J. Alexander's Mispriced Spin-Off Exacerbated By Understated Guidance

J. Alexander's: Mispriced Spin-Off Exacerbated By Understated Guidance|Must Read Oct. 22, 2015 11:58 AM ET5 comments

by: Lester Goh

Summary• Shares of J. Alexander's were a victim of intense selling pressure, likely as a

result of non-fundamental reasons. Naturally, it is my view that the said pressure was unwarranted.

• Due to its small size, investors that were long Fidelity National were likely primarily looking for exposure to the parent's insurance operations, and less so its restaurant holdings.

• As a result, the spin-off created a company that was likely a stub position for most investors, prompting market participants to sell off shares. Moreover, analyst coverage is limited.

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• J. Alexander's is experiencing strong business momentum. Additionally, management's FY15 guidance appears to be very modest, likely due to incentives for conservatism. Essentially, management is underselling the business.

• Even if we take management's forward estimates at face value, shares of J. Alexander's are trading far too cheaply relative to close comp Kona Grill. 100%+ potential upside.

ThesisIt is my view that shares of J. Alexander's (NYSE:JAX) are severely mispriced. I submit that the compelling elements of JAX are as follows:

• On an absolute basis, JAX trades at an inexpensive ~6x 2015 EBITDA - a multiple generally assigned to companies in severe distress or experiencing a cyclical peak to fundamentals. As we will see, JAX is anything but the above. Relatively, at just 0.7x sales, the firm trades at a huge discount to close comp Kona Grill (NASDAQ:KONA), despite stronger business momentum and similar EBITDA margin profiles.

• In my opinion, shares are compelling because of the unorthodox manner in which they came onto the market - JAX is a spin-off from FNFV Group (itself a spin-off from Fidelity National Financial). Spin-offs are usually not highly promoted by investment banks to their clients, unlike IPOs. They tend to be small in size relative to the parent company and thus a less reliable source of investment banking fees.

• It is important to note that my thesis is not predicated on business improvement (though said improvement would certainly contribute to the closing of the price/value gap), but on the market recognizing JAX as a player within the upscale dining industry.

• Finally, management's 2015 guidance appears to be understated by a decent margin - likely due to incentives for conservatism - making it highly likely for the firm to exceed guidance.



Due to its large discount relative to the peer KONA, shares of JAX should offer a significant margin of safety. Based on current fundamentals, I contend that JAX should trade at $20/sh (or ~100% upside) from current levels, if it manages to adopt a peer multiple. Given its positive business momentum, conservative capitalization, as well as an impressive track record of same-store sales growth, such a scenario seems highly likely.Reasons for the opportunityAs with every potential investment, it is crucial for one to evaluate the source of the mispricing. By knowing what the market is missing, opportunities for outsized returns can be realized. In the case of JAX, it is my view that shares are cheap because the firm is experiencing the usual mechanics associated with spin-offs.JAX was formerly owned by Fidelity National. Fidelity National is primarily a title insurer, but it has significant holdings in restaurants such as ABRH (owner-operator of O'Charley's, 99 Restaurants, Max & Erma's, etc). Additionally, it also has equity investments in Ceridian and Digital Insurance. By now it should be crystal clear that Fidelity National has a complex corporate structure. Thankfully, dissecting said structure is not required for the purpose at hand, which is evaluating JAX as a potential long. That being said, by simply conducting some surface-level analysis on Fidelity National, we can discover compelling reasons why JAX is severely mispriced.Fidelity National had $8b in revenues in 2014 - $1.4b from its restaurant group and the remainder stemmed from its insurance operations. Without a doubt, any market participant looking to go long Fidelity National was primarily looking to obtain exposure in the insurance space, not the restaurant space. After all, that operation contributed $6.6b in revenues for 2014. Given that JAX generates roughly $200m in annual revenues, we can reasonably assert that the average Fidelity National investor is not looking to invest in Fidelity stock for the purpose of obtaining an exposure in JAX - the upscale diner is simply too small relative to Fidelity. On a revenue basis, JAX was a mere 2.5% of Fidelity. Its irrelevance is further pronounced if one turns his attention to net profit (JAX had ~$9m in net profit compared to Fidelity's $583m in 2014 - JAX was ~1.5% of Fidelity on this basis).



