Bottom of the Barrel: Patient Investors May Like What's Cooking at Luby's

If you have the appetite for a turnaround -- filled with all the usual risks and potential reward -- this cafeteria chain may hit the spot.

San Antonio-based Luby's ( LUB) operates 202 cafeteria-style restaurants in Texas and across the Southwest. Although its brand name resonates among Texans, Luby's has never fully recovered from the 1997 suicide of former president and CEO John E. Curtis.

It's been a downhill ride since then. In 1998, the company turned a profit of $1.45 a share. Last year, it lost 27 cents a share. During that time, it also eliminated its 80-cent dividend.

A Scattered Strategy

However, some of Luby's problems stemmed from an aggressive expansion campaign outside its core Texas focus. With restaurants scattered as far away as Kansas, operating costs became erratic. Plus, the management void left by Curtis' death left the company in disarray.

Finally, the company began to refocus on core markets in the most recent fiscal year ended in August, as it closed 19 restaurants and opened only one new store. Since September, Luby's has shuttered 11 more restaurants and plans to close another six by August, with no new openings slated for 2002.

"The company believes its opportunities for growth currently center around improving same-store sales growth at existing locations and changing the concepts in some locations that demographically would support different types of food," according to its 10-K for 2001.

At a Glance
Luby's (LUB:NYSE)
Feb. 26 Close $6.20
52-week Range $10.05-$5.50
Price-to-Earnings Ratio* NE
Market Cap $141 million
Avg. Daily Volume 52,181
Inst. Ownership 38%
Dividend Yield N/A
Beta 0.2
Company Web site
*Based on 2002 estimates; NE=No Earnings
Source: Market Guide, Zacks, Company Reports

Luby's contraction will continue to exact a toll in 2002. The company lost 24 cents a share in the first quarter as declining customer traffic drove same-store sales down by 2.73%. "We believe the traffic number actually came in softer owing to weaker demand for eating out in the weeks following Sept. 11 as well as soft traffic in its Rio Grande markets, due to the tightening of security on the border crossings," notes Janice Meyer, restaurant analyst at Credit Suisse First Boston. She rates the stock hold, and CSFB has not provided banking services for Luby's.

Clearly, this isn't a story for the risk-averse. In fact, Luby's first quarter was so weak that the company missed the EBITDA target on its credit facility, but it received a waiver from lenders. The losses aren't expected to end soon, either: Consensus estimates call for the company to lose 12 cents a share in the second quarter and 3 cents a share in the third quarter before breaking even by the fourth quarter of 2002. In total, Luby's is likely to lose 39 cents a share this year. Estimates project that Luby's will earn 3 cents a share in 2003.

New Management, New Challenges

Though the problems loom large, Luby's could offer risk-tolerant investors an interesting turnaround opportunity.

Last year, Luby's board of directors went in search of a new chief executive officer who could save the flailing cafeteria chain. Two of Luby's major investors, Houston restaurateurs Chris and Harris Pappas, approached the company with an offer to help turn it around.

The Pappas brothers proved themselves in the food services business with a group of diverse restaurant offerings in the South, from Pappadeaux Seafood Kitchens to Pappasito's Cantinas, a Tex-Mex offering.

Not only do they bring fresh ideas and a solid track record to Luby's, but they also bring cash. As part of their agreement, the Pappas brothers loaned Luby's $10 million in the form of convertible subordinate notes, which will help support its future cash needs. Combined with expense reductions and a better product-pricing strategy, the loan helped lower Luby's working capital deficit from $31.4 million to just under $9 million at the end of 2001.

Luby's, Luby's, Luby's
A tough -- but possible -- turnaround
Year Revenue (in millions) Earnings per share
1999 $501.5 $1.26
2000 493.4 0.83
2001 467.2 (0.27)
2002* 450.0 (0.39)
2003* 469.0 0.03
Source: First Call, Company Reports, TSC Research

Chris Pappas, who assumes the titles of president and CEO, and Harris Pappas, who serves as chief operating officer, have both agreed to work for a minimal cash salary and to accept stock options as compensation. Some say that's a clear sign of their commitment and belief in the future of Luby's.

"Embedded in the agreement that brought this new management team into our organization was a serious financial commitment on the part of the Pappas brothers to Luby's and its investors," wrote Luby's Chairman Robert Herres in the company's 2001 annual report. "Clearly, their heavy dependence on stock options for their compensation and the infusion of a significant level of their own capital into the enterprise removes any doubt about their willingness to make sacrifices that inspire confidence."

The Pappas brothers do benefit in other ways from their relationship with Luby's. For example, Pappas Restaurants, the brothers' main enterprise, is providing services to Luby's and received $271,000 in compensation in the second half of 2001. Luby's new CFO, Ernest Pekmezaris, is also the CFO of Pappas Restaurants.

