Del Frisco's Restaurant Group Presents a Unique Investing Opportunity

High-growth fast-casual restaurant concepts like Chipotle Mexican Grill dominate the market's coverage of restaurant stocks. There is of course a valid reason for this, with fast-casual restaurants reporting the highest growth in traffic among all categories again in 2013. Interestingly, fine dining came in a close second with 6% overall growth in traffic during 2013. Fine dining remains a highly fragmented market, with companies such as Del Frisco's Restaurant Group (NASDAQ: DFRG  ) and Ruth's Hospitality Group (NASDAQ: RUTH  ) leading the pack of pure-play fine-dining companies. 

Pure-play opportunities
Del Frisco's and Ruth's Chris provide investors with unique opportunities to tap into the growing fine-dining market through pure-play investments. While many other high-end steakhouse chains (and other fine-dining concepts) exist, most are either privately owned or part of larger restaurant groups. For example, The Capital Grille is owned by restaurant conglomerate Darden Restaurants and Flemings Prime Steakhouse is owned by Bloomin' Brands

Capital Grille and Flemings are just two examples of situations where a solidly growing fine-dining concept makes up just a tiny portion of a much-larger company. This is a perfect time to apply Peter Lynch's sage advice in One Up on Wall Street to "investigate whether the product that's supposed to enrich the company is a major part of the company's earnings." In the case of Capital Grille, the concept represents just 53 of Darden's 2,190 locations at the end of the company's most recent quarter; this makes it unlikely that strong performance at Capital Grille will really move the needle for investors in Darden. 

Strong revenue and location growth
To gauge which concepts are really capitalizing on the growth trend in fine dining, it is important to look at revenue growth. This growth comes from both opening up new locations as well as increases in comparable-store sales. The table below provides a quick comparison of Del Frisco's and Ruth's Chris during the first quarter: 

  DFRG RUTH
Revenue growth (as a %) 11.4% 2.9%
     
Current restaurant count (including franchises) 40 157
2014 restaurant openings (estimated) 6
New restaurants as a % of 2013 restaurants 15% 3% 
     
Comparable-store sales growth 1.6% 2.6%* 

Source: Company earnings releases
* Ruth's Chris reported comp-store sales growth reflects only company-owned Ruth's Chris Steak House restaurants and excludes the 4.3% decline in sales at comparable Mitchell's Fish Market locations.  

There is a clear difference in the growth trajectories of these companies. While Del Frisco's reported weaker comparable-store sales (in part due to a shift in fiscal calendar), the most recent quarter marked the 17th consecutive quarter in which Del Frisco's Double Eagle concept recorded positive comparable sales growth. 

Tremendous growth potential from Grille
Aside from the obvious fact that the table above illustrates that Del Frisco's has only a quarter of the locations of Ruth's Chris, there is a growth driver that will propel Del Frisco's to much higher growth: Del Frisco's Grille. The company's new Grille concept combines Del Frisco's signature steak and wine expertise with a selection of upscale yet lower-priced menu items. This new concept targets a slightly younger demographic (25-54) and a mix of affluent urban and suburban areas.

On the most recent earnings call, Del Frisco's management revealed that an outside consulting firm concluded that the company can launch more than 170 Grille locations across the country and expect average unit volume, or AUV, of $5.2 million per location. With only 11 Grille locations open today, this presents a huge opportunity to expand the company's footprint.

Interestingly, Del Frisco's already has evidence in Fort Worth that the opening of a Grille within a few blocks of a Double Eagle Steak House had no discernible impact on the existing Double Eagle location. On the earnings call, management also noted the complimentary nature of the Double Eagle and Grille brands, speculating that an international market partner in a city such as London could open one Double Eagle and four or five Grille locations to build out a successful business.

A look at valuation
Del Frisco's grew revenue by 17% in 2013 and is heading toward another year of double-digit growth. While this growth is an important measure of the company's efforts to differentiate itself and capture market share in the growing fine-dining market, there is more for investors to consider before purchasing shares.

The market is at least partially aware of Del Frisco's growth potential and this is illustrated by the higher forward earnings multiple awarded to Del Frisco's in comparison to its restaurant peers:

DFRG PE Ratio (Forward) Chart

DFRG P/E Ratio (Forward) data by YCharts

While Del Frisco's forward P/E ratio is no longer below 20 as it was when I first suggested that investors take a closer look at the company, the current valuation of around 26 times 2014 earnings is not unreasonable for several reasons. Del Frisco's has no long-term debt, which provides it with multiple financing options (cash, stock, and investment-grade debt) to fund any acceleration in growth rate.

Analysts expect Del Frisco's to grow earnings by 20% annually  over the next five years, which translates into a PEG ratio of 1.3. This doesn't fully reflect the growth potential of Grille in my opinion, but even this relatively conservative PEG of 1.3 is a more reasonable valuation than fast-growing Chipotle's PEG ratio of 1.9.

By comparison, peers such as Ruth's Chris and Bloomin' Brands with lower valuation multiples are expected to grow at lower rates.

Foolish takeaway
Del Frisco's investment thesis is easy to understand, but  quite powerful. The company is rapidly expanding in a growing restaurant category, and is doing so with food, service, and ambiance that is differentiated from the competition. Add in Grille, a new restaurant concept that management believes can grow by more than 1,000% domestically, and the growth thesis is strong.

Meanwhile, management remains focused on disciplined growth that creates a strong balance sheet and results in carefully selected locations for new restaurants. With this proven opportunity and business plan, Del Frisco's trades at a very reasonable valuation. Investors looking for a long-term play on the growing fine dining category should consider adding Del Frisco's to their portfolios. 

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