Ark Restaurants: Lots Of Hidden Value + Low Liquidity + No Near-Term Catalyst = Excellent Opportunity For Patient Investors

Quick Overview

Ark Restaurants is a unique public restaurant company. It operates large, unique restaurants (typically 200-1000 seats, Olive Gardens are about 250 seats) that are in landmark locations, such as Bryant Park in NYC and the Sequoia in Washington D.C. ARKR also manages restaurants in casinos in Vegas, Atlantic City, Florida and Connecticut. The company’s current restaurant acquisition strategy (four owner/operated restaurants for $31M over the last five years) avoids bidding competition by acquiring, for cash, restaurants and the land underneath from owners/operators looking to retire. They utilize their management expertise to improve operations, resulting in acquisition multiples of 2-4X cash flow. The ownership of the land provides long-term control of the location and option to monetize it in the future. The company pays approximately 50% of free cash flow as a dividend (5% yield). Insiders control 41% of the company’s stock and three institutions control another 20% making the stock highly illiquid, which we view as a positive. The company owns 9% of the Meadowlands racetrack in New Jersey, providing a free option on the eventual approval of a casino at the location.

Reasons for Change in Business Model

Over the last 4-5 years, the company has lost over $6M in EBITDA due to lease expirations that were either not renewed or were too cost-prohibitive to renew. The company has been replacing this lost cash flow by acquiring properties where they also own the buildings and the land (or have a 20+ year lease), eliminating this risk. Changes to minimum wage laws, especially in New York, have pressured payroll expenses and reduced the opportunities to grow in New York City. Payroll expenses as a percentage of revenue have increased from 31.9% in 2014 to 34.9% in 2019. We encourage investors to read the company’s conference calls and shareholder letters. CEO Michael Weinstein goes into great detail on how the lack of tip credits and other factors have harmed the company’s operations. The new acquisition strategy has helped the company reduce its exposure to Las Vegas and New York City from 66% in 2010 to 58% in 2019. Revenue from Alabama and Florida now make up almost 30% of revenue. in 2013,100% of the company’s seating capacity was subject to a lease. At the end of 2019, 25% of the seating capacity was in owned restaurants. We view this as a very positive change.

Company Generates Relatively Consistent Free Cash Flow Which Supports the Dividend and Provides Flexibility to Execute the New Strategy

Outside of the $11M renovation at the Sequoia in 2017 to get a lease renewal, capital expenditures have generally ranged between $3M-$4M a year or 25%-50% of cash from operations. Current dividends of $3.5M account for almost 50% of free cash flow. In 2020, we expect cash flow from the recent JB’s acquisition to add about $1.5M to cash from operations (the company acquired the restaurant outside of peak season). Therefore, while the company is carrying more debt than historically (and generally more than management would like), the company’s liquidity is more than adequate to continue to support the dividend.

Sales By Region
$ Millions	2012	2015	2019	2012	2015	2019
Las Vegas	$57.00	$44.60	$48.80	41.0%	32.1%	32.1%
New York	$39.00	$39.00	$39.30	28.1%	28.1%	25.8%
Washington DC	$16.50	$13.30	$13.00	11.9%	9.6%	8.5%
Atlantic City	$3.40	$6.60	$7.00	2.4%	4.8%	4.6%
Boston	$3.70	$3.90	$0.00	2.7%	2.8%	0.0%
Connecticut	$3.80	$3.60	$2.00	2.7%	2.6%	1.3%
Alabama	$0.00	$0.00	$14.00	0.0%	0.0%	9.2%
Florida	$15.50	$27.80	$28.00	11.20%	20.0%	18.4%
Total	$138.90	$138.80	$152.10	100.0%	100.0%	100.0%

Source: SEC Filings

Historically the company has avoided debt, but the Sequoia renovations and recent restaurant acquisitions have increased net debt from $1M in 2016 to $19.5M at the end of the fiscal year 2019. We are not concerned with this increased leverage for a couple of reasons:

• The incremental cash flow from JB’s the company will have ample free cash flow to meet the debt amortization schedule ($3M a year).
• The acquisitions are creating value that can be realized to reduce debt.

We will cover this later in our analysis.

