Rising Star Buy: Red Robin Gourmet Burgers

This article is part of our Rising Star Portfolios Series.

A stock that's way down from its five-year high, a product that customers swear by, lots of hidden value, and activist hedge funds effecting improvements? That sounds like a recipe for gains. And that's what I think we have with the next purchase for my Special Situations portfolio: Red Robin Gourmet Burgers (Nasdaq: RRGB  ) .

The company, and why I'm buying
Red Robin serves hamburgers and fries that customers rave about, but for years the business was poorly managed, with executives pushing the company to expand unprofitably. Store count ballooned from 299 locations at the end of 2005 to 439 by the end of 2009, in the teeth of a massive economic slowdown. You can see the focus on expansion reflected in its operating margin, which has declined every year since 2004 and now sits at a svelte 1.7% for the trailing 12 months.

But that underperformance comes with opportunity, as activist hedge funds such as the Clinton Group stepped in to make changes late last year. These investors cleaned house, getting the board to appoint new directors who have restaurant industry experience. The CEO was dismissed, and a successor was installed. These hedge funds have an agreement not to pursue a hostile takeover until 2010 is over, but they have encouraged the company to seriously consider buyout offers.

It's rarely wise to bet on a takeout, but there's also opportunity for operations to improve and thus create value for today's buyers. A simple focus on maximizing free cash flow and deleveraging would add value, and the company has slowed store growth markedly in the past couple of years. Free cash flow is substantially larger than net income, with depreciation providing substantial operating cash flow.

But if operating income can simply be improved to 2008's levels -- not even the peak -- then the stock would now be trading at 4.7 times EV/EBITDA. That's a meaningful discount to peers such as Burger King, which was recently bought out at nine times. For context, top operators such as McDonald's (NYSE: MCD  ) and Chipotle (NYSE: CMG  ) trade at 10.5 times and 19.5 times, respectively.

Another huge source of hidden value is the company's restaurants. It owns approximately 70% of its locations and could unlock significant value by refranchising them, a process that McDonald's has used for a number of years to boost profit and return capital to shareholders. Of course, that would be easier if operations turned around. However, much of that hidden value would likely accrue to Red Robin's future owner, rather than to us common shareholders. That's part of the incentive to buy the company.

For these reasons, I'm allocating 5% of our total capital, or $850, to Red Robin. Although the stock is well off its five-year high and has treaded water for 18 months, there could still be some downside. If prices move materially lower, we could still pick up more, provided that the projected turnaround continues.

Risks
First, Red Robin may not find traction in its efforts to turn around. That's mitigated in the short term by the substantial free cash flow. But change must occur, and I'll be looking for meaningful improvement in store-level operations in the future.

Second, Red Robin has all its debt coming due in 2012. It will almost certainly need to refinance, and I'll be watching this to see what the company can negotiate.

Third, the company may start recklessly expanding again. Instead, it has a clear avenue to increase shareholder value by deleveraging and focusing on cost savings now, rather than increasing store count.

Summary
Red Robin offers us a couple different ways to win, and with its stock in a holding pattern in the past 18 months, it looks like the bad news has been priced in already. Buying a 5% stake now gets us in the game, and that solid free cash flow helps protect us in the short term.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios) here.

Jim Royal, Ph.D., does not own shares in any company mentioned here. Chipotle is a Motley Fool Rule Breakers recommendation. Chipotle is a Motley Fool Hidden Gems selection. The Fool owns shares of Chipotle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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