Next, JAX was likely a stub position for many Fidelity investors. Per its filings, each holder of Fidelity shares would receive 0.17229 shares of JAX for every one share of Fidelity (or 1 JAX share for every ~5.8 shares of Fidelity). Due to its small size relative to the original investment, stub positions tend to be sold off without any fundamental consideration of value. Additionally, considering its $150m market cap, JAX was likely a prime candidate for institutional selling as well. Notably, Fidelity National is 75%+ owned by institutionals, per Nasdaq data.Finally, JAX barely receives analyst coverage. The diner is covered by just two analysts from boutique firms (KeyBanc and Stephens), whereas Fidelity National is covered by eleven analysts (including bulge-brackets such as Goldman and Barclays). This should not be surprising given that analysts usually cover companies in hope of building relationships with management and ultimately receive investment banking mandates which carry juicy fees. JAX's small size simply makes it economically unviable for larger research teams (Goldman, Morgan Stanley, Citi, CSFB, etc) to cover the name (at least for now).While it is impossible to pinpoint exactly which one (it was likely a combination of the three) of the aforementioned factors contributed to the intense selling pressure experienced by JAX's shares post-spin (-24% at its low), one can safely assert that the reasons for selling were likely to be non-fundamental in nature. Although shares have recovered slightly (now just down 11%), they still trade at a substantial discount to key comp KONA, presenting a potential long opportunity.In a nutshell, shares are cheap due to non-fundamental reasons, thanks to the unorthodox way JAX came to the market.Company DescriptionJAX is a rather simple business to understand. It owns and operates 3 complementary upscale dining restaurant concepts: J. Alexander's, Redlands Grills, and Stoney River Steakhouse and Grill. The firm has 41 locations in 14 states - 19 J. Alexander's, 12 Redlands Grill, and 10 Stoney River outlets. Average checks range between $30-$45 (growing recently, overall average check likely to be in the mid-$30s) between the three concepts.



The company places huge emphasis on quality and the dining experience in an attempt to retain customers. While no retention numbers are given, a consistently increasing average check coupled with resilient SSS growth indicates that customer retention might be on the high side - certainly a positive.Further information can be found on the company's September 2015 investor presentation.Great restaurants in prime locationsAs with every restaurant company, location makes a huge difference between success and failure (one can argue that it heavily tips the probability of success, provided that the location is accompanied with decent food/customer service).In this respect, JAX appears to have restaurants in prime locations. AUVs of its J. Alexander's stores are comparable to that of industry leader Del Frisco's Grill concept (JAX has 2014 AUV of $5.6m, while Del Frisco's Grill has an AUV of $5.7m for the same period - slide 8 of Del Frisco's investor presentation. Notably, Del Frisco's classifies its Grill concept as having outlets in "urban and affluent suburban locations").If one considers the fact that Del Frisco's Grill have average checks of $51, whereas J. Alexander's have average checks of $30, I think I can assert that the strength of JAX's restaurants is undeniable. In essence, despite a significantly lower average checks, J. Alexander's commands comparable AUVs relative to the industry leader. The situation remains similar (JAX is superior, albeit to a lesser degree), if we compare JAX's Stoney River concept with Del Frisco's Sullivan's (Stoney River $3.4m AUV at $45 average check vs Sullivan's $4.3m AUV at $62 average check - moreover, Sullivan's locations average 7k-11k sqft vs Stoney River's 6.4k-8k sqft).Strong business momentum likely to continueA quick glance through the company's investor presentation reveals that the business is experiencing strong momentum. Execution has been exceptional, evident by the fact that the firm has been posting 22 quarters of same-store sales growth, as seen below.



Source: J. Alexander's September 2015 Investor PresentationUnit-volume growth has trended similarly, indicating that management has had little difficulty in driving overall growth, per the slide shown below.



