Is Ruby Tuesday solving the right problem?

As the slowing economy eats into restaurant sales, Ruby Tuesday is trying to improve sales with a $50 million investment to spruce up stores. The Wall Street Journal reports:

To boost sales and set the company apart from its casual-dining competitors, Ruby Tuesday is spending at least $50 million on remodeling, with 668 of its 721 company-owned locations getting a new look. It is replacing its decor of Tiffany lamps and roller skates with custom artwork and leatherlike upholstered furniture. Servers are wearing black pants instead of jeans.

The company has changed some of its food suppliers to trim costs. It saved $800,000 on broccoli by using a different supplier, and an additional $500,000 by switching mashed-potato suppliers. Ruby Tuesday is installing a new frying-oil filtration system to reduce the amount of cooking oil the company uses, a move Mr. Beall estimates will save $2 million a year.

Even if we work with their premise that improving the ambiance will steer customers to their restaurants, the numbers do not work well. Suppose, they capitalized the $50 million and depreciated it over 10 years and they are able to keep up with the $3.3 million cost savings. Their 2007 10-K says their current free cash flow is $59 million and one of their goal is to reach a 3% year over year same restaurant sales growth. If we assume that they achieve this and this increase flows to a 3% increase in free cash flow. Let us assume their discount rate (WACC) is 12% and discount the increase in cash flow over the 10 year period. This investment turns out to be a NPV negative one.

Why is Ruby Tuesday and all other places seeing slowing sales? As the restaurants proliferated at a rate faster than population growth, they generated sales by selling more per customer. As people cut their spending, eating out is one of the first to go. Even though the economic slowdown may be short lived the increasing oil prices and grain prices are here to stay. This calls into question their profit growth.

More important than these finance issues, there is a bigger positioning issue here. The customers are not walking away from Ruby Tuesday to their competitors. Hidden in the data is that customers are buying more prepared meals from supermarkets. The market demographics is also shifting with more women staying at home. This indicates that the value proposition to these customers is convenience and not ambiance. Ruby Tuesday is seeing itself in the business of providing a better dining environment than their competitors, the casual dining places.

An alternative to restaurant redesign project would be to aggressively enter prepared meal segment and reach their customers through supermarkets. This requires Ruby Tuesday to see itself in the food service or even convenience business and not in the restaurant business.

Since they are committed to the $50 million spending, I expect their stock to fall further from its current level of $7.35.