Casual Dining Too Pricey to Nibble On

OVERVIEW

Restaurant stocks sizzle

Casual dining restaurant stocks are sizzling. The Zacks Casual Dining Restaurant Index has surged 218% from its November lows, far outpacing both the Russell 2000 (up 37%) and the S&P 500 index (up 28%). The Russell 2000 and the S&P index both remain roughly 40% off their 52-week highs. And although the Zacks Casual Dining index is 30% from its high, there appears to be more downside risk than upside potential.

Casual dining cooks up positive earnings surprises but offers no sustenance

The chief catalysts in the recent restaurant stock rally were better-than-expected earnings reports by Darden Restaurants ( DRI - Analyst Report ) , Brinker International ( EAT - Analyst Report ) , Ruby Tuesday ( RT - Snapshot Report ) and California Pizza Kitchen ( ) . With the exception of Darden, however, the out-performance was driven by strong cost controls, decelerating commodity prices and conservative assumptions.

Darden was the only operator that saw customer traffic improve in January and February -- though two months during milder-than-normal weather does not a trend make -- and that limited same-store sales declines to the low single-digits (down 3.2% in its latest quarter). The remaining three earnings out-performers saw same-store sales fall at a mid-to-high single digit rate in 1Q09, and those results were bolstered by menu price increases, masking steeper drops in customer traffic.

Valuation multiples are not justified by fundamentals

The surge in stock prices has expanded the casual dining group's valuation multiples to about 17.4x 2010 consensus EPS estimates -- while 2010 estimates remain at levels equating to just 10-12% year-over-year growth. To be sure, we think 2010 industry earnings won't exceed 2008 levels.

While there is little visibility to 2010 earnings and ample time for positive estimate revisions, upside surprise is unlikely. There are three potential drivers of net income growth: unit expansion, improved same-store sales and cost cuts.

There seems little chance that upside will come from more aggressive unit expansion, as current development plans remain extremely light and restaurant development takes about 18 months from planning to opening.

The second driver, same-store sales growth, consists of price increases and revitalized customer traffic. Any price increases, other than the most minimal, would likely serve only to drive value-conscious customers elsewhere in this fiercely-competitive environment. Likewise, a brisk resurgence in customer traffic in 2010 is anything but guaranteed, especially in the first half of the year.

The majority of economists expect unemployment to continue rising into the second half of 2010, after reaching levels not seen in decades. Consequently, it is more likely that this time around the consumer's recovery will be slower than in past recessions, because this one was deeper and longer. When employment resumes, consumers will be saddled with debt -- which is currently at record levels. Without the subsidies from rocketing home values that consumers had come to rely on the last decade, a return to thrift may be in vogue.

Finally, some of the cost cuts achieved in the last two quarters will anniversary in 2010. These include labor savings from new scheduling systems and food waste savings from new kitchen technology. Commodities, however, seem set to continue decelerating with the economy, enabling some casual dining chains to lure cash-strapped diners with value menu offerings like the quick service operators have done so well. Brinker International's three concepts -- Chili's, On The Border and Maggiano's -- have each launched their own value menus.

Excess industry capacity looms

When the economy recovers, the casual dining industry will continue to suffer from an oversupply of capacity and lack of differentiation, particularly in the crowded bar and grill segment. To meet investors' expectations for growth, publicly traded restaurant chains expanded faster than demand for years, and in the mid-1990's, began opening units in less-traffic locations when "A" sites became scarce.

As the recession eroded sales and tightened credit, most casual dining operators finally began curtailing unit growth and closing those that were under-performing -- for some, this is years after profitability began to sag. Independent restaurants and small franchisers with fewer resources to weather the recession are closing at a rapid clip.

But to date, most large chains have closed relatively small numbers of under-performing units. S&A Restaurant Corp., the parent of Bennigan's and Steak & Ale restaurants, filed for Chapter 7 bankruptcy last June, but many of the units remain in operation. Consequently, despite curtailed growth and a growing number of bankruptcies, industry capacity has not meaningfully shrunk the way it did in the quick service segment a few years ago.

WEAKNESSES

Casual dining underweight recommended

Given the sector's recent multiple expansion, coupled with an expected slow recovery, we recommend underweighting the casual dining industry, particularly companies that lack differentiation or suffer from an outsized cost structure. We expect that any earnings disappointments or change in the overall economic outlook would be met with sharp stock price corrections and valuation multiple contractions.

We are maintaining our Sell ratings on casual dining growth chains that continue to grow, despite sub-par profitability. BJ's Restaurants ( BJRI - Analyst Report ) and Red Robin Gourmet Burgers ( RRGB - Analyst Report ) are two examples.

OPPORTUNITIES

Buy "best of breed"

For buying opportunities, we would look for pullbacks in companies with strong brands that offer good value propositions and have a history of superior profitability and shareholder returns. Companies able to contain costs will have the ability to offer a "value" menu without squeezing margins, thereby boosting sales without sacrificing profitability.

Darden Restaurants ( DRI - Analyst Report ) is our best example. We would also be a buyer of Buffalo Wild Wings ( BWLD - Analyst Report ) on a sharp pullback. The company offers investors the strongest growth (25% EPS growth expected in 2009) and same-store sales (+4.5 in 4Q08) in the industry and a history of superior ROE and ROIC. However, the company is highly levered to the price of chicken wings (roughly 21% of sales), which has soared 39% since December, leaving estimates particularly vulnerable and too much risk in the stock at the current valuation of 18x the 2010 consensus EPS estimate.