marked the trough for margins if beef costs continue declining, and while traffic is down in the industry, quick-service names should benefit from trading down.
That said, at 12x EV/EBITDA and with TAST more than 15% above its next support level at $1.35, I still don't see an attractive reward/risk bet just yet.
Just over two months ago, I wrote on Carrols Restaurant Group (TAST), noting that the valuation didn't offer enough margin of safety. At the same time, Restaurant Brands International (QSR) was trading at its cheapest levels in years. It was the far more attractive way to get exposure to Burger King/Popeye's, given that it has a fully-franchised model and exposure to two other iconic brands (Firehouse Subs, Tim Hortons). Since then, TAST has declined by more than 22%, and QSR has outperformed by 3100 basis points. This can be attributed to Restaurant Brands International's [RBI] strong Q2 beat, with better than expected results at Tim Hortons.
Carrols Restaurant Group (Company Presentation)
Unfortunately, for Carrols, it was another tough quarter, with the company reporting an adjusted net loss driven by continued pressure from commodity/wage inflation. While RBI's system hasn't been immune from inflationary pressures, its fully-franchised model, which is more inflation-resistant, and aggressive buyback program have helped it to enjoy annual earnings per share growth. Although 2023 should be a better year for Carrols as it works hard on new initiatives and with beef costs potentially peaking, I still don't see enough margin of safety at current levels. Hence, I wouldn't be in any rush to buy the stock at $1.65.
Q2 Results
Carrols Restaurant Group ("Carrols") released its Q2 results last month, reporting quarterly revenue of $441.9 million, a 4% increase from the year-ago period. From a same-restaurant sales standpoint, Burger King reported 2.8% growth and continued to outperform the US system. In comparison, Popeye's reported 2.0% growth, outperforming the US system, but lapping very easy year-over-year comps. From a two-year stacked growth standpoint, same-restaurant sales for Burger King came in at an impressive 15.4% (Q2 2021: 12.6%), offset by Popeye's, which saw negative two-year same-restaurant sales despite taking price, with many brands struggling to hold the line on traffic.
Carrols - Quarterly Revenue (Company Filings, Author's Chart)
Overall, these were satisfactory sales results, especially considering the tough comparisons, with the industry lapping a tailwind from stimulus payments in Q1/Q2 2021 and having multiple major headwinds this year: soaring gas prices, higher mortgage costs, and rising grocery prices. Unfortunately, while sales were slightly better than expected, profitability continued to suffer, impacted by rising commodity costs and wage inflation. This was evidenced by Carrols' cost of goods sold jumping to 31.9% and labor costs increasing to 33.8%.
Given the higher costs, adjusted EBITDA and restaurant-level adjusted EBITDA declined to $15.1 million and $34.6 million, respectively. These were quite unfavorable relative to $29.3 million and $47.9 million in the year-ago period, with restaurant-level adjusted EBITDA margins dipping to 7.8% vs. 11.3%. This led to an adjusted net loss in the period of $8.9 million, down from quarterly net income of $16,000 in Q1 2021. To combat these inflationary pressures, the company plans another modest price increase in September, with menu pricing set to remain at high single-digit levels on a year-over-year basis.
So, what's the good news?
While the headline numbers weren't pretty, the company appears to continue to work on initiatives to turn its results around, which include the following:
raising the bar on operational excellence related to the guest experience
improving productivity/improving turnover by motivating team members
turning around the most challenged locations using best practices
The company appears to have made solid progress on the first initiative, with drive-thru wait times below 2020/2021 levels. Meanwhile, the company noted that it is seeing applicant flow improve, which could be related to the sharp increase in wages vs. pre-pandemic levels and the more challenging macro environment, which is pushing some back to work in the industry vs. staying home. Carrols noted that it expects to see some of the progress shine through in future results, even if it wasn't evident in the Q2 results, which didn't quite meet expectations, resulting in a sharp decline in the stock.
Industry-Wide Outlook & Headwinds
If we look at the industry, traffic declined sharply year-over-year this summer, with consumers getting hit from every angle, with soaring gas prices being the straw that broke the consumer's wallet. Fortunately, gas prices have fallen sharply from their highs above $5.00/gallon, and even if rising grocery prices, higher mortgage payments, and the reverse wealth effect are headwinds, I would expect these to be a larger issue for casual dining brands, and less so quick-service restaurants and pizza.
Burger King Menu Offerings (Company Website)
This is because quick service restaurants and pizza tend to benefit in recessionary environments, with most consumers unable to stop 'treating' themselves but instead settling for trade-down options. Meanwhile, quick-service and pizza are very high from a convenience standpoint without breaking the bank, which certainly benefits Carrols, with two quick-service brands: Popeye's and Burger King. Finally, while all restaurants are raising prices to combat wage/commodity inflation, quick-service brands might be able to get away with this easier, given that average checks are lower, making it less noticeable. Lastly, even in cases where average checks are similar, consumers save on tips at quick service.
To summarize, while the macro backdrop is difficult, I believe brands like Tim Hortons, McDonald's (MCD), Taco Bell (YUM), Domino's Pizza (PZZA), Burger King, Popeye's, Wingstop (WING), and several others should be able to weather the storm quite well, even if they index more towards less affluent consumers. Hence, if I wanted to be long the restaurant space, the safer area to go fishing is in these stocks vs. their casual dining peers, especially with valuations becoming more attractive for names like Domino's Pizza and Yum Brands.
Wholesale Food Prices (National Restaurant Association, BLS)
From a margin standpoint, one theme in Q2 was that applicant flow appears to be improving, which could help to pull down labor costs a little, given that there should be a reduction in overtime/bonus pay to properly staff restaurants. Meanwhile, from a commodity standpoint, costs remain high, but some brands appear confident that costs for some commodities have peaked. Carrols noted that labor and commodity costs appear to have stabilized at this higher level, while beef has begun declining: one of its highest input costs. Assuming this trend continues, beef costs should finish the year at $2.55/lb. to $2.60/lb., down from a peak of $2.90/lb., a major help from a profitability standpoint.
To summarize, while some of the negativity surrounding the restaurant space makes sense, especially for casual dining, which could be hurt by trading down or simply eating at home, it's possible Q2 marked near the worst for quick-service given the combination of peaking commodity costs and traffic headwinds from higher gas prices. Therefore, while Carrols' stock has been killed, down 80% from its 2021 highs, the optimism in the prepared remarks makes sense, though a return to the highs for gas prices would certainly derail this view. Let's take a look at the valuation:
