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Mariusz Skonieczny, founder and president of Classic Value Investors LLC and author of the Classic Value Investors website and his book Why Are We So Clueless about the Stock Market? Learn How to Invest Your Money, How to Pick Stocks, and How to Make Money in the Stock Market, has provided a guest post on Ark Restaurants Corp (NASDAQ:ARKR).

Here’s his idea:

Business

Ark Restaurants is a New York corporation founded in 1983. Over the last two decades, the company evolved from being a holding company of small mid-priced to upscale restaurants in New York to a company with a wide range of restaurant styles with a variety of concepts. Today, it owns and/or operates 20 restaurants and bars, 30 fast food concepts, catering operations, and wholesale and retail bakeries in New York, Nevada, New Jersey, Connecticut, and Massachusetts.

Moat

A moat is what gives a company a competitive advantage which allows it to generate and maintain high returns on capital by keeping competitors at bay. Since anyone can start a restaurant, the barriers to entry into this business are low. Despite this fact, Ark Restaurants was able to create an economic moat around its business, and this is evidenced by the returns on equity below.



Traditionally, there are two different business models for restaurants. The first is operating a restaurant chain, such as TGI Fridays, and the second is operating an independent restaurant. Restaurant chains benefit from brand recognition, and this allows new franchisees to build clientele faster and to break even sooner in a new location. Also, the chain restaurant structure offers a cost advantage by centralizing backroom operations and taking advantage of economies of scale. The independent model, on the other hand, offers something else that a chain restaurant model does not – a unique atmosphere, which often allows the restaurant to charge higher prices than competitors in its class.

Ark Restaurants employs a unique business model which combines the best of both models. It operates each restaurant as a separate business with its own theme. By having multiple restaurants in the same city, it is able to benefit from economies of scale by centralizing backroom human resources and purchasing operations. Because it can still offer a unique atmosphere, it can price its meals above chain restaurants, but below independent restaurants of the same quality.

Another advantage of positioning multiple restaurants in the same area is the ability to vertically integrate operations. Wholesale bakeries are strategically located so that they can serve the company’s local restaurants as well as provide bakery products to other restaurants. The catering business is also located in the same area as the local restaurants.

Because each restaurant operates under a separate theme, it has to establish its own moat or competitive advantage to be a successful operation. The management achieves this by location. The company builds its restaurants in high-impact locales where customers are practically captive. The company’s CEO, Michael Weinstein described this advantage in his own words:

“If you take a Bryant Park Café or a Sequoia in Union Station or our waterfront Sequoia in Washington, I don’t care how many restaurants are built around us, we are going to have an advantage because these site-specific restaurants do good business because of the density of population.”

In the restaurant business, rent is a very significant expense which singlehandedly can make a restaurant a success or failure. Ark Restaurants has an ability to get lower rents than their competitors, and this creates a huge advantage. Many new restaurant owners focus so much on the dining part of the business that they fail to analyze if their restaurant can sustain paying rent and, as a result, many fail within a relatively short period of time. Because Ark Restaurants has been in business since 1983, possesses a pristine balance sheet, and did not ever miss a rent payment, landlords are happy to lease to Ark Restaurants at lower rates. Also, the company has a reputation of having superior negotiating skills with landlords. The management is not afraid to walk away if the numbers do not work in Ark Restaurants’ favor.

Another often overlooked advantage that Ark Restaurants has is lower employee turnover than its peers. This translates into lower training costs and, at times of extreme distress, lower payroll costs. The company’s management has done a tremendous job building loyalty among employees. For example, when one of the locations shut down for an eight-month remodeling project, the company kept the entire staff on payroll even though Wall Street was not too happy with it because of its short-term effect on earnings. The company also offers medical benefits to employees who work three shifts and allows artists and actors take time off for gigs with a guaranteed job upon their return. While treating employees in such a manner is considered unconventional, it definitely pays off in the long run. One example of this payoff happened after 9/11. As a result of Ark restaurants’ reliance on tourist locations and an overleveraged balance sheet, the company nearly went bankrupt. The employees, seeing significant drop in business, voluntarily approached Ark Restaurant’s management and offered to take a temporary pay cut. This was tremendously helpful because it allowed Ark Restaurants to cut payroll from $40 million to $30 million, which is significant considering Ark Restaurants’ size.

Finally, Ark Restaurants is one of the best payers in the industry. Usually, the company pays its suppliers within 10 days. This allows the company to enjoy bargaining power and suppliers’ loyalty.

Click here to download Mariusz’s report on Ark Restaurants – ARKR (.docx).

[Full Disclosure:  I do not have a holding in ARK. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]