Description

Luby's is a liquidating restaurant operator with most of the value tied to the owned real estate (69 properties). And while it might seem to be the worst time to be selling-off restaurant assets, management has provided a liquidation value estimate of $3-$4/share (8%-44% upside to current prices). These figures are supposedly based on indications of interest already received from the potential buyers of Luby's assets (real estate + restaurant operating businesses). Various cross-checks also indicate that such liquidating distribution range is achievable and might even turn out to be conservative. 

Although management did not share further details on how they arrived at these liquidating distribution estimates, several points suggest a high margin of safety at current share price levels and provide confidence in shareholder-value-maximizing liquidation process and outcome:

• Appraised valuation of the owned restaurant real estate more than covers the current enterprise value ($191m of real estate vs $120m in EV). The proxy notes the involvement of 'two real estate appraisers' during the strategic review process. However, the $191m figures seem to be based on real estate appraisals from the last annual report (Aug'19 - $211m) less sale of several properties in the current fiscal year. Post-COVID the valuation of these assets is likely to be somewhat lower.
• The gross (undepreciated) book value of land and buildings on the balance sheet stood at $163m as of Jun'20 and represents the cost basis of these properties, most of which were acquired a while ago. Real Estate asset sales during FY2019 and Q1-Q3 FY 2020 (ending Jun'20) have been done at significant premiums (+150% to +400%) to the depreciated balance sheet book values, indicating that the appraisal of restaurant real estate (which also shows material premium to the balance sheet values) should be at least directionally correct. 
• Comparable for sale property listings on the market indicate that max 30% haircut might be applicable to the appraised property values (based on mid-June assessment, so the situation likely has improved since, see here).
• Disposal of real estate has already begun and the company generated $11m proceeds in June and then further $9m in August. In total $27m of real estate has been sold during fiscal 2020 so far.
• Management/board together with affiliates own 40% of LUB - thus incentives with shareholders should be well aligned here.
• Final/formal bids for the operating businesses were expected to be received by mid-August. And while the proxy statement does not elaborate on this further, the liquidation plan filed in mid-September refers to 'indications of interest provided by third parties for various assets of the company'.
• Negotiations with a specific party regarding the sale of Fuddruckers business and franchise operations have been ongoing since the end of 2019. As of May, this party ('Party A' in the proxy) was still interested in Fuddruckers, but likely at amended terms.
• Two ex-CEOs (one of them is still on the board) that were behind the wheel of the company since 2000 hold 33% of shares and have recently filed an agreement to access confidential information of the company to consider making a proposal for certain assets. While this smells of potential related-party transaction it clearly shows that Luby's assets are attractive in the post-COVID environment.
• Institutional investors with large stakes in LUB add confidence to the situation, albeit all of them likely sit on significant losses on their investments. (1) Bandera Partners - small hedge fund with a 9.3% stake in LUB (3-4% of the current portfolio). Bandera has been a shareholder since at least 2010 with a relatively similar position. At the end of 2018 Bandera launched and lost a proxy fight trying to replace 4 incumbent directors. (2) Hodges Capital Management - a large $1bn diversified investment manager with an 8% stake in LUB (a small part of the portfolio). (3) Dimensional Fund Advisors - heavyweight $600bn AUM asset manager with a 6% stake in LUB.

It's hard to judge how much hard indicative interest (i.e. actual proposals to acquire assets) management really has for the provided liquidation estimates. However, at the end of July'20, Duff & Phelps (the main advisor during the strategic review) noted the reference range for the distributions of $4.15-$5.62 per share ($127m - $172m). A month later Special Committee reduced this to $2.94-$3.75 per share ($90m-$115m, or 30% haircut on the low-end) providing the following explanation: "The Special Committee recommended an estimated aggregate dollar range that was lower than the reference range noted in the Duff & Phelps evalutation based on an updated real estate inventory list which showed fewer properties available for sale due to interim real estate sales (the proceeds of which were used in part to pay down debt), lower potentially realizable real estate values at the upper end of the range and the impact of the COVID-19 pandemic on the value of the Company’s real estate and operating businesses."

The first point (subsequent sale of some properties and debt repayment) is an obvious non-sense, as it should not have impacted the liquidation proceeds. As for the COVID impact - D&P valuation was kind of supposed to include this already so it is hard to see what could have changed in a month. My guess is that the adjustment was driven by the bids for Luby's assets received in August. These likely came in lower than Duff & Phelps expected in their projections. And while this is worrying, I take some comfort that the expected liquidation range provided by management already materially haircuts the figures derived by consultants.

Valuation Thoughts

Does the $3-$4/share liquidation range shared by management make sense? There are a number of moving parts and uncertainties here, particularly with the valuations of operating businesses (especially post-COVID) and cash burn till full liquidation. So it's a bit of guesswork. However, it seems that the risk of large/unexpected downward adjustments should be tolerable.

I split assets into real estate, franchised restaurant business, owned restaurant business, and Culinary Contract Services (CSS). They might get sold differently (e.g. all of Fuddrucker's owned and franchised business together with some real estate), but its easier to come up with some numbers this way.

Real Estate

In the proxy, management indicates real estate valuation at $191m, which likely based on the pre-COVID valuation appraisal provided the fiscal 2019 annual report (ended Aug'19). Another reference point is the cost basis for the land and buildings - in the Q2'20 report, it stands at $163m. Given most of these assets have been acquired a while ago, it is hard to see how the current realizable market value could be significantly below the cost basis even after taking into account the COVID effect on restaurant property values.

