Restaurants on a Downward Spiral

I listened to J. Carlo Cannell of Cannell Capital LLC speak about his Investing Strategy, "Selling Short: Controversial Black Magic". He agreed to let me share some of the broad themes from his lecture.

His thesis is,

"it is more difficult to pick a stock and go long than it is to pick an absolute loser. What do any one analyst or stock picker know more than the rest combined? On the other hand there are industries that perpetually weak and all businesses in that segment someday go out of business. Find one such weak industry segment and find the worst loser in that segment and short it. Look for signals like, unknown auditors, bad reps for their C level officers, lawsuits, labor union, dealings with Governments. Do not short a stock based on valuation, the market always will move against the valuation call as the company manages earnings through complicated schemes. Look for the real duds."

Once such industry is Restaurants, Carlo has considerable experience and knowledge about this segment.

"There are no barriers to entry, customers are fickle with no switching costs, employees steal from the business, from money to food carted out through the back door and for a food service business most of its profits come from liquor sales. In the data, from 1983 to 2005, the stocks shrank -8.7% CAGR. Once a restaurant hits the downturn, it is not suddently going to turnaround. People who left for the next cool place are not going to come back. Given enough time every restaurant will go out of fashion and will go out of business."

I asked him specifically about the Ruby Tuesday case and its current investment of $50 million to improve the lights and upholstery. He replied, " people did not leave because of bad lighting, just by changing they are not going to come back. May be they have done some EBIDTA calculations that show a positive outcome". But as I discussed last time, at their projected growth rate of 3%, $50 million investment is not a positive NPV project.

Finally, given this loss making characteristic of restaurants, should anyone open a franchise?
" If you are the first one to get franchise for an geographic area and your plan is to roll it out, make money in 2-3 years and sell it off, then yes". The corollary is, it is not usually a good option to buy a franchise from a previous owner. You have to ask, why are they selling and will you be able to find another buyer who will buy this from you at a higher price.

That said, I am in no hurry to short Ruby Tuesday. I am a simple indexer.