Cash Flow Analysis
$ Millions	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019
Revenue	$114	$136	$137	$129	$138	$145	$148	$151	$160	$162
Cash from Operations	$6	$9	$13	$13	$12	$11	$8	$10	$9	$11
CFO % of Revenue	4.8%	6.3%	9.5%	10.1%	8.7%	7.6%	5.1%	6.9%	5.8%	6.5%
CapEx	$3.0	$3.0	$8.0	$3.0	$4.0	$3.0	$2.0	$14.0	$5.0	$3.0
CapEx % CFO	54.5%	35.3%	61.5%	23.1%	33.3%	27.3%	26.3%	134.6%	53.5%	28.3%
FCF	$2.5	$5.5	$5.0	$10.0	$8.0	$8.0	$5.6	-$3.6	$4.3	$7.6
Dividend	$7.0	$3.5	$3.2	$2.4	$3.3	$4.2	$3.4	$2.6	$3.4	$3.5
Dividend % FCF	280%	63.6%	64.0%	24.0%	41.3%	52.5%	60.7%	-72.2%	78.3%	46.1%
Cash	$9.0	$11.0	$9.0	$9.0	$9.0	$10.0	$7.0	$1.0	$5.0	$7.0
Total Debt	$0.0	$0.0	$2.1	$3.7	$7.3	$5.5	$8.0	$18.0	$21.0	$26.5
Net Debt	-$9.0	-$11.0	-$6.9	-$5.3	-$1.7	-$4.5	$1.0	$17.0	$16.0	$19.5

Source: SEC Filings

Even with no improvement in cash flow, the company should return to a net cash positive position by 2023. Management has traditionally avoided using leverage and we believe that debt pay down is a priority. As we will show later in this report, we believe management has the ability to monetize some of its land holdings to pay for any new restaurant acquisitions.

Acquisition Strategy Achieves Several Objectives that are Positive for Shareholders, yet not Reflected in the Current Valuation of the Company

The three biggest factors that have impacted ARKR’s ability to grow cash flow have been:

• The loss of leases on profitable restaurants.
• The change in circumstances at existing restaurants beyond the company’s control (Faneuil and Thunder Grill)
• The increase in labor costs in NYC. According to management, the loss of profitable restaurants due to lost leases has cost the company over $6M in cash flow in the last 5 years.

The decline and subsequent closure of the restaurant in Boston (Faneuil Hall Marketplace) generated nearly $4M in revenue at its peak and the closure of Union Station in Washington D.C. due to the relocation of the Amtrak corporate office have also negatively impacted profitability. The company has been able to replace this lost revenue and cash flow with its acquisitions and improvements at the other restaurants. The company wants to be able to control its own destiny, so we expect more acquisitions that include the buildings and land in the future. The company’s most recent acquisition of JB’s on the Beach did not include the land and buildings but came with a 24-year lease and the right of first refusal on the property.

Cash Flow Easily Supports Debt Amortization
$ Millions	2020E	2021E	2022E	2023E
CFO	$12.00	$12.00	$12.00	$12.00
Cap-Ex	$3.00	$3.00	$3.00	$3.00
FCF	$9.00	$9.00	$9.00	$9.00
Dividend	$3.50	$3.50	$3.50	$3.50
Debt Amortization	$3.00	$3.00	$3.00	$3.00
Increase in cash	$2.50	$2.50	$2.50	$2.50
Net Debt	$14.00	$8.50	$3.00	-$2.50

Source: SEC Filings and Author Calculations

Since 2014, ARKR has spent approximately $31M to acquire four restaurants and the underlying land in Florida and Alabama. According to management, the average acquisition cost has been around 5.5X cash flow. The company has been able to utilize its management expertise to boost cash flow and lower the acquisition multiple. Management’s expertise in lease negotiation occasionally provides for opportunities to add value as well. In 2017, the company expanded its Rustic Inn concept to Jupiter, Florida. The company had a right of first refusal on the property and was able to flip the property for a $3M profit when the right was triggered. We believe that this type of opportunity is one reason why ARKR negotiated the right of first refusal on the recent JB’s acquisition.

General criteria for restaurant acquisition

Acquire one-off non-branded restaurants to reduce bidding competition from large branded competitors. Acquire restaurant, buildings, and land for 5-6X cash flow. Look for motivated sellers (owner/operator 70-90 years old looking to cash out). Cash purchase (owners want their money now because of their age) to reduce competition from local leveraged buyers. Substantial seating (200-1000 seats) and retention of long-tenured managers where possible. Opportunity to increase sales and profitability through professional management (i.e. raise menu prices, lower food, and operating costs).

We believe the best way to illustrate the accretive nature of this strategy can be illustrated by ARK’s acquisition of the Rustic Inn in 2014.

Example: Rustic Inn Dania Beach, FL

ARKR acquired the Rustic Inn in Dania Beach, Florida in 2014. The company paid $7.5M to acquire the restaurant and the land. Because the company was offering an all-cash deal, the seller, over 90 years old, was willing to take less than the original offer price. The cash flow was $1.5M at acquisition. Through operational improvements, the restaurant is now cash flowing $3.5M. On several conference calls, management has provided examples of how the company could monetize the land through a sell/leaseback transaction. The table below summarizes the basic strategy.

