We are initiating a 600-share position in Luby's (LUB) . The company operates cafeteria-style restaurants -- mostly located in Texas -- that cater to value-oriented customers. This under-the-radar play was recently trading at $9.44, and we believe shares offer investors a very favorable risk/reward at the current level.
The restaurant industry has seen its share of lows over the past few months. As we've mentioned in past Weekly Summaries regarding Denny's (DENN) -- another restaurant operator that is currently part of the model portfolio -- consumers seem to be tightening their budgets and takeovers within the sector have calmed.
Luby's has also been a part of this downtrend as shares are down 20% on the year. But based on the value of its assets and solid execution ability by management, which we saw with last quarter's results, we believe shares are at least 25% undervalued.
Looking at Luby's assets, as of last quarter the company operates 127 restaurants and owns 93, or 73% of them. Also, the company has $25 million in cash, is expected to generate $18 million in free cash flow for the fiscal year and has zero debt. To put this in perspective, Denny's owns less than 40% of its stores, has $35 million in cash and has $450 million in debt.
Granted, Denny's has improved its financials considerably since last year and reaches a much larger demographic than Luby's since it operates more than 1,500 stores (which was the reason behind our recommendation), but Luby's assets highlight the hidden value in the share price. Also, management can use its cash to revamp existing stores and open new ones, as they mentioned during last quarter's conference call a few weeks ago.
Luby's third-quarter top-line results on June 12 fell short of estimates, sending shares lower by 6% that day. Management blamed the miss on an overall decline in traffic trends throughout the industry, but also mentioned that the current weakness is temporary.
Despite the shortfall in sales, profit margins at the company increased year over year by 50 basis points to 18.9%. This improvement demonstrates management's ability to increase productivity during tough times -- a positive considering that most industry analysts are expecting softening conditions to last for at least another quarter. We expect this operational improvement to continue given that 84 of the 128 general managers at Luby's have more than 10 years of experience.
On the growth side of things, the company is anticipating opening four to eight new restaurants a year going forward and is extending its culinary services to hospitals and universities. This represents a solid growth opportunity for the company as its cafeteria-style niche gives them more leverage to expand into areas that are traditionally known for serving value-oriented food.
We admit that Luby's does not have the appeal or controversy of other model portfolio companies like Taser (TASR: Nasdaq), Home Solutions (HSOA: Nasdaq) or DynCorp (DCP: NYSE), but the company does offer solid long-term potential and little downside risk for investors over the next 12 to 18 months. Also, its solid real estate portfolio, positive free cash flow and strong balance sheet could result in private equity interest or even draw a bid from a larger competitor looking to expand its presence in Texas, one of the most populated states in the U.S.
Frank Curzio is a research associate at TheStreet.com.
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