Ruth’s Hospitality: Derisked Story, Steady Growth Potential (NASDAQ:RUTH)

Investment Conclusion

Ruth’s Hospitality Group (NASDAQ:RUTH) owns and operates Ruth’s Chris Steakhouse fine-dining restaurants, which primarily serve premium quality steak and wine dinners. Customer demand over the previous 12 months has been stronger than usual, which in part can be attributed to the post-pandemic pent-up appeal for experiential dining. That is not to say that the concept’s restaurants were struggling prior to the viral outbreak. They were generating reasonable growth in system sales and same-store sales with consistent margins.

With respect to future growth, with a current restaurant footprint of 151 stores, there appears sufficient white space for geographic diversification, particularly in foreign geographies. In addition, considering that sales associated with RUTH’s restaurants in major metropolitan areas, as well as those related to its catering and private dining businesses remain below pre-pandemic levels, a rebound in customer demand linked to the ventures represents a near-term revenue expansion opportunity. Further, given economic projections for deceleration in commodity prices over upcoming quarters, gross margins are likely to advance. Nevertheless, on a secular basis, we expect sales growth and margins to normalize around pre-COVID-19 levels, for the most part. Overall, RUTH is an established business with limited potential for major upside or downside shifts.

In our opinion, investment in the firm’s shares is appropriate for long-term investors seeking low volatility steady growth with dividend income and capital gains related to share repurchases. However, for rapid and substantial appreciation in stock price, we recommend that investors look elsewhere. We are initiating on RUTH with a Buy Rating, and a 1-year Price Target of $24/share, based on our 10-year Discounted Cash Flow model.

Investment Thesis

RUTH’s first restaurant was opened in New Orleans in Louisiana in 1965. Currently, the brand is comprised of 151 restaurants, of which 74 are run by the company, 74 are operated by franchisees, and three are under contractor control. In the U.S., RUTH has ~128 locations in ~120 cities and ~37 states. In addition, the brand has a significant international presence, with ~23 foreign restaurants, all owned and operated by franchisees.

In FY2021, RUTH generated: ~$402 million in sales, reflecting a growth rate of 54.2% compared to FY2020, ~$429 million in revenues, representing an advance of 54.5% on a year-over-year basis, customer-traffic growth of 40.2% over the prior year, ~$42.3 million in net income compared to negative ~$25.3 million during FY2020, $1.23 in earnings per share, relative to negative $.80 over the previous year, and ~$81.4 million in operating cash flows. At the end of June 2022, RUTH had a cash and cash equivalents balance of ~$44.9 million and long-term debt of ~$40 million on its balance sheet.

The predominant element which appears to be of interest to investors is whether rapid growth is an eventual possibility for RUTH? The secondary issue surrounding the story is related to the ultimate size of RUTH’s restaurant footprint, specifically how large a store base is optimal and possible?

Established Business With Limited Upside Or Downside Potential

We don’t expect significant expansion in growth rates associated with RUTH’s business over the long term. Our argument is propelled in part by our conviction that a large restaurant footprint is inappropriate for exclusive establishments such as those associated with RUTH. Considering that typically new unit development accounts for a larger fraction of a restaurant company’s growth over the long-term, and given that geographic diversification options appear limited for RUTH, same-store sales, which generally play a secondary role, are likely to assume the position of the brand’s key growth driver. Therefore, given that the scope of same-store sales growth is typically limited, we cannot envisage a scenario, where RUTH might experience more than moderate growth on a perpetual basis.

Our thesis is reflected in the company’s financial performance over the prior five years, during which growth associated with revenues and same-store sales have been moderate (although lumpy) and margins have been consistent. In that context, it is noteworthy that from FY2017 through FY2021, revenues expanded by 7.4%, 9.16%, 3.12%, negative 40.7%, and 54.3%. In contrast, margins have been largely consistent coming in at 7.27%, 9.21%, 9.02%, negative 9.11%, and 9.85%, over the same time horizon.

With respect to same-store sales, long-term growth will be fueled by RUTH’s objective of improving customer experience. Specifically, the firm plans to continue to deploy technology, including table management software to support employee efforts to improve customer service. In addition, each table at RUTH’s establishments is already equipped for ordering and making payments utilizing technology-enabled devices. Further, restaurant remodels, menu innovation, and the loyalty program are additional elements that are likely to further advance customer appeal for the concept. With respect to actual sales growth, there appear several short-term opportunities, in form of a resurgence in customer demand associated with the firm’s restaurants in New York and Boston, and that linked to RUTH’s private dining and catering businesses, which remain at below pre-pandemic levels, although figures appear to be on an upswing.