Rustic Inn Analysis
	$ Millions
Acquisition Price	$7.50
2019 Cash Flow	$3.50
Lease Cost	$1.00
Net Cash Flow	$2.50
5X Cash Flow	$12.50
Cap Rate	7%	8%	10%
Value	$14.29	$12.50	$10.00
Total Value	$26.79	$25.00	$22.50

Assumptions:

The restaurant is currently generating $3.5M in cash flow. Commit $1M in cash flow to support a sell/leaseback.

• Still leaves 2.5X coverage. Triple Net Lease REITs are doing restaurant deals in the 6-6.5% cap rate range. Using cap rates of 7-10% produces $10-$15M in proceeds to ARKR. Using 5X on the remaining cash flow produces $12.5M in value. This would be $22-$27M in total value achieved on a $7.5M initial investment.

Investors should keep in mind that the company owns the buildings and land under Shuckers and the Original Oyster House properties, which could benefit from a similar type of transaction. Management has stated publicly that the value of the land under all its owned properties could be as high as $20M.

Theoretical Takeout Valuation Based on Scenario Presented on Q4 2018 Conference Call

CEO Michael Weinstein is 75 years old – similar in age to the owners of the restaurants ARKR has been acquiring. We believe at some point in the near future, 3-5 years, it is possible that Mr. Weinstein could look to sell the company as the other restaurant owners have done. With insiders owning 42% of the stock and institutions owning another 20%, reaching a majority vote for a sale is certainly possible. On the Q4 2018 conference call, CEO Weinstein walked through a theoretical transaction with a company like Delaware North, a global food service and hospitality company. Delaware North also operates gaming devices at racetracks, which means they could also have an interest in ARKR’s 9% ownership in the Meadowlands. We think it is likely that Landry’s would return as a bidder if the company was put up for sale.

We want to be clear that we do not believe any transaction is imminent. We do not believe Mr. Weinstein was suggesting that they were pursuing such a transaction and we believe that clarification of the status of a casino at the Meadowlands may be required before the company could be sold.

While an investor is getting paid about 4.5% to wait for this theoretical transaction to occur, there are several other factors for investors to consider when looking at this implied takeout price.

Positives:

• The 9% investment in the Meadowlands is valued at ZERO.
• The below-market lease of Clyde’s is valued at ZERO.
• The $1.5M potential incremental cash flow from owning JB’s for a whole year is NOT INCLUDED.
• The net pay down of debt of $3M per year is NOT INCLUDED.
• Assumes no extra value for fact JB’s is grandfathered in and no beachside restaurants can be built in the area.
• Assumes no optionality on ARKR ability to eventually acquire and sell the condos on Jensen Beach property. We believe a 5X multiple is conservative.

Negatives:

• Insiders must agree to a sale and have turned down one offer already.
• Operating margins could deteriorate further due to higher labor and rent costs.
• There is an opportunity cost (albeit is somewhat mitigated by 4.5% dividend). The timeframe for a transaction is completely unknown making IRR calculations impossible.
• Clarity on Meadowlands casino is probably necessary.

Theoretical Valuation Using Q4 2018 Conference Call Scenario
	Millions
Revenue	$162.00
F&B Costs	$43.40
Payroll	$56.70
Occupancy	$17.40
Other Operating	$20.30
Total	$137.80
Restaurant Cash Flow	$24.20
G&A	$12.00
Sustaining G&A	$2.00
Adj. Restaurant Cash Flow	$22.20
6X Adj. Restaurant Cash Flow	$133.20
Net Debt	$20.00
Equity Value	$113.20
S/O Millions	3.5
Implied Stock Price Per Share	$32.34

Return on Investment in the Meadowlands Could be Substantial but is Still Years Away

Beginning in 2013, ARKR has invested a total of $5.1M in the Meadowlands Racetrack LLC (“NMR”), which has resulted in a 7.4% diluted share in the LLC. In addition, the company loaned Meadowlands Newmark, LLC (an existing member of NMR) $1.7M which is due in January 2024. ARKR has also secured the exclusive right to operate the food and beverage concessions (excluding a new Hard Rock Restaurant that could be built on-site) at the new raceway grandstand and casino. ARKR is entitled to receive 5% of the net profits of the F&B operations. The Hard Rock is the majority owner and ARKR already has a relationship with them as the operator of food courts for them at two casinos in Florida.

The Meadowlands has been the primary beneficiary from the approval of sports betting in the state. The racetrack typically has between 40-50% market share and in November took in $14.8M (up 111% YOY) out of the $32.9M in bets made. The Meadowlands partners are FanDuel and Pointsbet. Other advantages of the Meadowlands include the fact that it is only six miles away from New York City and is one of only two active sports books in the country within walking distance of an NFL stadium. The racetrack is also benefiting from the lack of mobile wagering in New York and no sports betting in casinos near NYC.

