Why I'm Changing My Outlook on This Company

When Del Frisco's Restaurant (NASDAQ: DFRG  ) went public last year, I wasn't jumping on the wagon. Shares came at a premium price -- and still do 13 months later; the company has a P/E ratio of 35, compared to the industry average of 22. Moreover, shares are up over 50% since the IPO. Yet now, even after this run-up, I'm changing my stance on Del Frisco's. Allow me to share why. 

But first, my bear argument
Rather than taking in the big picture, my entire argument hung on two temporary factors: unfavorable beef prices and a disruptive Hurricane Sandy. 

Beef prices skyrocketed, up to 16% for prime cuts, in 2012 due to the megadrought that gripped America's Midwest. I believed this would crimp profits. But despite the challenge, Del Frisco's management was able to decrease costs as a percentage of sales. 

It also seemed that Del Frisco's was in for a temporary hit as Hurricane Sandy ripped through New York. In 2011, the company derived 18% of all revenue from New York. When the storm shut the city down, I wondered how long it would be before life got back to normal -- normal enough to go out to an upscale steak restaurant. Management acknowledged that its revenue likely took a $1.1 million hit, yet comp-sales were still able to grow 4%, exceeding expectations. 

Both of these factors were temporary and didn't account for the big picture. Even so, Del Frisco's thrived where it could have temporarily stalled.

The bigger picture
When you zoom out to account for the bigger picture, you see a little company achieving big results.

DFRG Revenue TTM Chart

DFRG Revenue TTM data by YCharts

Last quarter, Del Frisco's revenue increased 19% and net income soared 22%. This far outpaced competitor Ruth's Hospitality (NASDAQ: RUTH  ) . Ruth's fundamentals are improving. Net income was up 18%, although revenue was only up 5%. Some of this improvement was due to beef prices. While higher, they are not as high as anticipated, and menu-price increases delivered higher earnings. Unfortunately, Ruth's management foresees beef prices increasing in the second half of 2013 and absorbing some of this net income success. 

Restaurant growth
Though only opening a few restaurants a year, Del Frisco's is outpacing several competitors in the steak arena. 

Restaurant New Units 2012 Percentage Growth
Del Frisco's Restaurant Group 4 13%
Outback Steakhouse (Bloomin' Brands) 8 1%
Fleming's (Bloomin' Brands) 1 2%
Longhorn Steakhouse (Darden) 32 9%
The Capital Grille (Darden) 2 5%

New-unit growth is fairly slow at Bloomin' Brands (NASDAQ: BLMN  ) . Instead, the company is focusing on growing comp sales through remodels. So far this year, 30 Outbacks have been remodeled, leaving 80 more to be remodeled before year end. Management sees the remodel process as one of the main reasons for Outback's 2.8% comp-sales growth. For Bloomin', only Fleming's 3.8% comp-sales growth was better.

Outback is also opening for lunch. This has only been initiated in 25% of Outback restaurants, leaving plenty of room to further grow earnings. Lunch doesn't carry the same profit margin as dinner for the company, so only expect a minor increase to Bloomin's bottom line.

One of the fastest-growing brands at Darden Restaurants  (NYSE: DRI  )  is Longhorn Steakhouse, but growth is starting to slow. The company will go from 44 new units in 2013 to a planned 37 to 40 in 2014. While slower, these 40 locations could grow Darden's top line over 2%. This is the lion's share of the company's 80-unit 2014 growth plan. Any hiccup here would impact Darden in a big way.

While comp sales are important, and a lunch menu contributes to both the top and bottom lines, this growth doesn't compare to the expansion that comes from new units. Del Frisco's is outgrowing the competition, and it may also be, as with Longhorn, that competition is slowing while Del Frisco's is revving up. The company is opening six new locations this year, representing 18% unit growth.

Solid balance sheet
When it comes to these steakhouses, Del Frisco's has the best balance sheet.

RUTH Debt to Equity Ratio Chart

Ruth's debt-to-equity ratio data by YCharts

Both Darden and Bloomin' Brands have some of the highest debt burdens in the industry. These expenses are fairly common in corporate America, but limit a company's ability to return value to shareholders since it must be returned to creditors. Ruth's has smartly been whittling its debt down. Last quarter, it paid off $3 million.

Del Frisco's approach is to fund new units with cash flow. Last quarter, cash flow from operating activities was $7.9 million. The company also had $0.3 million in expenses related to opening just one store. It doesn't take much to see that this strategy of growing from cash flow instead of debt is effective. And someday, when the company is done growing, there will be no outstanding liabilities to worry about.

Conclusion
By overcoming tough situations, operating efficiently, opening new restaurants, and sporting a solid balance sheet, Del Frisco's looks to be a great company to invest in. Having cooled down 17% from July highs, now just might be the time to get in. 

The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.


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