Restaurant Industry

Bites of Opportunity Remain in Overcooked Sector

OVERVIEW

Restaurant stocks have room on the downside

Restaurant stock prices have doubled since their November lows, which were retested in March. The Zacks Restaurant Index has surged 211% from its 52-week lows, far outpacing both the Russell 2000 (up 63%) and the S&P 500 index (up 48%). The major indexes remain roughly 25% off their 52-week highs.

Valuation multiples have expanded from trough levels and the group now trades at roughly 15 times 2010 earnings. While there are pockets of opportunity in the sector, we think the recovery will be slower than anticipated by the market, weighed down by a consumer sobered by shriveling home values and retirement portfolios and record levels of debt.

Casual dining cooks up positive earnings surprises, but offers no sustenance

Driving the restaurant stock rally, was a slew of better-than-expected earnings reports – and upward earnings estimate revisions -- including those by Darden Restaurants (DRI - Analyst Report), Brinker International (EAT - Snapshot Report), Ruby Tuesday (RT - Snapshot Report) and California Pizza Kitchen (CPKI - Analyst Report). 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 and had 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.

Highly-leveraged companies rocket as credit markets thaw

Some of the steepest stock price gains in the restaurant sector, as in the overall market, were made by those of highly leveraged companies at risk of covenant violations or bankruptcy as sales shrank. As the credit markets thawed and it appeared less likely that these companies were headed towards bankruptcy, this group soared, including Ruby Tuesday (+785%), O’Charley’s (+776%), Dine Equity (+388%) and Einstein Noah (+319%).

Valuation multiples are not justified by fundamentals

Consensus estimates incorporate a 15% earnings growth in 2010 off expected growth of 33% in 2009 and almost no growth in 2008.

In the midst of what is expected to be a tepid recovery, we think 2010 earnings estimates may be challenging. 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.

Casual Dining plagued by excess capacity

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 restaurants 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.

Upscale Segment

Like the casual dining segment, upscale restaurants proliferated over the last decade as the economy thrived. The degree of upscale overcapacity appears less severe, however; in part we believe this is because the segment is not dominated by public chains but rather by smaller private chains (Roys, Flemings, Palm, etc.) and by slews of independent operators.

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 (+6.4 in 1Q09) in the industry and a history of superior ROE and ROIC.

The successful chain’s Achilles heel is its high leverage to the price of chicken wings -- roughly 21% of sales -- which are volatile and have soared 40% since December to nearly $1.80 per pound in March (the latest data available at the time of this writing). Impressively, BWLD has contained food costs with menu price increases.

WEAKNESSES

Underweight Casual Dining and Upscale

Given the sector’s recent multiple expansion, coupled with an expected slow recovery, we recommend underweighting both the casual dining and upscale segments of the industry, particularly companies that lack differentiation or suffer from an outsized cost structure. We expect that any earnings disappointments would be met with immediate sharp stock price corrections.

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.