Recent property sales also indicate that Luby's balance sheet significantly understates the true valuation of real estate - which is likely a mix of realizable value being above the cost basis as well as significant depreciation amounts recorded against the buildings (exact amounts unknown as PP&E depreciation is not itemized). All property sales from fiscal 2019 till fiscal Q3 2020 were carried out at a very substantial premium to BV (+150% to +400%) judging by gain-of-sale recorded for these transactions. Details on the latest property sales ($20m during fiscal Q4 2020) have not been reported yet.

I am pinning real estate sale proceeds at $163m

Culinary Contract Services

Given their clientele (hospitals, medical centers), CSS was the least impacted segment by the COVID outbreak. A further impact should be negligible as well, so, overall, I'm estimating CSS valuation at 10x TTM operating earnings. In Q4'19 CSS earned $1m and during 3 quarters of fiscal 2020, the operating income stood at $1.7m, resulting in a potential valuation of $27m.

Franchised Restaurant Business

The latest annual report (ending Aug'19) shows that with 102 franchised locations the business was generating $6.7m in royalty revenues and $5m in segment level profits (80% margin). I assume that some of the expenses are recorded at the corporate level and the 'true' margin of franchised business would be lower at around 50% if this business is taken as a separate entity or acquired by another franchise operator. Valuing these adjusted royalty stream profits at 10x and adjusting for the reduced franchised restaurant count to 85 as of the time of the proxy results in a $27m valuation.

Company-Owned Restaurant Business

As of 26th of August Luby's operated 82 company-owned restaurants under brands of Luby's Cafeteria (58) and Fuddruckers (24). Given that shortly after post-COVID reopening, with only 17 venues operating, this segment managed to reach store level profit indicates that there might be some value left in this business as well. Albeit this profitability level was before the rent expense, which needs to be taken into account if the operating business and real estate are valued separately. During fiscal 2019, company-owned restaurants generated $28m in segment level profits (10% decline in revenues and profitability vs FY18). However, it is not clear how much of the corporate overhead needs to be deducted to support these operations (despite the high profitability of individual segments overall Luby's reported -$21m and -$27m in operating losses for FY19 and FY18 respectively).

I think the easiest way to pin a potential value on these company-owned restaurants is by looking at the royalty stream these good generate if franchised. For this exercise, I am assuming revenues per store will stand at 2019 levels after the restaurant market fully recovers from COVID. FY19 revenues were $284m. Adjusting for the lower company-owned restaurant count (82 vs 124) and using 5% franchisee fees, could potentially result in a $9m royalty revenue stream. With a 50% profit margin and 10x multiple, I arrive at a potential $45m valuation. I would call it the best-case scenario. Another possibility is that most of these restaurants get closed, resulting in zero/negative liquidating value. That's the worst-case scenario. Taking the average of the two (call it $20m) should be good enough for my rough sum-of-the-parts.

Cash burn

This is the main head-scratcher so far, especially with the uncertain timing and effects of COVID. In 2019 LUB operations burned $13m, while the recent quarter (11th Mar to 3rd June) shows a negative operating cash flow of $14m. I have no clue neither how large the cash burn is going to be going forward neither how big will the other liquidation expenses be. So, just pinning this leakage at $50m, should be conservative enough.

Putting It All Together

Real Estate $163m

+ CSS $27m

+ Franchised Restaurants $27m

+ Owned Restaurants $20m

+ Total Assets = $237

- less Net Debt -$42m (as of June'20)

- less Negative WC -$27m (as of June'20)

- less Cash Burn and Liquidation Expenses -$50m

= Total Equity Distributions = $118m (or $3.85/share)

I am likely incorrect on a number (or all) items indicated above, however this shows that management's liquidation estimate of $3 - $4 /share is likely to be in the right direction.

Risks and Other Not So Positive Points

The strategic review (started in Sep'19) has included a full-sale of the company. However, no firm buyers neither for the full company nor for its assets have been found during the last year (except for the above mentioned August bids, which have not been publicly disclosed yet) and liquidation ended up to be the most valuable option. This raises some skepticism re total distribution size estimates - can the liquidation in the post-COVID world really be so lucrative if no-one has shown any real interest in buying the company pre-COVID.

The whole strategic review process seems to have been a mess and does not inspire much confidence in how management is handling the situation (potentially this was due to the on-set of COVID and larger problems at hand). Even-though a number of potential strategic options were set on the table initially, it seems that the only path really considered during 9 months of the review was the sale of Fuddruckers. And even that part of business attracted only a single interested party (this was still pre-COVID). Only after the strategic review concluded at the end of May (without any real outcomes/decisions) the Special Committee started exploring the potential sale of all assets or company in its entirety. At that point, it was decided not to adopt a plan of liquidation. Then 2 months later, at the end of July, all strategic options (including continuing with operations) were reconsidered again and the board finally decided that liquidation is the way to go.

Luby's continues to burn substantial amounts of operating cash flow (-$11m during H1'20 and -$14m during FY19). With no clear timeline till liquidation or asset sales, these expenses might end-up eating a substantial part of the liquidation proceeds. On a positive note, management noted that further operating expenses will be cut down substantially and that due to implemented cost savings the company was already operating above break-even at store level during May'20.

There might also be some tax leakage as real estate gets sold for materially higher than balance sheet values.

Also worth noting, that during Q2'19 LUB made $12.7m impairment to tangible assets for 35 of their locations, which seems quite strange, especially when in parallel management is also arguing for a relatively high real estate value estimations.

Finally, keep in mind that the same management has been destroying shareholder value for years, failed with the turnaround, and eventually decided to sell the real estate at the worst possible time for the restaurant business.

Catalyst

Asset sale announcements

Q3 earnings where some additional information and details on liquidation are likely to be provided.