ONE Group Hospitality, Inc. annual report, FY2017

ONE Group Hospitality, Inc. — FY2017 Form 10-K

Reporting period: Fiscal year ended December 31, 2017; comparative figures are for FY2016. Although the request refers to 2017 Q4, this filing is an annual report. Amounts below are in U.S. dollars; financial statement figures are generally in millions unless otherwise stated.

Business context

The ONE Group develops, operates, manages and licenses upscale restaurants and provides food-and-beverage services to hotels, casinos and other hospitality venues. Its primary brand is STK. At year-end it reported 31 venues: 10 company-owned, 17 managed and 3 licensed, plus one other venue. Its stated strategy is to grow primarily through licensing and management agreements that require less company capital.

Financial performance and liquidity

Metric	FY2017	FY2016
Total revenue	$79.7 million	$72.4 million
Operating loss	$2.7 million	$5.6 million
Loss from continuing operations before tax	$3.8 million	$6.0 million
Net loss	$4.0 million	$16.5 million
Net loss attributable to ONE Group	$4.2 million	$16.7 million
Operating cash flow	$6.0 million	$2.1 million
Adjusted EBITDA	$7.5 million	$5.0 million

• Revenue increased 10.0%. Owned restaurant revenue rose 8.5% to $58.7 million; management, license and incentive-fee revenue grew 27.3% to $10.8 million. Comparable unit sales increased 0.5% across six comparable units.
• Operating loss improved to 3.3% of revenue from 7.8% in FY2016. Owned restaurant cost of sales rose to 26.5% of owned restaurant revenue from 25.5%, principally attributed to higher beef costs; owned restaurant operating expenses improved to 63.2% from 63.9%.
• Adjusted EBITDA is a non-GAAP measure: $7.5 million, including $1.2 million of settlements, $2.2 million of lease termination costs and asset write-offs, and other adjustments. Management cautions that the measure may not be comparable across companies.
• FY2017 net loss was substantially lower than FY2016 partly because FY2016 included a $12.7 million deferred-tax valuation allowance. FY2017 tax expense was $0.6 million. The reported diluted loss per share attributable to the Company was $0.17, versus $0.66 in FY2016.
• Fourth-quarter revenue was $21.5 million, versus $20.4 million in Q4 2016. Q4 2017 net loss was $0.2 million, versus $16.1 million in Q4 2016; the prior-year quarter included a large tax provision.
• Cash and cash equivalents were $1.5 million at year-end, compared with $0.9 million. The company reported a $7.2 million working-capital deficit. Operating cash flow was $6.0 million; investing cash use was $4.3 million and financing cash use was $0.9 million.
• Gross debt was $14.1 million, including $3.2 million current and $10.1 million long-term debt, compared with $17.2 million gross debt at the prior year-end. Interest expense increased to $1.2 million from $0.5 million.
• Contractual operating lease payments totaled $120.1 million, including $7.5 million due within one year. Total scheduled debt and interest obligations were $16.8 million, in addition to lease commitments.

Material changes and unusual items

• Revenue growth reflected a full year of Orlando operations and most of a year of Denver operations, partly offset by the Washington, D.C. restaurant closure. Management and license fees benefited from higher U.K. incentive fees and new licensing arrangements.
• Pre-opening expense fell to $1.6 million from $6.0 million. Conversely, lease termination expense and asset write-offs increased to $2.2 million, including about $1.5 million accrued for future Austin and Dallas lease payments, net of expected sublease income. The company abandoned those planned company-owned restaurants in favor of its capital-light strategy.
• Settlements were $1.2 million, versus none in FY2016. They included employee class-action settlements and a $0.5 million dispute resolution with a management-agreement partner. A further $0.2 million installment on the New York employee settlement was paid in March 2018.
• The November 2017 registered direct offering issued 1.75 million shares at $1.50 per share, generating approximately $2.6 million gross proceeds, and included warrants to purchase 875,000 shares at $1.63. Shares outstanding were 27.2 million at year-end.
• The 2017 tax provision included provisional effects of the Tax Cuts and Jobs Act, including remeasurement of deferred tax assets at the new 21% corporate rate. The company used foreign retained earnings as a proxy for earnings and profits and said the final tax effect remained subject to analysis.

Outlook, risks and controls

• Management expected FY2018 same-store sales growth at a mid-single-digit pace, up to three to five STK openings annually primarily through licensing, and one to two new F&B hospitality agreements annually. Planned openings included a company-owned San Diego STK and licensed locations in Puerto Rico, Dubai, Qatar and Mexico; opening plans were subject to partners, sites, staffing and financing.
• The filing gives two FY2018 capital-spending figures: approximately $3.0 million including maintenance in MD&A, and $1.0–$2.0 million net of improvement allowances for the next 12 months in the business section. Investors should clarify the scope and assumptions behind these estimates.
• Management said expected operating cash flow and landlord construction allowances should fund planned needs for at least 12 months after issuance of the financial statements, but warned that additional financing might be needed and was not assured on acceptable terms. Year-end cash was limited, and the company had a working-capital deficit.
• The company was in compliance with BankUnited financial covenants at year-end and expected continued compliance through 2018 based on its projections. Debt agreements impose restrictions; substantially all company assets secure the BankUnited term loans, and trademarks are pledged as collateral.
• Management and the CEO/CFO concluded disclosure controls and internal control over financial reporting were ineffective at December 31, 2017. Previously identified material weaknesses in financial close and reporting, tax-account review, segregation of duties and IT access controls remained unremediated; management expected remediation during 2018 but could not assure success or timing. The auditor gave an unqualified opinion on the financial statements but did not opine on internal control effectiveness.
• Key risks include dependence on discretionary dining and business travel, competition, beef and other commodity and labor costs, weather, food safety and reputational events, long-term lease obligations, licensee execution, cyber and payment-card security, regulation, litigation, and ability to obtain financing. The company said second and fourth quarters typically have higher sales volume.
• In March 2018, the company agreed, subject to conditions, to sell its 10% interest in One 29 Park for $0.6 million. It did not declare or expect to pay common-stock dividends in the foreseeable future.

Important facts for investors to verify

• Whether the company generated sufficient operating cash and landlord allowances to meet near-term obligations, planned capital expenditures and scheduled debt service, given low cash and the working-capital deficit.
• Whether the 2018 same-store sales and venue-opening targets were achieved, and whether the stated capital-expenditure estimates are comparable in scope.
• Progress and independent evidence of remediation of the material weaknesses in financial reporting controls.
• Final tax effects of the TCJA after the company’s earnings-and-profits analysis, and any resulting 2018 tax adjustments.
• Debt balances, covenant compliance, maturity and repayment requirements, and the substantial lease commitments; also whether pledged collateral or financing constraints affect strategic flexibility.
• Settlement and other legal exposures, including the remaining employee-settlement payment, as well as the completion and proceeds of the One 29 Park sale.
• Potential dilution from warrants, options and equity awards; the filing reported 3.3 million securities issuable under outstanding equity awards and warrants in its equity-plan disclosure, with additional offering warrants described separately.