There is no guarantee that a casino will ever be built at the Meadowlands (2016 referendum was defeated nearly 4-1) and the eventual approval of mobile wagering and sports betting in NYC would negatively impact revenue at the racetrack. However, many view those things as a catalyst for motivating the New Jersey legislature and voters to move forward on the approval of casinos in the northern part of the state.

Potential value-creating scenarios upon approval of casino at Meadowlands

Capital call.

• If the company wants to maintain its approximate 9% ownership in the venture, the company will have to contribute its pro-rata amount. This could be in the tens of millions of dollars and significantly increase the leverage of the company. We think this is the least likely scenario. Sale of ownership to Hard Rock and/or other partners in the LLC.
  • We think this is the most likely outcome of any approval of a casino at the Meadowlands Racetrack.
  • We think Hard Rock would like to simplify the ownership structure of the venture.
  • Without knowing the scope of the casino or estimated profitability it is difficult to estimate what ARKR could receive for both its ownership interest and the exclusive right to operate restaurants on the property. Jeff Gural, who is the managing partner of the Meadowlands track has estimated a Meadowlands casino could generate $800M-$900M in revenue. For reference, in 2016, the Borgata in Atlantic City had revenue of $812M and EBITDA of $212M. MGM sold the Borgata to MGM Growth Properties for $1.175B in consideration.
  • Management has indicated a willingness to distribute cash windfalls to shareholders. Issuance of a contingent value right (“CVR”).
  • The approval process for a casino at the Meadowlands site would be complicated and drawn out and this may be an option for shareholders to realize value before any transaction actually occurs.
  • Management has indicated in the past that they have considered this option, but valuation is extremely difficult and there may be other complications, such as tax treatment.

Risks/Premortum

One glance at a long-term stock chart and the fact that the company missed 2018 EBITDA guidance of $14M by about $4M will give some investors pause as to the merits of the investment analysis above. Fair enough. There are several real risks to the company. We list what we believe are the most important ones to consider:

Continued wage pressures and national minimum wage without tip credit relief

• While this risk is not unique to ARKR, it would still have a negative impact on labor costs.
• Payroll expenses as a percentage of revenue have increased from 31.9% in 2014 to 34.9% in 2019.

Leases of the restaurants operated at New York-New York casino in Las Vegas expire in 2023

• 32% of revenue is generated by these restaurants.

Bryant Park lease expires in 2025

• This restaurant has 13% of the total seating at the company provides substantial cash flow.
• The company has lost profitable leases in the past that have reduced operating income.
• The rent could be increased substantially, reducing the profitability of the restaurant.

Continued underperformance of the Sequoia Restaurant

• In 2017, the company invested $11M to renovate and re-image the restaurant.
• In the 2018 letter to shareholders, Michael Weinstein indicated that based on their new acquisition criteria, they should have invested $6-$7M to justify retaining (or increasing) the $1.5M in cash flow the restaurant generated in 2016.
• Results to date have not justified the incremental $4-$5M investment.

Continued underperformance of Clyde’s in NYC

• Company recently took a $2.8M write-down on this property.
• Company owns below-market lease which could be valued at $2-$4M if subleased, but there is no indication the company is willing to move on from this restaurant.

In 2013, ARKR received an unsolicited $22 per share bid from Landry’s that was rejected out of hand

• The stock has substantially underperformed the markets since then. Insiders control 41% of the stock. While we believe Michael Weinstein has been a good fiduciary for shareholders, shareholders are also limited on effecting any change in management they feel will be beneficial to them in the long-term.
• Highlighting the difficulties in operating in the restaurant space, the company substantially missed guidance on EBITDA in spite of having confidence to finally issue guidance in the first place.

Conclusion

ARKR is the type of an investment that we are comfortable making, but it is not for everyone. The company is run by a well-respected CEO who has a significant ownership in the company. The company is valued at a 10%+ free cash flow yield and is returning a reasonable amount of that cash flow back to shareholders. The company is adding value that is not reflected in the financials, reducing competition from many types of investors. The stock is relatively illiquid and there is no clear catalyst to realize the value we believe is building at the company. We think that due to the age of the CEO, there is a reasonable chance that, in the next 3-5 years, the company will be sold or other liquidity events will occur to help monetize the value being created by the company.

We encourage investors to read the CEO letters in the annual reports. Mr. Weinstein expresses his thoughts on a variety of subjects relevant to the success or failure of the company. Please do your own analysis and risk assessment.