I’ve happened across an interesting situation in Granite City Food & Brewery, Ltd. On Monday evening, the company released its preliminary 2014 results and also announced it would explore a “strategic transaction.” These words are music to investors’ ears, because they often portend a sale of the business in the near future, or some other value creating action by the company. As I read the announcement, I felt that little twinge of excitement that always arrives when I suspect I’ve stumbled onto something good. The market felt the same thing and bid shares up 27% on Tuesday to close at $1.85, with a bid/ask mid-point of $2.20. While the price rise cooled my interest a little, I was still eager to begin my due diligence, hoping I might find a cheap company ripe for a rich takeover offer.

Turns out things aren’t quite that simple. Granite City’s results are not strong, and the company’s track record is one of mediocrity and missed expectations.

Granite City Food & Brewery is a restaurant company with two different concepts: Cadillac Ranch and Granite City food & brewery. The Granite City concept has 31 locations in the Midwest and Cadillac Ranch has 5 locations: Miami, Indianapolis, National Harbor, MD, Minneapolis and Pittsburgh. The Granite City concept emphasizes a casual American menu and polished interiors heavy on natural materials, and serves the company’s own beer. Cadillac Ranch is a throwback concept that emphasizes roll n’ rock and automotive decor and offers dancing and musical entertainment.

Cadillac Ranch is the company’s newer concept. The chain was founded in 2009 and purchased by the company in 2011. If you think the concept sounds a little uninspired, you’d be right. The restaurant industry is intensely competitive, and success for a new entrant requires both an interesting concept or presentation and good food and drink offerings at the right price point. Come up short on any one of those factors and customers will happily spend their dollars at another of the dozens and dozens of other restaurants clamoring for their business. Unfortunately for Cadillac Ranch, the reviews are in, and they’re not good. The restaurants garner a meager 2.5 out of 5 stars on yelp.com with hundreds of reviews from various locations. Guests repeatedly complain of indifferent staff, cold or mis-prepared food and a cheesy atmosphere. I’m not surprised by the poor rating. There’s a Cadillac Ranch in a shopping center outside my own city, and every restaurant in the whole complex is of the bland, corporate chain variety. Seems right that Cadillac Ranch would offer more of the same.

The Granite City-branded restaurants enjoy much better reviews, but it bodes ill for the company that its newer concept has suffered such a lackluster market reception. The poor results are readily apparent in Granite City’s financial statements. Though revenues grew 41% from 2009 t0 2014, the growth is almost entirely the result of huge investment in new restaurants. Sales per unit actually grew just 14% over the same time period, a period in which restaurant receipts surged as the economy recovered following the Financial Crisis.

Here’s a look at Granite City’s financial statements since 2008. While the company has grown, it hasn’t once produced a profit and has repeatedly sold equity and taken on additional debt to fund its expansion. The figures I’ve presented below look slightly better than the actual statements, because I’ve added back one-time expenses like pre-opening costs to EBITDA and EBIT.

With results like that, it shouldn’t be hard to understand why the company’s stock has gone nowhere in the last five years. What makes the results more difficult for investors to stomach is how the results compare to management’s own projections. Granite City released a presentation in 2012 projecting its restaurant-level EBITDA would increase by $7-8 million in 2013/2014. The actual results? Restaurant-level EBITDA was virtually flat, even as revenues rose 12.5% from restaurant openings.

With results like these, it’s not surprising that Granite City’s owners are thinking about cashing out and letting someone else enjoy the headaches. So who are these owners, and what kind of price might Granite City fetch?

Granite City is controlled by Concept Development Partners, which is in turn controlled by CIC Partners, a private equity firm. CDP took over in 2011, providing financing in the form of convertible preferred stock. Since then, CDP has received another 482,000 common shares through dividends on its preferred stock, and purchased 3.125 million common shares in a stock offering in 2012. Through its ownership and through a voting agreement with the former majority owners, CDP controls 78% of the voting power of Granite City shares, and holds a 67% economic interest in the company.  Thus far, the involvement has not been profitable. CDP paid $2.37 per share to purchase 3 million shares from the previous controlling shareholder, and paid $2.08 per share to buy an additional 3.125 million shares in 2012. At the current trading price, that’s a loss of about $2.2 million.

So, CDB is seeking to cut its losses and offload Granite City to somebody else. The price that Granite City fetches will depend on the buyer’s belief in its ability to bring the company to profitability and to what degree corporate-level costs (as opposed to restaurant operating costs) can be cut.

At its present bid/ask mid-point of $2.20, Granite City has a market capitalization of $32 million, assuming all convertible preferred stock is converted into common shares. The company has net debt and capital leases of $53 million (as of September 30) for an enterprise value of $84 million. Adjusted 2014 EBITDA was $10 million, and operating income was $2.4 million. I constructed a peer group of other similar restaurant operators with EBITDA below $100 million, to see how Granite City’s valuation compares.

Granite City Food & Brewery trades about 3 EBITDA turns below the peer median valuation. Then again, a discount is deserved. Granite City is both unprofitable and the most leveraged of all its peers, so it carries a significantly higher risk of financial distress. The leverage ratios for some peers are likely under-stated, since many restaurant companies make significant use of operating leases. However, I doubt anyone would dispute my characterization of Granite City as “highly-leveraged” as a consumer discretionary company carrying net debt and capital leases of 5.3x EBITDA.

Because Granite City is so leveraged, its equity could command a wide variety of market values depending on its EBITDA multiple and potential cost savings. The chart below illustrates various share prices at different EBITDA multiples and corporate cost savings. (The company hasn’t yet released its official 2014 financial statements, so I’ll use 2013’s corporate expenses.

It’s not tough to get to a share price well above the current price using even modest corporate cost reduction assumptions and an EBITDA multiple at or slightly above the current valuation.

Once again though, it’s not that simple. This multiple and cost savings matrix ignores several other factors that any Granite City buyer would have to consider.

• Incremental operating capital – Granite City is not profitable. Any potential turnaround would take time, and the company would need a source of additional cash to bridge the losses until breakeven was achieved. Whether equity or debt, an acquirer would have to factor the additional capital requirements into the bid price.
• Capital expenditures – Cadillac Ranch isn’t working, and any acquirer would have to sink lots of cash into figuring out why not, and then fix the issue. Maybe it’s as simple as a revamped menu, or maybe the chain requires a complete rebranding. The costs could easily run into the millions, and the acquirer would need to reduce its bid accordingly.
• Long lease terms – many of Granite City’s restaurant locations have lease terms of a decade or longer. This can be a positive or negative factor, but its typically a negative factor for struggling operators. Ordinarily, a restaurant owner dealing with some struggling units could choose to stop the bleeding by boarding up shop and vacating when the lease expires. Granite City does not have that option. Even if the company shut down certain restaurants tomorrow, it would still be on the hook for another decade of lease payments. A company can often negotiate a lump payment for breaking a lease, but it’s yet another cost an acquirer would have to account for if their strategy included shuttering any underperforming locations.

I could go on, but you get the idea. Maybe Granite City will find an optimistic (or naive) buyer willing to pay a high multiple and assume low turnaround costs and big cost savings. In this case, shareholders will make a handsome profit. But maybe acquirers will notice the company’s dismal history, underperforming properties and offer little, expecting huge “repair” costs. I don’t know enough to feel confident one way or the other, and I doubt additional research will lead me to a strong conclusion. And let’s not forget it’s not even a foregone conclusion there will be any strategic transaction. The company could instead choose to conduct a large capital raise, merge a private competitor into the company, or even do nothing at all. For these reasons, Granite City is a pass for now.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.