In addition, given historical trends, we don’t anticipate significant margin expansion, over the long term, besides that related to an expected deceleration in commodity prices, over the near term. Given our thesis for moderate top-line growth, and stable margins, earnings and free cash flows are likely to expand over the long term, but at moderate rates of growth. Overall, RUTH is an established business with solid unit economics that is unlikely to undergo major shifts in growth, on a secular basis.

Geographic Diversification Likely To Unfold Below Industry Average

RUTH is not a Quick Service Restaurant group, which would typically evolve into thousands of stores. The concept is a labor of love, where ambience, food quality, and customer service are the best-of-the-best. The steak at RUTH’s restaurants is USDA Prime and Choice Grade, served on a 500 degrees warm plate, sizzling and topped with butter. The atmosphere is posh, with dark wood paneling and sparkling tableware. The customer service is high-touch with teams of servers assigned to each table. Not surprisingly, although RUTH’s is a chain of steakhouses, the customer experience its restaurants provide is more consistent with that offered at higher-end chef-driven independent single-location establishments. Accordingly, a key element of the brand’s business model is to maintain the high standards associated with its business, which could become difficult if the number of restaurants was to expand substantially every year.

Within the U.S., there are several other well-established fine-dining steakhouses, similar to RUTH’s restaurants. Although there are variations between their menu items, all of the concepts serve USDA Prime and Choice Grade steaks, featuring similar cuts of meat. Specifically, there is Capital Grille with ~62 locations, The Palm with ~22, Smith and Wollensky with ~9, Fleming’s with ~64, and Morton’s with ~72 restaurants. In addition to these brands, there are numerous independent Michelin Starred steakhouses that enjoy significant customer demand. Moreover, considering that domestically, almost all higher-end steakhouses (including RUTH’s), have made major metropolitan cities the focus of their business, the concept’s ability to expand in these markets is likely limited. However, as RUTH remains underrepresented in second-tier cities, further penetration into those regions represents a considerable growth opportunity within the country.

In regard to foreign expansion, we view Europe which lacks higher-end American restaurants as low-hanging fruit for RUTH. Considering the high quality associated with USDA steaks, as well as the distinct ambience and excellent customer service that the concept’s restaurants provide, we believe the geography could evolve into a major growth driver for RUTH, if it were to direct its attention towards the opportunity. In that context, it is notable that the company currently operates through franchisees, successful restaurants in key international countries, including, Aruba, Canada, Hong Kong, Indonesia, Japan, Mexico, The Philippines, Singapore, and Taiwan.

Further, with respect to new unit development, it is noteworthy that with franchising being a primary component of RUTH’s business model, almost half of the growth associated with geographic diversification, requires limited capital expenditure, as franchisees typically finance spending associated with the launch of new restaurants. In addition, franchisees pay RUTH a significant one-time licensing fee, royalties on net sales, and advertising costs.

Overall, we believe that potential for domestic footprint growth is limited. In contrast, foreign diversification represents a major business development opportunity for RUTH. Therefore, we would not be surprised if management were to accelerate overseas new unit growth, over the upcoming years. Nevertheless, net-net footprint growth is likely to be moderate and consistent rather than rapid, over the long term, in our opinion. We believe, given business dynamics, RUTH’s plan to add five to seven new restaurants every year appears optimal.

Risks

Market Volatility Could Drive Shares Below Current Levels. RUTH’s shares are not immune to market forces. In case an economic recession unfolds, it is likely that the company’s stock might experience temporary pullbacks. However, considering that the depreciation in shares would be based on a market downturn rather than a major decline in RUTH’s business, (as the group’s customers are typically higher-income types, that are highly unlikely to ever experience a financial impact that could potentially prevent them from dining at their habitual restaurants), the decrease in share prices would be relatively weak and bounce back every time the firm reports earnings.

One-Year Price Target

We utilized 10-year Discounted Cash Flow analysis including a perpetual growth-based terminal value, to arrive at a 1-year Price Target of $24/share for RUTH. We assume a normalized 10-year revenue growth rate of 6%, (vs. FY2021 revenue growth rate of ~54.3%). In addition, we derive our net income for 10 years using a net profit margin of 10% (vs. net profit margin of ~9.9% in FY2021). Based on our analysis of RUTH’s historic financial reports, we model normalized 10-year operating cash flows as 16.5% of revenues/year and straight-line 10-year capital expenditure as 6% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and the present value of free cash flow figures. We utilize the current diluted outstanding share count of 34.1 million to arrive at our 1-year Price Target.

Bottom Line

Anyone that has dined at RUTH’s restaurants knows that they are guaranteed to be served a high-quality meal that is consistent in taste and experience unfailingly excellent customer service, every time they visit a location. The same holds true for the brand’s business performance, steady moderate growth, even in recessionary times. Overall, not a bad investment to ride out an economic downturn, in our judgment. Buy shares here for near-term capital preservation and long-term gains on investment.