BJ's Outperforms Restaurant Stocks but May Trade Lower

It’s amazing to see how many retail stocks have booked incredible gains over the past several months. The gains are largely a combination of severely depressed stock prices during the market panic of late 2007 / early 2008, and a very significant change in investor perception regarding how consumers spend available income. The low base coupled with optimism in certain issues has resulted in a handful of stocks with triple digit gains - many of which come from the retail sector.

BJ’s Restaurants, Inc. (BJRI) is one of those stocks which has experienced an incredible rally over the past several months. The stock rallied 174% from its low in November to the recovery high of $18.14 in late April. Since that time, the stock has consolidated its gain as investors attempt to gauge the future growth of the company. On Monday, BJRI was featured in Investor's Business Daily as the “New America” section explained how the company has grown rapidly despite the harsh economic environment.

BJ’s is characterized as a casual restaurant chain although management tries to set itself apart by claiming the “upscale casual” category. An average ticket runs at roughly $12 which is considered a value price point for dining out. Yet BJ’s prefers to compete not on price, but more as a function of the quality and unique dining experience offered to customers. Part of the appeal is certainly the handcraft beer selection which is usually brewed in the company’s own micro-breweries or specific contract brewers. Despite the recessionary environment, the chain has been able to maintain pricing power without having to cut menu prices. This has led to flat same store sales over the first quarter which is a major victory given the challenges faced by most casual restaurants.

Analysts have been generally bullish on the stock citing increasing consumer confidence. As consumers become more comfortable with an economic recovery, they are more likely to dine out. But last week’s employment numbers have likely tarnished that confidence as workers are seeing layoffs increase and even those who remain employed are likely to spend less as concern mounts.

If consumer confidence is important for BJ’s sales, investor confidence is likely 10 times as important for the company’s stock. At this point investors are willing to pay roughly $32 for every dollar of earnings which reflects strong confidence in the company’s growth prospects. While analysts expect 2009 to provide flat earnings levels, the expectation is for 21% growth in 2010. While 21% growth is robust and an attractive rate for this small company, a multiple of 32 still points to a relatively expensive stock price.

Much of investor confidence is based on the company’s aggressive growth plans. While many restaurants are cutting back on the number of locations, BJ’s expects to open an additional 9 to 11 locations in 2009. The locations are likely to be set on prime real estate tracts because of the wide availability for quality retail locations. BJ’s has a relatively attractive balance sheet with low debt and a moderate cash balance. Much of this cash will likely be spent on new store openings, so it will be interesting to see how attractive the balance sheet is at the end of 2009.

Margins in the restaurant business are notoriously very slim. Looking at the first quarter numbers for BJ’s, the company recognized a net profit margin of just 3.6%. This tight profit margin leaves little room for additional economic weakness that we might see in the third and fourth quarter of this year. If sales come in a bit lighter than expectations, the profit level could be drastically impacted as costs will likely remain relatively stable. During the majority of 2008, the company saw earnings drop as rising costs more than offset increases in revenue. Another difficult period could bring the stock back to a much more conservative multiple.

Given the fact that BJ’s is a small company and has significant room to grow, I believe a bit of premium is merited. At this point, a fair value might be 20 times earnings which would represent about a 35% drop in the stock. However, if the economic rebound truly is another few quarters away, current earnings could be sharply lower than expectations. If this were to happen, the multiple could contract to single digits, bringing the stock back to test the lows from November. That scenario is not as likely as a 35% drop, but still appears possible and worth protecting against as an investor.

At this point, I would recommend exiting any long positions in the stock. An aggressive short position might be worth considering with a tight stop a bit above the $18.14 high posted in April. Economic weakness resulting in unemployment, low consumer spending, and increased savings rates could push many stocks in this sector significantly lower.

Disclosure: Author does not have a position in BJRI.

Comments

[Alan Brochstein]

Right on...

2009 Jul 08 08:01 AM