Source: J. Alexander's September 2015 Investor PresentationClearly, momentum is on their side. The question is whether this momentum is sustainable. Considering that the continued growth in unit volumes, as well as the long history of same-store sales increases, were primarily due to growth in average check - average check at J. Alexander's was $30.68 for 1H 2015 (+4.1% Y/Y growth), whereas the figure was $45.38 (+2.3% Y/Y) for Stoney River over the same period - JAX's momentum appears sustainable.



While beef prices (which represent 30%+ of JAX's F&B costs) have increased mid-to-high single-digits over the prior year, the trend appears to be stabilizing and hence margin pressure stemming from increasing commodity prices seems unlikely for the time being. Management has further indicated that in the event of substantial price increases, they would look into entering into fixed-price contracts for their supplies.2015 guidance seems very conservative, likely due to incentives; 2016 seems set for a strong compOne interesting point to note is that management's 2015 guidance seems to be on the conservative side, as detailed below:

• Management forecasts 3.5%-4.5% SSS growth, while its MRQ achieved a 5%-6% increase. Looking back ~10 quarters, SSS growth averaged 5% - 6%. Revenue guidance implies ~7% growth, whereas 2014 and 2013 experienced ~7% and ~19% growth respectively. Note that 10 stores (the company currently has a total of 41 outlets) were opened in 2013; assuming a 2-3 years ramp, 2015/16 revenue growth should accelerate substantially - possibly into the low double-digits. The firm's own unit economics model seems to imply a 3-year ramp (slide 21 of its investor presentation cites average unit volumes for year 3).

• Forward estimates imply ~11% Adj. EBITDA margins whereas 1H 2014/15 margins were 12%+. Given continued average check/SSS growth and contribution from the ramp-up of stores opened in 2013, 2015 margins should be expanding substantially (the fact that 2014 incremental Adj. EBITDA margins were ~33% certainly supports this assertion).

• Guidance pegs 2015 net income within the range of $5.5m - $6.5m (slide 33 of presentation) which appears considerably understated, considering that 2014 net income was $8.5m and 1H 2015 net income clocked in at $5.5m (pg 90 of 10-12b, ex 99.1). Given that 1H 2015 numbers have essentially met guidance for 2015, I am hard-pressed to figure out how full-year figures would not be far greater than management's estimates. Restaurant operating expenses have remained stable at ~85% of sales. Transaction and integration costs are probably unlikely to be incurred going forward, now that the spin-off transaction has already been completed. Although G&A rose, it was a slight increase due to



non-cash compensation expense associated with a profits interest plan implemented this January, increased incentive accruals, salaries, payroll processing fees, employee relocation, and many other factors (public company expenses, etc). The whole list of factors is laid out in the 10-12b (specifically, pg 93). However, these increases do not seem to be a trend - employee relocation is certainly one-off, increases in rental will be more than offset by higher sales, etc. Increased expenses may also arise from the consulting agreement JAX has with Black Knight Advisory Services - a 7-year term, 3% of Adj. EBITDA are paid as fees, or ~$780k per mid-point of 2015 Adj. EBITDA guidance. Finally, JAX paid off a $20m note in 2Q 2015 (in May, to be specific); the note accrued interest at 12.5% or $2.5m, and is now barely levered. In short, it appears supremely unlikely that management would not blow past current 2015 guidance.

As it turns out, management has significant incentives to be conservative in its projections. Per its filings, the board approved an equity incentive plan which provides for the granting of RSUs, stock options, and other stock-related awards. These grants are based on the market price of JAX's shares at the date of the grant. In a bid to ensure consistent compensation, boards tend to award more RSUs/other stock-based compensation as shares trade lower, and vice versa.Considering that compensation has yet to be issued under the above plan, it is not a stretch to contend that management likely wants shares to remain depressed for the time being. With some spin-offs, officers of the firm usually elect to retain ownership of the parent company instead of the SpinCo. Hence, the fact that equity incentives are awarded in JAX-related securities strikes me as a bullish signal.While conservative guidance might be a sign that management is indicating market weakness, I do not think that such a scenario is highly likely for a couple of reasons.As a result of the nature of its business (upscale dining within the $25-$50 average check range), management likely does not have visibility beyond a few weeks. Most customers tend to book a week or two in advance - JAX is not a revered luxury restaurant like Claridge's (one of Gordon Ramsay's many restaurant holdings) and thus I am doubtful that customers would book months in advance (which would theoretically result in higher revenue visibility) due to low availability. The point I am trying to get at is that it seems implausible that management would be able to



