Sure, the steak may taste great, but you don't have to be a meat-eater to appreciate this company's potential.
I present you with Ruth's Hospitality Group (Nasdaq: RUTH ) .
You see, for just $6.50 -- less than a haircut these days -- you can with 100% sincerity claim to own a steakhouse.
OK, OK: You will technically own a 43 millionth of 67 steakhouses (including Cameron's Steakhouse), royalties from another 67 franchised locations, as well as a smattering of seafood restaurants, but who's counting really?
The fact remains that when you buy a share of stock you are buying partial ownership of a business. Thus I would have no moral objections to Ruth's shareholders walking into a Ruth's Chris Steakhouse like they owned the place.
And Goodfellas fantasies notwithstanding, being a Ruth's shareholder is looking pretty good right now for owners who can stomach volatility. Here's why.
The power of operating leverage
In order to see why Ruth's could be a wonderful investment, it's important to understand how operating leverage can make or break a company. For that, let's take a trip in the WABAC machine.
The year is 2001. McDonald's (NYSE: MCD ) is priced around $27 per share and is making $782 million in free cash flow. Sales stand at $14.9 billion. The company is an established leader and is trading at 21.2 times earnings.
Fast-forward to today. Sales now stand at $24 billion, a 5.5% annualized increase from 2001's sales numbers. This means sales growth was just slightly above inflation.
So did McDonald's stock grow at just 5.5% per year? Heck no. McDonald's stock went up 14.2% annually compounded from 2001 to today. And that's not including return from dividends.
What happened, you see, is that operating income grew by 12.2% compounded, not the 5.5% compounded, as revenue would suggest. And free cash flow grew at an even more ferocious 18.3% compounded.
This phenomenon of small increases/decreases in sales leading to tremendous increases/decreases in operating income is known as operating leverage. And because of high fixed costs (marketing, etc.) and low variable costs, restaurant franchisers like McDonald's have operating leverage in spades.
Not all restaurant chains are like this. While the vast majority of McDonald's restaurants are franchised, restaurant behemoth Darden (NYSE: DRI ) owns the overwhelming majority of its restaurants (such as Ruth's Chris competitors Capital Grille and LongHorn Steakhouse). As a result, Darden does not have anywhere near the kind of operating leverage that McDonald's has.
But Darden does have a greater amount of another kind of leverage, financial leverage. This makes sense since the company has virtually no operating leverage to worry about.
Leverage is why Ruth's five consecutive quarters of same-store sales growth in its flagship brand (Ruth's Chris) matters. Small changes in revenue can have a tremendously large effect on future profitability. Ruth both operates (like Darden) and franchises (like McDonald's) in approximately equal amounts, so it has a hefty amount of operating leverage.
In just the last quarter, Ruth's overall revenue increased from $94.7 million to $98.8 million. Or 4.4%. But operating income -- excluding a one-time benefit in 2010 -- increased nearly 9% year over year. That's operating leverage.
But in Ruth's case this operating leverage gets turbocharged by high income elasticity of demand. That's fancy econ speak for a small change in individual income leading to large changes in demand for a good.
And with an average check of $70 per guest, you can bet that demand for Ruth's steaks and seafood depends mightily on how well the economy is doing.
So as the economy improves, even slowly, Ruth's bottom line should shoot up from increased demand amplified by high operating leverage, as I think we already started to see last quarter. The combination should power the stock forward like a speeding bullet train.
Valuation, valuation, valuation
You may be thinking there must be a downside to all this juicy high leverage and high income elasticity of demand. And you'd be right.
It's a sword that cuts both ways. Entering a recovery, leverage is a Godsend, and when entering a recession, leverage is a menace. Even a successful and relatively inelastic restaurant operator such as Chipotle Mexican Grill (NYSE: CMG ) saws its shares plummet from $151 to $39 during the Great Recession, only to fly back to $328.22 during the recovery.
So you can imagine what owning a steakhouse must be like. Ruth's has seen its share price as high as $23 and as low as (not a typo) $0.74, and now back up to $6.50. How's that for volatility?
But I think risk may be overdone: Ruth's trades at about 10 times forward free cash flow, or a 10% free cash flow yield. And Ruth's operating income covers its interest payments by a factor of 6.8 times, making default now unlikely in my opinion.
And if it can still deliver 10% in a bad economy, what could it do -- with all that leverage and income elasticity -- in a halfway decent one?
We'll find out in part when Ruth's reports earnings Friday. Stay tuned.