Time To Start Nibbling at Restaurants?

by: Alan Brochstein, CFA

There is an apparently large faction of people who expect that Americans, weighed down by their debt burdens and facing rising costs, will abandon restaurants and start cooking.  Yeah, right.  While I have been very negative on the industry, I want to say that I am rapidly warming up.  Similar to my recent views on Whole Foods (WFMI), the bear trade has played out, perhaps to an extreme.  In particular, I was bearish on two names and shared my views:

I have no position in any restaurant stock at present, though I am personally very overweight the Consumer Discretionary sector and have significant exposure relative to the market in my two model portfolios - Top 20 and Conservative Growth/Balanced.  I covered my shorts too early on both names.  I confess still to never having stepped foot into either establishment.  For that matter, I don't believe that I have stepped foot into any of the names in the table below except California Pizza Kitchen (NASDAQ:CPKI) once, but being a glutton and a wino qualifies me to at least understand what goes on in these places!  Let's just say I am not much of a chain kind of guy when it comes to food and drink.

Before laying out the bullish case for investing in restaurant chains, let's review why they absolutely stunk as investments over the past year or longer.  Here are my reasons, in no special order:

  1. Customers getting pinched on discretionary income (rising costs, rising interest on adjustables)
  2. Input prices killing them (nat gas, labor, food,
  3. Biz models dependent upon store expansions vs. unfriendly capital markets
  4. Valuations were too high considering same-store-sales deceleration
  5. Some companies boosted growth by buying out franchisees (not sustainable growth)
  6. Balance sheets not exactly pristine
  7. Cash flow generation (lack there of) not a good thing

I am sure that there are some other good reasons, but these pretty much cover the bases:  Costs up, demand down, valuation too high.  Now, though, the story is out, in my opinion.  The valuations have come down.  Some chains - PF Chang's (NASDAQ:PFCB) comes to mind in particular - have curbed expansion plans to focus on growth within the existing restaurants, and the ever-increasing input cost pressure may now actually be over.  Natural gas prices have plunged, and food inflation looks now to be behind us.  The longer-term bull case of convenience in a society starved for time can now play out. 

The table below lays out some metrics for the companies that I follow peripherally.  Note that PFCB, the first to scale back expansion, has reversed its multi-year downtrend.  I am not going to say which stock I would buy today, as I haven't really thought that through, though the highlighted ones would be the first ones I would evaluate.  I really just wanted to share that I am no longer bearish on the industry and expect that it could at least bounce here.

These companies, all of which I believe are "full-service" restaurants, are hopefully an inclusive list - please let me know if I have omitted one or erroneously included one:

O.K.  So, what are we looking at?  Here are a few observations:
  • What is that smell?  Worse than the dumpsters behind these restaurants - down over 20% this year after falling 29% or so last year
  • LEVERAGE - Lots of debt, not even including operating leases
  • Where is the cash flow?  Expansion (3rd to last column - zippo)
  • Discounted Margins - 6% EBIT compared to close to 8% normally
  • Discounted valuation:  PEs are about 60% of the past few years, P/S even worse at 40% median
  • Some "deep value":  P/TB is 1.7 median, but FRS, CHUX, BJRI and BNHNA all very low despite relatively strong balance sheets
Here are my brief uneducated and probably irrelevant comments on some of the names:
  • DRI:  Lots of debt and margins too high, but lots of shorts I believe (and lots of market cap)
  • PFCB: got my attention for reigning in expansion and looks solid to me
  • BOBE:  I don't know what it even is, but it's up this year and seems reasonable - rising estimates?
  • EAT:  Whoops - been to Chili's - forgot to mention that above, margins are too high
  • FRS:  Huh?  Looks pretty good for one I have never heard of - nice balance sheet and cheap
  • CPKI: Looks o.k.
  • TXRH:  Nice balance sheet and great valuation - open for lunch, guys!
  • RRGB:  I hear good things about this one from my family - seems reasonable
  • CBRL:  I plead ignorance again - most of profits come from restaurant not store - too much debt for me
  • CHUX:  May have eaten here in a different life (and probably against my better judgment) at Madison Square Garden - dirt cheap, only one way for margins to go, decent balance sheet
  • LNY:  I live too close to Mr. Fertitta to tell you what I really think, but if you didn't sell this stock, you had your chance
  • RT:  I will be surprised if they survive
  • BJRI:  First on my list to investigate further - deep value in some ways, but high PE - no debt
  • DIN:  Sounds better than IHOP, too much debt
  • SNS:  The only thing that has been shaken is the earnings and free cash flow
  • CAKE:  I almost highlighted it - probably works and seems to have low expectations embedded
  • BNHNA:  Nice balance sheet, my friend Chris loves it (they are contrarians), founder just died.

In summary, I don't know much about any of these companies, but their odor is starting to become a bit more appealing.  If any of you care to enlighten me further, especially about BJRI or perhaps even CHUX, I encourage you to either respond here or consider emailing me.

Disclosure:  I don't have positions in any stocks mentioned in this report, though I did buy some WFMI early this morning but sold it already.  I may buy WFMI before and/or after they report today.