Thinking of Investing in Restaurant Stocks? Prepare for Indigestion

A year ago, I highlighted the fast casual restaurant segment favorably, suggesting these chains would benefit from falling input costs and a slowdown in expansion. Most of the stocks mentioned are higher today despite the overall market being down. I followed that article up a few days later with a explanation of why I bought BJ's Restaurants (BJRI), which turned out to be a real winner.

While most of the stocks mentioned are up, the path wasn't so straight, as all of these stocks were hammered in the October massacre. I had alluded to the too-high debt levels of many of these companies, and those were the ones that fared the worst. Several, in fact, suffered losses over the ensuing months of 80-90%.

I certainly have been impressed with the resurgence in these stocks. In addition to the headwinds of rising input costs for the restaurants and gasoline and other expenses for their consumers abating and reversing, several other factors have helped the sector to do relatively well despite the overall weaker economy. First, the expansions have pretty much halted. I had mentioned in the article a year ago that P.F. Chang's (PFCB) had already strategically decided to focus on its existing portfolio rather than opening more restaurants. I will give an example below of how the math works, but these companies have cut expenses by slowing or halting expansion. A second reason for stabilization is likely share gains. I don't have hard data, but the credit crunch buried some weak players like Bennigan's and countless other smaller competitors. Finally, the "comps" were pretty easy, as the industry has been struggling for a while.

Let's take a look at the data. The table below (click to enlarge) is pretty similar to the one I shared a year ago, though there is one additional company, the tiny Mexican chain Rubio's (RUBO). Here is the universe of fast casual chains sorted by how they have performed over the past year:

A few observations:

• The key information is that earnings for the group this year are projected to rise a median 11% - this is why the group has performed well
• Over the past year, the median return for the group is over 6%, while the S&P 500 is down about 20%
• The biggest change in the data is the FCF yield - as CapEx has halted, it has shot up
• Debt levels are still quite high typically
• While some of the YTD returns are spectacular, they represent escape from near-death (I highlighted 4 that are more than 4X off the lows that, on average, have still lagged the group)

As I look out, I am not that optimistic for the group to continue beating the market. I believe that the strong performance came from very pessimistic assumptions a year ago followed by non-recurring cost improvements. In the coming year, traffic is unlikely to escalate, as the economy remains sluggish with continuing labor market woes. Unlike other companies, these derive all of their business from the domestic economy. But my biggest concern is that investors are not understanding the real source of earnings growth and that it isn't sustainable: slowing down store openings.

I listened to two calls recently, BJ's and Texas Roadhouse (TXRH). In both cases, earnings growth for the quarter was quite strong. For BJRI, which showed 45% EPS growth y-o-y, new restaurant opening expenses declined year-over-year. Were it not for this dynamic, growth would have been 15% or so (still quite strong). This remains, by the way, one of my favorites in the group, though I find it a bit expensive.

For TXRH, which reported EBIT growth of 20%, over half came from this same phenomenon. SG&A fell 9% while sales rose 12% (all from openings over the past year, as s-s-s were slightly negative). The strong growth historically for these chains and their peers has come from expansion. I don't believe that investors are going to pay high multiples for restaurants that aren't going to expand. I wrote about TXRH two years ago when it operated or franchised 270 restaurants. Now it operates 325. Q3 earnings calls should be quite interesting, as analysts are anxious to learn about plans for 2010.

For restaurants to do well in the next year, they will need to see better same-store sales. Traffic figures have been, not surprisingly, weak all year, and some chains reported a fall-off in July. Pricing has become much more aggressive as well, with companies acting extremely promotional to keep market share.

If these companies begin expanding again, the cost pressures of openings will be a big drag on earnings. So, the way I look at it is that in a weak economy, pressure will most likely remain on the revenue line, and the companies won't be enjoying input price declines to the extent that they have this year or the strong improvement in opening costs. This bodes for flat or even negative earnings growth, depending upon how weak the top-line might be. On the other hand, if business picks up, the restaurants are likely to depress their earnings by reinvesting in long-term growth. In either case, I expect a year from now to find most of these stocks trading at levels near or below the current prices.