discern short-term trends before the fact and thus incorporate the trend into their guidance numbers. Essentially, management's knowledge of customer trends is likely to be derived mainly (and less from forward-looking data) from historical data (which shows no indication of market weakness; average check, weekly sales, volumes are all increasing).It is difficult to tell whether understating guidance is JAX's preferred modus operandi as the firm was originally owned by Fidelity National. Being a small part of the parent, Fidelity National has never provided guidance to that level of granularity (they do not detail guidance individually for each of their holdings). In spite of this, it is still possible to deduce that management guidance is understated (management offers a few hints here and there).JAX has indicated that they plan to open 4-5 restaurants annually. On its own, this statement tells us very little. However, if one places it in context, it reveals a lot. JAX has operated for 20+ years and currently has 41 stores. A back-of-the-envelope calculation indicates that management opens an average of 2 stores per year, which is not aggressive by any measure. This careful and steady pace of expansion suggests that management will only embark on new store openings when they are very confident that it would result in profitable growth. As a result, management's acceleration (4-5 annually vs. an average of 2) of new store openings tells us everything we need to know about how executives view long-term trends and is indicative that current guidance is highly conservative. Moreover, as the company recently came on the market, management likely wants to set a positive tone with shareholders, further increasing the likelihood that they have high confidence that their growth initiatives will be very successful.In short, while it is probable that management's modest guidance is indicative of weakening trends in the market, due to limited revenue visibility, it is highly unlikely. Although one cannot definitively confirm that management has a history of understating guidance (as JAX is a relatively "new" company due to it being a spin-off from a larger firm), as a result of incentives, it seems very likely that current guidance is understated. Perhaps the best (albeit subtle) indication of this is the company's stated growth plans, which far exceeds the pace of historical expansion on average.

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Furthermore, JAX seems to be a prime position for a strong comp looking out into 2016. This assertion is not based on a drastic acceleration in operations leading to strong year-over-year comparisons. Instead, my view is based on the fact that problems experienced in 2015 as well as several one-off charges are unlikely to be experienced in 2016.During 1Q 2015, JAX lost 32 days of revenue due to severe winter conditions, which the company classified as atypical. While winter comes every year, it seems unlikely that the season would be as severe as what the company saw in 2015. In addition, one location was closed for 35 days while 1Q 2015 as it was undergoing a major remodel. Further, transaction and integration expenses, which amounted to ~$2m in 1H 2015, are unlikely to recur. Finally, the company is no longer burdened by the $20m note it paid off in 2Q 2015. As a result, 2016 seems set to comp extremely favorably.Relative valuation and catalystsIn my view, KONA is a close comp of JAX due to their striking similarities - both sport a similar margin profile (18% store-level EBITDA margins on an LTM/2014 basis, per slide 19 of the presentation), JAX has a slightly higher average check compared to KONA (JAX's 2014 average check is probably mid-$30s overall; the presentation details average check for J. Alexander's and Stoney River. KONA's 2014 average check was $25), similar 2014 same-store sales growth at ~4%, similar debt profile (both are barely levered), and they have a similar number of locations (40+ for J. Alexander's vs. 30+ for KONA). As an aside, although other upscale diners such as Yard House have an average check that is closer to that of JAX, they are not publicly-traded, making it impossible for one to compare their valuations.While JAX certainly sports better financial metrics compared to KONA (specifically in terms of average check, number of locations, and the fact that JAX is much more profitable), to be conservative, I do not assume that JAX can trade at a premium relative to KONA. As of the time of writing, KONA trades at ~1.58x 2014 sales while JAX trades at ~0.76x 2014 sales. If JAX trades at a multiple in-line with KONA, shares would see ~100% upside. The reader should note that the multiple differential is similarly pronounced if we use 2015 numbers. Additionally, as detailed in prior sections, 2015 numbers are likely to be understated.