Still, Luby's has intriguing turnaround potential with the Pappas power behind it, but the board knows it will take time. "The process of re-establishing Luby's in a position of prominence and profitability in our industry will be tedious," noted Herres. "But, the success achieved by Chris and Harris in building their Houston-based, multistate and multiple-concept restaurant business speaks volumes about the exciting possibilities that lie ahead."

Having loved Luby's mac-and-cheese as a kid, I hope so. There's no need to get excited about Luby's right now, but it's a name to watch. If you're looking for a small-cap turnaround, this name is interesting below $6 a share. It closed Tuesday at $6.20. However, the risks are potentially huge. Luby's gets one barrel and is added to the Bottom of the Barrel Special Situations portfolio.

For an explanation of our barrel rating system, see our recent description.

Seeing a Little Green

Last week's pick, Rare Hospitality ( RARE) has performed well so far. If you think the economy is about to turn, restaurant stocks are still a good place to be, and Rare is a good name in the group. It closed Tuesday at $27.

Perking Up
Market rally also lifts small-caps
Original Barrel Rating CurrentOutlook Company/Ticker Date ofMention CurrentPrice MentionPrice* PriceLast Week % ChangeFrom Mention % ChangeWeekly
Positive Outlook
2.5 Positive Rare Hospitality (RARE:Nasdaq) Feb. 20, 2002 $27.00 $25.72 $25.72 4.98% 4.98%
3 Positive NetBank (NTBK:Nasdaq) Feb. 6, 2002 14.34 13.45 13.79 6.62 3.99
2 Positive Endocare (ENDO:Nasdaq) Jan. 23, 2002 14.90 18.21 13.49 -18.18 10.45
2.5 Positive SurModics (SRDX:Nasdaq) Dec. 19, 2001 34.62 34.60 33.91 0.06 2.09
2.5 Positive VitalWorks (VWKS:Nasdaq) Nov. 21, 2001 4.45 4.30 4.55 3.49 -2.20
2 Positive FPIC Insurance (FPIC:Nasdaq) Nov. 14, 2001 12.42 12.83 13.32 -3.20 -6.76
3 Positive Witness Systems (WITS:Nasdaq) Oct. 31, 2001 13.05 8.06 12.75 61.91 2.35
Market Outlook
2.5 Market Coastal Bancorp (CBSA:Nasdaq) Dec. 12, 2001 31.64 27.84 30.40 13.65 4.08
2.5 Market Coinstar (CSTR:Nasdaq) Nov. 7, 2001 29.75 19.96 27.80 49.05 7.01
2.5 Market Hibbett Sporting Goods (HIBB:Nasdaq) Oct. 24, 2001 22.10 20.04 21.65 10.28 2.08
2.5 Market Quixote (QUIX:Nasdaq) Oct. 3, 2001 18.12 21.44 17.73 -15.49 2.20
Special Situation
3 Special Situation Quanta Systems (PWR:NYSE) Jan. 9, 2002 14.75 16.05 15.09 -8.10 -2.25
2 Avoid Actrade (ACRT:Nasdaq) Jan. 30, 2002 14.45 $20.65 13.26 -30.02 8.97
0.5 Avoid Goody's Family Clothing (GDYS:Nasdaq) Nov. 28, 2001 4.38 4.50 4.05 -2.67 8.15
1 Avoid Bridgford Foods (BRID:Nasdaq) Oct. 10, 2001 11.00 13.18 10.75 -16.54 2.33
Income Portfolio
2.5 6.04 Empire District Electric (EDE:NYSE) Jan. 16, 2002 21.05 21.23 20.53 -0.85 2.53
2.5 2.43 Met-Pro (MPR:NYSE) Oct. 17, 2001 13.48 11.16 14.35 20.79 -6.06
2.5 4.62 Integra Bank (IBNK:Nasdaq) Jan. 2, 2002 19.94 20.75 19.75 -3.90 0.96
3 4.49 Alexandria Real Estate (ARE:NYSE) Feb. 13, 2002 41.28 40.25 41.67 2.56 -0.94
*Average price on date of mention. **Prices Adjusted for 3:2 split on Feb 20, 2002. Source: TSC Research

It's been erratic lately, but NetBank ( NTBK) ended higher for the week as well. Rumors that its merger with Resource Mortgage would be pushed back are unfounded, according to SunTrust Robinson Humphrey analyst Christopher Marinac. He expects the merger to close by the end of March and upgraded the stock to buy from outperform Tuesday. His firm has not provided banking services to NetBank.

Do you have candidates for Bottom of the Barrel? If so, shoot me an email with the company's name, why you think it qualifies and your full name and hometown. If I profile your suggestion, I'll send you a TSC gift to commemorate your pick.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds.

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