Tuesday, April 13, 1999
Will Investors Get Hungry Soon?
Many non-Internet stocks are being shunned the same way a director striving to make a movie with quality acting would avoid Keanu Reeves. The disdain for stocks not jumping up 10%-20% per week is understandable since so many stocks are actually meeting that criteria. Nonetheless, plenty of companies with earnings are out there growing the bottom line by a respectable 10%-20% annual pace. One sector with attractive prospects but low valuations is casual dining restaurants. These stocks aren't going to get you rich in a couple of weeks, but many of them could yield significant appreciation over the next few years.
Valuations for most companies in the casual dining sector are significantly below those of the S&P 500 index, yet their earnings growth projections tend to be significantly higher than the 4% projected for the overall index. Beyond simply having attractive valuation characteristics, though, these companies also seem to have the economy and industry dynamics in their favor. The currently strong domestic economy should result in continued increases in disposable income, in turn fueling the sales of restaurateurs. With higher levels of cash, people tend to not only go out more often, but also spend more on each occasion.
Capital constraints placed on the industry by the stock market should help the performance of many restaurant companies. Since most of their stocks are trading at low valuations, the companies are unwilling to sell shares to raise cash to fund accelerated unit expansion. Without an influx of outside capital, restaurant companies have been growing their unit counts at much slower rates. Fewer new units means more sales for the existing properties. Higher comparable-store sales then result in higher profitability per store, leading to much improved earnings growth for the restaurant owner.
Recent history actually shows how investors react to slower unit growth and an increased focus on profitability. Fast food companies began focusing on these attributes over the past couple of years. Taking aim at profitability measures such as return on invested capital, McDonald's (NYSE: MCD), Tricon Global Restaurants (NYSE: YUM), and Wendy's (NYSE: WEN) have seen one year stock price jumps of 50%, 135%, and 30%, respectively. These portfolio-fattening returns have occurred after the companies resumed double-digit earnings growth after having previously reported stagnant or declining profit.
Over the past year, many of the casual dining companies have taken a look at profitability and decided that unit expansion may not be the best use of their available capital. They realize that a better investment would be buying up their own stock at bargain prices. The buybacks have been widespread. Over the past year, Brinker International (NYSE: EAT) owner of Chili's, Romano's Macaroni Grill, and On the Border, has repurchased over 1.8 million shares. Uno Restaurant Corp. (NYSE: UNO) issued a tender offer last fall for 1 million of its shares. Darden Restaurants (NYSE: DRI), purveyor of the Olive Garden and Red Lobster, has repurchased 8.7 million shares over the past nine months. Max & Erma's (Nasdaq: MAXE) completed a buyback of 12% of its stock in the fall. CBRL Group, (Nasdaq: CBRL) operator of Cracker Barrel and Logan's Roadhouse, said last September that it planned to repurchase 3 million shares. And those are just some of the announcements.
Concurrent with these stock buybacks, signs are emerging that many restaurant chains are starting to perform better. Last night, Rare Hospitality (Nasdaq: RARE), which owns the Longhorn and Bugaboo Creek steakhouses as well as The Capital Grille, announced that earnings would be well above expectations and the prior year because of strong results at Longhorn. Uno released strong earnings on Monday, driven by a comp-store sales increased 4%. Last month Darden Restaurants reported that same-store sales at the Olive Garden and Red Lobster were up 6.5% and 5.6%, respectively. To sum up, many companies are enjoying surprising strength in their operating results.
Certainly, not all of the companies in casual dining land are enjoying success. Cracker Barrel has been struggling with declines in same-store sales as the chain raised prices too aggressively and endured significant restaurant-level management turnover. Lone Star Steakhouse & Saloon (Nasdaq: STAR) has been suffering from double-digit drops in same-store sales at its namesake units, with labor turmoil again an issue. While other factors may be at play, not being able to retain solid store-level managers seems to be a primary problem facing struggling chains.
Assuming results from casual dining chains continues to be strong, stocks in the sector appear to represent excellent bargains. You might benefit from taking some time out of your day to evaluate these stocks. I would first look for a restaurant chain that you and your friends like. Next, go to the Web and get some information. Find out about the company's cash flow, growth plans, and same-store sales results. Chat with the restaurant manager or your wait person to see what they think of the company. If you like what you see and hear, consider taking the plunge. With accelerating growth, investors may soon get hungry for these stocks.
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