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Ark Restaurants (ARKR) runs 20 restaurants and bars, and 30 other food operations, including fast food restaurants, food courts, and wholesale and retail bakeries. The company owns operating leases at some of the most prominent and well-trafficked locations in the US, including Bryant Park Grill and Café and The Grill Room (next to the World Financial Center, formerly the World Trade Center) in New York, Center Café and Thunder Grill at the Union Station in Washington DC, and multiple restaurants in famous casinos at Las Vegas and Atlantic City. In total, the company has 7 restaurants in New York, 4 in Washington DC, 5 in Las Vegas, 2 in Atlantic City, and one each in Connecticut and Boston.

The business model of Ark Restaurants is a rather interesting one, being a blend between the traditional individual restaurateur business and the restaurant chain (such as Applebees and TGI Fridays). Compared to an individual restaurant, the chain restaurant has a cost advantage, being able to centralize backroom operations and exploit economies of scale. A meal at the individual restaurant therefore costs more, but offers the prospect of an artisan meal amid a better atmosphere. Ark Restaurants tries to marry the best of both business models. By setting up multiple restaurants at prime locations in a single city with a healthy tourism industry, yet allowing each restaurant to retain its own chef and unique identity, the company is able to centralize backroom human resource and purchasing operations and still charge the higher fares typical of full-service restaurants. Multiple restaurants in a single city gives the company local market power, as well as allows some degree of vertical integration. For example, Ark Restaurants typically sets up wholesale bakeries in the cities where its restaurants are located. In addition to providing its own restaurants with baked goods, these wholesale bakeries also provide goods to the local restaurant industry. Ark Restaurants also owns catering businesses in these cities, which provide food from its restaurants for special occasions at other locations. Furthermore, landlords are more willing to charge a lower rent to Ark Restaurant because its healthy balance sheet and demonstrated expertise in running restaurants. This lower rent reflects the fact that Ark Restaurant is a better credit risk and is less likely to default on its lease and leave the landlord with an empty location. Lastly, this business model is capital intensive. Mature well-run restaurants are filled to capacity and typically do not show year-over-year growth in sales, so opening new restaurants is required to achieve growth. Opening new restaurants is capital intensive, as pre-operating losses in the first year is routine due to costs incurred for training personnel, excess kitchen costs, and publicity, as each new restaurant must build its own reputation anew. Restaurant chains typically operate with the franchise model, where individual managers pay part of the startup costs, and benefit from immediate brand recognition and a shorter break-even period. Compared to the restaurant chain, Ark’s business model does not bring costs down as much, and growth requires more capital. However, Ark is primarily competing in the space of individual restaurants, which provides a unique dining experience that chains cannot provide, where this particular business model gives it substantial advantage over the individual restaurateur.

Many new restaurateurs focus on the dining experience and ignore the two critical factors required for a restaurant’s success, location and rent. Therefore, the failure rate of independent restaurants is extremely high, with many failing within the first year of opening up shop. At Ark Restaurants, CEO Michael Weinstein has been managing restaurants since 1983, and has a reputation for good negotiation skills, being able to secure operating leases of prominent locations at reasonable rents. Furthermore, Weinstein was an investment banker before he caught the restaurateur bug, and unlike the typical restaurateur, concepts such as shareholder value and return on investment are not foreign to him. Being the largest shareholder (Weinstein owns 1 million of the 3.5 million shares outstanding), his interest is aligned with that of minority shareholders. Weinstein is quick to shut down unprofitable businesses, and has previously shut down several restaurants and a wholesale bakery in New York after they failed to be profitable. In 2006, Weinstein was offered $14 million for his lease at the Venetian Resort Hotel Casino in Las Vegas by other prospective tenants. Recognizing that this is a good deal, Weinstein took it and distributed the proceeds as a one-time $3 special dividend to shareholders. In short, management is competent and shareholder-friendly.

Exposed to the unfashionable tourism and restaurant industries, Ark is now being heavily sold off by its institutional holders, Loeb Partners and Pride Equity Partners. The suspension of Ark’s dividend also contributed to its decline, although Weinstein felt that conserving capital to launch new restaurants in this environment is a better use of cash. However, Joel Greenblatt, who runs Gotham Asset Management, has recently become a new holder of this stock.

My investment thesis for Ark is this : Ark Restaurants will be able to survive the downturn due to its healthy balance sheet and low costs, and many independent restaurants will go out of business before it does. Furthermore, it possesses leases of outstanding value at multiple prominent locations, which can be probably be sub-leased for cash if necessary. Unless the restaurant and tourism industries in the US is permanently wiped out, ARKR is likely to emerge from this recession with better market power and profitability. This investment thesis is similar to Pabrai’s thesis for Frontline, an oil shipper hurt by a downturn in shipping rates in the 2001-2002 recession. While shipping rates were running below the level required for profitability, Pabrai saw that small Greek shippers with single hull tankers were being hurt more than Frontline, and were rushing to scrap their ships before other shippers flood the market with scrap. He reasoned that Frontline could stay afloat simply by scrapping one or two ships if the need arose, and when oil demand next surged, Frontline would be in a position to capitalize on it, which was indeed what happened.

I estimate that Ark has annual fixed costs of $9 million for SG&A, and $15 million for other fixed expenses. Variable costs include food and beverage costs (25% of revenue) and payroll (33% of revenue). Rent is partially fixed, with some restaurants being charged a portion of sales, while others have fixed non-cancellable rents. Management reports that minimum non-cancellable lease payments total $7M annually, with typical rents being 14% of revenue. In fiscal 2008, ARKR had revenues of $125 million, and net income of around $7 million. In the first quarter of fiscal 2009 (last 3 months of 2008), management reports that revenue is down 15% from year ago, mainly due to a 23% drop in revenue from its New York City restaurants, and smaller declines in revenue from other restaurants. Assuming that revenue in 2009 takes a 20% hit to $100 million, then with fixed costs of $24 million and variable costs of $72 million, operating profit will drop to $4 million, and net income to $2.6 million (assuming a 35% tax rate), or $0.74 EPS. In addition, Ark has surplus working capital of $8 million, or $2.28 per share. Therefore, at the current stock price of $10, the market is valuing ARKR at slightly above 10 times earnings. In the worst case scenario, the company may run at a loss. In that case, Ark may have to either draw down on its substantial cash holdings, or more likely, negotiate lease reductions to regain profitability, or alternatively sub-lease its locations to other companies who can profitably run other businesses from those locations. Given that Ark holds leases in many prominent and well-trafficked locations, even if the restaurant business prove to be no longer viable at those locations, it is likely that other businesses will achieve profitability in those locations. I estimate that ARKR is minimally worth $10, and probably much once the recession passes.