Second Chance on Lone Star

Almost invariably, the stock market gives second chances to the patient. If you miss a stock's run-up to new highs the first time around, it's typically just a matter of time before Mr. Market, in his next depressive state, gives you another chance.

Such is the case this year with Lone Star Steakhouse (Nasdaq: STAR  ) . The stock started the year around $22, ran up to a high of $33 in April on Atkins fever, and now has fallen back to $22 on twoconsecutive earnings warnings due to record-high beef prices.

The company hasn't been able to pass along these price increases -- not yet, at least -- and so lower profit margins are hurting this year's earnings, which has caused investors to bail ship. But here at $22, Lone Star is back down to a level at which value is evident from several angles.

First, there's the historical perspective, in that $22 is a level that's attracted significant buying interest in the past. In early 2002, Lone Star received a buyout offer of $20.50 per share from buyout firm Bruckmann, Rosser, Sherrill & Co. That offer was ultimately declined, and a few months later Lone Star did a massive share buyback via Dutch auction at $21.38 per share. Combined with other share repurchases in 2002, Lone Star in one year bought back nearly 20% of the outstanding equity -- at an overall average price of $21.25.

Second, there's the perspective of asset value. Lone Star, as of June 30, had tangible book value of roughly $416 million, including $91 million in cash and no debt whatsoever. That compares to a current market cap of around $536 million, or only 1.29 times tangible book. If anything, that ratio is conservative considering the company owns 164 of its 291 restaurant locations and has land (all purchased prior to the current real estate boom) held on the books at historical cost of $113 million.

Third, the dividend yield of 3.1% is getting to a level that should provide support for the stock. Lone Star has paid quarterly dividends since 2000, and has increased its dividend four times since then.

Furthermore, while profits are on course to be lackluster this year, the health of Lone Star's business in terms of sales is outstanding. Comp-store sales growth has been on a tear across each of Lone Star's four concepts:

Lone Star Concepts 2003 2004 YTD*
Lone Star Steakhouse 0.4% 2.3%
Sullivan's 6.6% 8.7%
Del Frisco's 10.6% 28.6%
Texas Land & Cattle** NA 10.6%
* Twenty-four weeks through June 15, 2004.
** Texas Land & Cattle was acquired on Jan. 28, 2004.

Sales for 2004 should be on course to grow about 12% to around $660 million. This growth is largely due to the January 2004 acquisition of Texas Land & Cattle, which added 20 restaurants. The company is very conservative in its expansion, but is in the process of adding a few new Lone Star Steakhouse locations, as well as remodeling a few others (here's the new look). Along with same-store sales growth, this modest level of expansion should allow the company to sustainably grow overall sales in the low-to-mid single-digit range.

How much in free cash flow will these sales produce? In the first six months of 2004, free cash flow amounted to only 2.4% of sales. With high beef prices showing no signs of abating, the 2004 free cash flow margin will likely not top 4%. But obviously this year's results are depressed due to extraordinarily high beef prices.

From a valuation perspective, what matters is not any one year's profits but the sustainable level of earnings power. From 1998 to 2003, Lone Star's free cash flow margin has averaged 6.8%. At some point down the road -- maybe next year or the year after -- I expect Lone Star's margins will again revert to that mean from some combination of lower beef prices and/or higher prices passed along to the consumer.

So in valuing Lone Star, I look at what free cash flow would be at the mean level of profitability, which let's say is a 6.5% free cash flow margin. Applying that margin to Lone Star's $660 million in expected sales for 2004 amounts to "free cash flow power" of $42.9 million, or $1.79 per share.

At yesterday's close of $22.30, the market cap for Lone Star was $536 million. If you back out cash of $91 million, the value of the business (enterprise value) is $444 million, or around $18.50 per share. Thus, the business is selling for a little over 10 times my estimate of free cash flow power. That's pretty reasonable for a business where management is diligent about returning cash to shareholders through growing dividends and opportunistic share buybacks, and where there's little in the way of stock option dilution.

Investors predictably shun companies like Lone Star that are at a trough in their profit cycles. But that's how you get a second chance on a good business at a good price.

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Guest columnist Matthew Richey has been a longtime contributor to The Motley Fool and is a portfolio manager at Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At the time of publication, Centaur Capital held beneficial interest in Lone Star Steakhouse.


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