MSSR Poised to Endure Recession

Highlights include McCormick & Schmick's Seafood Restaurants (MSSR - Snapshot Report), Morton's Restaurant Group, Inc. (MRT - Snapshot Report) and Ruth's Hospitality Group, Inc. (RUTH - Snapshot Report).

As the market declined and the restaurant sector dived Friday, shares of McCormick & Schmick's Seafood Restaurants (MSSR - Snapshot Report) gained 17% despite reporting dismal earnings and a dark outlook Thursday night. Investors are apparently reassured that McCormick can weather the deepening recession with its tight cost control, strong balance sheet and positive free cash flow.

Excluding roughly $5.15 in one-time impairment charges, EPS from continuing operations fell 33% to $0.16 in 4Q08.  We were expecting $0.14. Guidance calls for EPS to fall 56% to $0.20 in 2009 from $0.45 in 2008.

It came as no surprise that more diners are trading down or eating at home. Same-store sales at the high-end seafood chain tumbled 13.5% in 4Q08 after sliding 1.4% in the year-ago quarter, and remain down 13% thus far this year with no visibility to an upturn other than easing comps in 1Q10.

But the company is adroitly controlling what it can: food, labor and overhead costs. Despite commodity and labor inflation, seen throughout the industry, McCormick's food and labor costs as a proportion of sales grew just one-third of one percent during 4Q08, and management expects to lower those costs in 2009.

Cost savings have been wrung from G&A, which management slashed G&A by one-third as sales stalled (down 0.7%). The company continues to right-size its business, squeezing costs wherever possible – a feat not accomplished at many of MSSR's competitors.

After opening two restaurants thus far this year, the company has stopped building new units, which should leave enough operating cash flow in 2009 to repay all of its $24 million in outstanding debt, even if same-store sales continue to fall at their current low-teens rate. This positive levered free cash flow and low debt-load separate McCormick and Schmick's from its debt-laden upscale competitors, Morton's (MRT - Snapshot Report) and Ruth's Chris (RUTH - Snapshot Report).

Shares of the company appear inexpensive near-term, trading at 8.6x estimated 2009 earnings, well below its projected five-year growth rate of 13%. MSSR's market cap is just $25 million, slightly above MSSR's projected free cash flow of $22 million for 2009. Looked at another way, McCormick has enough availability on its revolving bank facility ($66 million) to (in theory) buy back all its common stock.

Longer-term, we question whether McCormick's will ever achieve superior investment returns. ROIC and ROE peaked at less than 9%, the industry's last full year of rising traffic and same-store sales.