As far as particular stories, BJRI is a gem. I continue to think that their strong balance sheet, high perceived value and their relatively small size gives investors potentially a good shot at going along for the ride from 85 to 300 locations. Most impressively, the company has had higher comps than other chains despite its very strong presence in the economically challenged California.

TXRH, which I visited last month, should face continuing challenges. My thesis on the company is that they cater to a lot of families, and this segment is under pressure. There are just too many cheaper alternatives despite the high value that they do offer. When both parents are working, the concept works well. My concerns are that they are hurt worse than average by the economy. Their comps dipped dramatically in July, and they are changing their store-opening philosophy (end-caps), which could result in problems down the road.

I wrote negatively recently about DineEquity (DIN), and worry about their high level of debt and the fact that they grabbed a lot of low-hanging fruit as they sold off Applebee's franchises. They are probably going to issue stock shortly, and the filing along with disappointment regarding their near-term franchising outlook knocked 1/4 off the stock. I actually ate at an IHOP last week and found it to be surprisingly "refeshed" - they actually had healthy items on the menu. I don't know about Applebee's, but the IHOP value proposition is extremely high. My best guess at this point is that the stock will struggle due to the high debt burden. I plan to reassess it after the equity offering.

I don't know the Cracker Barrel (CBRL) story, but it looks very unattractive on the surface. They have a ton of debt. They have slowed their CapEx, but it is still higher than D&A. At the rate they generate FCF, it would take at least 10 years to pay off their debt. Further, their dividend might be at risk. Their fiscal year just ended, and the summer is their big season, so the call in September will be interesting.

My caution on the group has a lot to do with my negative view on the consumer, but it also reflects my concern that investors don't quite understand the dynamics that have led to rising earnings on negative same-store sales. The top-line growth next year will be negatively impacted by the lack of openings this year, while the bottom-line won't likely be helped by improved pricing, lower input costs or a further slow-down in store openings. In a best-case environment, consumers start spending more freely, costs don't rise and the restaurants decide to continue their slowdown in new openings, as this will result in earnings growth. I wouldn't count on that scenario.

Disclosure: No positions in any stocks mentioned

Comments

[John Gordon:]

Alan's article is very thoughtful. I'd make just a few supplementary comments:

Restaurants can get only so much out of lower commodity costs, and other controllable cost reductions. While cost reductions essentially flow to the bottom line 100%, there is only so far that can go. The controllable operating cost reductions, and that some analysts underestimated the significant commodity cost reductions from the summer 2008 peaks, drove virtually all of the earnings upsides this spring and summer.

Casual sales and traffic dining has been weak for some time, and continues. QSR is now weak, as well. In all the earnings calls last two weeks, I was impressed that CAKE had sales down 3.2% and traffic down only 3.8%. CAKE has rolled out a small plates program that did not destroy the average check (in fact, check up .6%, subcomponent pricing +2.2%). They also aren't discounting. We will visit and take notes.

Keep in mind CAKE is really a niche player, with about 150 units. Broad national/international operators with thousands of units like Darden (DRI), Brinker (EAT), Outback and others have different situations. The geography, price/value perception and franchisee/frachisor base are all different.

The agility of the R&D new product discipline is also critical. I bet Brinker wished it tested its 10 for $7 program further, before rolling it out systemwide (and then yanking it, after poor response).

Near term: store level commodity costs should be lower for most in the near term and some easier sales comparables versus the steep falloff experienced in October-December 2008 should be some positive factors. Traffic looks weak in absolute terms.

John A. Gordon
Chain Restaurant Earnings and Economics Experts
pacificmanagementconsu...

Disclosure: no stock positions

Aug 10 10:38 AM

[Monica Hahn:]

You guys hit the nail on the head. The unfortunate truth in this business is that most investors don't really understand the restaurant business. They don't understand how it really makes money, therefore stocks don't really trade on sound fundamentals. They continue to think they can drive the value of these companies by focusing on the middle of the P&L, instead of investing in the value propositions that will create organic growth by improving the customer experience.

Aug 10 05:26 PM