An Investment Opinion
The Rainforest That Couldn't Be Saved
Rainforest Cafe is the jungle-themed restaurant premise that grew from the humble origins of a single unit in 1994 to currently having 38 units open including 28 domestic locations and 10 international units. With promised growth ultimately leading to 100 domestic Rainforest units, and a similar number of international ones and earnings per share growth that was coming in at above 100% per year, shares peaked at a bit above $25 a share in late 1997. Ever since the company announced in early 1998 that it would be missing earnings estimates by a penny, the stock has been in a long decline. This afternoon, in response to last night's announcement, the stock had moved up $1/2 to a mere $4 7/8 per stub. Yikes.
Many questions should come up in relation to this, and the one that is probably most on the mind of investors is what the company is "really worth." After all, according to the last 10-Q, Rainforest Cafe still has total shareholders' equity of about $219 million, so why would the company agree to sell itself for substantially less than book value?
In a case where management admits that the value of the company is less than book value, management is acknowledging that it has really invested the money given to it by shareholders poorly. In this case, it is reasonably obvious that current management doesn't actually know how to allocate capital -- i.e., it doesn't know how to run its own business. In fact, this is a company that as recently as the end of the third quarter of 1996 had over $160 million in cash and cash equivalents lying around as the result of a number of secondary offerings. In the subsequent years, management managed to spend that money on a consistent business plan that it has been following right up to this moment, and it admits through the sale price that it has done far worse by investing that money than if it had never been given any of that money in the first place.
Management couldn't possibly have picked a worse strategy than pursuing growth in earnings per share, though that statement might seem counterintuitive to any who base any of their investment philosophy on things like a PEG ratio. Consider the following numbers for Rainforest Cafe:
1995 1996 1997 1998 1999
Sales (in millions) 13.5 48.0 108.1 211.7 256
EPS $0.10 $0.27 $0.46 $0.57 $0.53
Return on Equity 4.5% 2.9% 5.5% 6.9% 5.9%
Market Cap (in millions) 190.5 419.8 580.0 149.4 95.6
(All numbers courtesy of Multex.)
As we can see, throughout the time that Rainforest Cafe's management was growing sales explosively, well over 100% per year between 1995 and 1998, and growing earnings per share 470% over that time, it was rapidly destroying shareholder value. The market cap dwindled between 1995 and today despite the fact that during that time hundreds of millions of dollars were raised in follow on equity offerings.
Keeping in mind the return on equity figures from the above chart, look at this chart from "Valuation: Measuring and Managing the Value of Companies," by Tom Copeland, Tim Koller and Jack Murin:
Return on Invested Capital
8% 10% 15% 20%
5% 8.5x 10.0x 12x 12.9x
10% 5.7x 10.0x 15.8x 18.6x
15% 0.1x 10.0x 23.4x 29.9x
20% NM 10.0x 38.2x 52.2x
This chart reveals the P/E multiples for a range of earnings growth rates and returns on invested capital, assuming all equity financing, a weighted average cost of capital of 10% and a 20-year forecast horizon. As you can see, the lowest valuation comes from simultaneously pursuing rapid earnings growth while achieving return on invested capital substantially below the cost of capital. This is exactly what Rainforest Cafe's management insisted on pursuing.
Of course it didn't take Rainforest Cafe's management close to 20 years to reduce the value of the company to a P/E multiple in the mid-single digits as Rainforest Cafe was pursuing a strategy of earnings growth well in excess of 20% per year while actually seeing return on invested capital come in at far below 8%. Given enough time though, the pursuit of this strategy would have decreased the value of Rainforest Cafe to a P/E of zero within just a couple of years. In this respect, the fact that Landry's has moved in to save Rainforest Cafe from its current management -- even at a price that doesn't rise to book value -- should be a welcome turn of events to shareholders.
This chart, and the sorry history of Rainforest Cafe, demonstrates one of the fallacies of pursuing stocks mostly on the basis of the PEG. It is perfectly possible to have a stock that is dramatically overvalued at a PEG of 0.5 if the projected growth is being funded by new issuances of equity, and the return on that investment doesn't cover the cost of capital. For related analysis about factoring in the cost of growth even when applied to a well-run company, see Starbucks Brew Ha-Ha.
This explains a lot of how Rainforest Cafe's valuation got up as high into the stratosphere as it did back in 1996 and particularly in 1997. Investors (including this one) were buying a growth story when they should have been running away. Granted, part of the problem was that with a store base of only three and little operating history, it wasn't evident that same-store sales were going to crumble. However even back then the example of Planet Hollywood was available for those who were interested in listening to what it had to say about growth at the expense of sane allocation of capital.
Other companies that come to mind as ones that have pursued the rapid unit growth ostensibly to generate earnings per share growth at a time when it should have been obvious that the returns on capital weren't coming close to meeting the cost of capital would include Dave and Buster's (NYSE: DAB) and Restoration Hardware (Nasdaq: RSTO). Investors who are looking at Wall Street analyst earnings per share growth should always determine whether that growth is going to be funded through internally generated excess cash from operations (see this week's Home Depot Duel) or simply through a string of equity offerings. Avoid the latter.
A Look at Return on Invested Capital (ROIC)