Pair Trade: The Restaurant Industry

See part I, with an explanation on pair trading, here.

Industry: Restaurants

The restaurant industry has seen stocks plummet as consumer spending has dropped, input prices have cut into margins, and high oil prices result in less traffic to the restaurants. Many of these issues are subsiding now, and stocks are ready to approach a more fair valuation. Cheesecake Factory (CAKE) CEO stated on 10/23 that

in the midst of unprecedented times. . . . Pressures are further squeezing restaurant operators' margins, and like many others in casual dining, our earnings were impacted by spikes in commodity and energy costs.

Five major restaurant chains have filed for bankruptcy protection so far this year compared with two chains in 2007. Although there are further headwinds for the industry the companies with the strongest management that can keep costs down, and maintain traffic at a stable rate will outperform the rest of the group. On the long side we will look for a company with strong operating margins, low debt, and high management efficiency ratios.

Long: Jack in the Box (JBX), $17.68: Jack in the Box shares are trading at a PEG of 0.37 and are down 44% for the year. ROA is one of the highest in the industry group at 9.37% as is ROE at 23.38%. With 16.9% of the float short there can be a sharp move on short covering on any signs of a turnaround. Jack in the Box is one of the more volatile names in the group, and operating margins are right in the middle of the pack. We expect fast-casual restaurants such as Jack in the Box to outperform the fancier chains in the long run. Management has shown a prowess for adapting quickly to a changing environment in the past, and we feel that this company comes out of the recession strongly.

The only concern currently is the balance sheet, as the company does have a long term debt-to-equity ratio of 0.85, but this is in-line with the industry average. Jack in the Box excels at growth and expansion, and chains such as Qdoba should continue to fuel growth for the company. The recent divesture of Quick Stuff, store branded fuel stations, should boost margins in the long term and also improve ROA and the balance sheet. If shares can break the downward trend-line with a move above $18.50, shares could ride much higher.

Short: PF Chang’s China Bistro (PFCB), $18.47: PF Chang’s has one of the lowest current ratios in the restaurant industry and has enough debt that is worrisome considering expected growth rates and operating margins (a weak 3.76%). Shares trade at a 40% premium to book value and at a forward PE of 12.07, fairly high in the current market environment. 

The stock is heavily shorted, with 32.78% of the float short, but shares may have further downside as they currently sit at levels from 2001-2002. $15 looks to be the “last stand” support level, and shares may be due to consolidate after the breakdown at $20. Management recently issued downbeat guidance although margin contraction in Q3 was less than expected. There are a lot of uncertainties with PF Chang’s, especially with the reliance on natural gas prices, so we feel this stock will underperform peers for the next 6 to 12 months.

“Fight Card”

The Trade

JBX: Long 1 March ’09 $17.5/$20 vertical call spread for $1.10

PFCB: Short 1 April ’09 $17.5/$20 vertical call spreads for $1.10 each

Disclosure: none