Although I would certainly prefer to compare the two based on P/E instead of a multiple of sales, the P/E comparison would lead to ludicrous results as KONA is barely profitable (it made ~700k in net profit in 2014 or 200+ P/E). Hence, a multiple of sales comparison appears to be far more realistic here.As for catalysts, I believe that JAX has several on the horizon:

1. The company is currently covered by 2 analysts, who initiated coverage earlier this month. KONA is covered by 6 analysts while the industry leader, Del Frisco, is covered by 8 research teams (3 bulge-brackets). Hence, it seems plausible that there is a decent chance for increased research coverage, which would certainly catalyze shares higher. JAX would likely be touted as a growth story due to its stated expansion plans.

2. As detailed in a prior section, management guidance appears to be highly conservative. As a result, JAX should comfortably beat 2015 estimates, which should increase confidence in its future. Alternatively, management might revise guidance - once the board has granted them RSUs/other stock-based compensation at currently-depressed market prices - to much higher (and realistic) numbers.

3. Due to the fact that JAX is barely levered (~0.3x net debt to LTM Adj. EBITDA), there is potential for the company to raise a significant amount via bank debt/bond offerings at very low interest rates in order to drastically increase the pace of expansion. Considering that JAX currently has only 41 locations in 14 states, the potential for growth remains through new store openings remains immense. If JAX manages to raise capital via a bond offering (an equity offering does not make sense due to JAX's currently-depressed share price) through a bulge-bracket firm, research coverage should follow from said bulge-bracket.

4. While the company has an investor presentation uploaded on its website, it seems that management has not yet marketed the company (firms tend to issue press releases when they are embarking on roadshows/participating in conferences - JAX has no press release highlighting such events). Presumably, this is due to management being focused in transitioning the company/ensuring that the spin-off transaction goes off without a hitch. In any case, it seems reasonable to expect that management would participate



in roadshows/investor conferences within the coming months, which would not only increase the probability of research coverage, but also spread news of the company's strong business momentum and growth trajectory.

Risks and conclusionAs for risks, JAX is an upscale diner thus is levered to the expansion/contraction of the general economy. Partial mitigant: management has a combined 186 years of experience spread across 9 officers (an average of ~20 years per officer). Middle management is comprised of 41 general managers (presumably one per location) with average tenures of ~10 years at J. Alexander's/Redlands Grill, and ~6 years at Stoney River (it is a relatively new concept). The fact that management (whether executive or middle management) has been at the company for a long time suggests that they are very experienced with running a restaurant operation. A cursory look at costs in prior periods also indicates that the team is very disciplined in terms of controlling expenses, which would be a huge positive in times of economic contraction.Additionally, management has laid out its expansion plans, which may or may not work out. Partial mitigant: management has decades of experience (per above), and the fact that the firm has seen 22 consecutive quarters of same-store sales growth indicate that JAX's upscale dining concepts are a huge success.In sum, it is my view that JAX is cheap due to the non-traditional way shares came to market, leading to the firm operating very much under the radar. If JAX was marketed as an IPO, shares would probably trade at much higher levels. The company's strong business momentum is likely to continue. Finally, management 2015 guidance seems extremely modest, likely due to incentives for conservatism. Catalysts that will drive shares higher include: increased research coverage, a revision of guidance to higher levels, as well as the potential for the firm to raise further capital to accelerate its growth initiatives. If shares of JAX manage to trade in-line with KONA, they would see 100%+ upside from current levels.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.



I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: The author's reports contain factual statements and opinions. The author derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. The author's reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. The author accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. The author advises readers to conduct their own due diligence before investing in any companies covered by him. The author does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.



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J. Alexander's Mispriced Spin-Off Exacerbated By Understated Guidance