A Cracked Robin's Egg?

As many of you know, Peter Lynch loved to look for ideas based on his wife's shopping habits. "Buy what you know" is one of his mantras.

Let me tell you something I know: Red Robin Gourmet Burgers' (Nasdaq: RRGB  ) Santa Fe Burger is to die for. I'm willing to pay a little more for that tasty treat, and it may make me swear off McDonald's (NYSE: MCD  ) , Burger King (NYSE: BKC  ) , and Wendy's (NYSE: WEN  ) for good.

Start with a Lynch-ism
So in proverbial Peter Lynch style, I made a mental note to dig a little deeper into what the company does and how well it does it. But before I had the chance, Red Robin released its third-quarter earnings.

Sales grew slightly more than 30% for the quarter, mainly because the company opened new stores and acquired restaurants from franchisees. Same-store sales only clicked ahead 0.8%. Unfortunately, profits declined about 8% for the period, despite the excellent sales growth. Rising sales and falling profits don't tend to be the ideal combination of performance.

Add in some pessimism
Top off that overcooked burger with some wilted lettuce (management lowered sales and earnings guidance for the year) and a bitter tomato (Bear Stearns downgraded the stock), and it's no wonder that, on Friday, the stock price dropped from $46 to close at $34, a 26% haircut.

True to my Foolish value-investing form, the drop grabbed my attention, causing me to gather some more data to see if this could, in fact, be an opportunity to profit from the panic.

I first looked for info on the Motley Fool's new CAPS rating service. Thirty-eight of 43 investors rated Red Robin an "outperform" in CAPS. Unfortunately, with last week's big drop, many of them are in the red. However, a few enterprising Fools have popped out of the woodwork to rate the stock early this week.

Lingering questions
But some questions still remain. Can the company recover from the leadership scandal and the slowdown? Will Dave continue to stick with the Santa Fe Burger, or muster up the courage to try something new (see my disclosure below for the answer)? Will Rocky and Bullwinkle be able to escape the clutches of Boris and Natasha one more time? Ok, we know Moose and Squirrel will always make it, and I haven't met too many burgers I haven't liked. So let's focus on the first question. Specifically, let's look at some cash flow and return data to find out whether the fall cracked Red Robin's egg, or whether it can survive and hatch into a beautiful bird.

Since 2001, cash flow from operations has averaged 26% annual growth, significantly outpacing the amount of net income produced. That's a good sign, suggesting well-managed working capital requirements and robust earnings quality. Free cash flow is negative, as the company continues to raise capital to fund growth. That's to be expected for a company still in its early stages of growth. It's debt capital, something to be mindful of, but the most recent debt-to-capital ratio is about 33%, according to CapitalIQ.

Follow the return, not just the cash
Good food, good growth prospects, and good cash flows. What's stopping me from scooping up shares? Returns on invested capital (ROIC). The table below shows Red Robin's ROIC performance over the last four years.

FY2002

FY2003

FY2004

FY2005

ROIC

9.6%

9.2%

10%

9.9%

Adjusted to account for operating leases.

Those results confound me. Red Robin's averaged about 10% over the past four years while increasing the amount of capital allocated to opening new restaurants. That's probably about breakeven from a value-creation standpoint. But remember that Red Robin is raising capital to build out its store base, so we need to be mindful of the lag between when capital is spent, and when that capital generates returns.

ROIC is an important performance metric for me, and I think it should be an important one for you, too. I try to figure out whether a company has a competitive advantage. If so, it usually enjoys high and rising levels of ROIC. That doesn't necessarily seem to be the case for Red Robin. The company can attract people to pay up for upscale burgers in a pretty festive atmosphere, but who's to say that someone can't come in and create an even better burger, in an even more fun-filled atmosphere? Restaurants are a tough gig; they're easy to start and hard to keep going.

The Foolish bottom line
So what's a Fool to do? I say, keep it high on the watch list, and run some different scenarios for changes in ROIC. That's the best way to see whether Red Robin, at these levels, is a value or a value trap. I'm leaning toward "value" right now, but the data isn't overwhelming just yet.

For more thoughts whether Red Robin can cut the mustard, check out:

Have an opinion about Red Robin? Join CAPS and let your voice be heard!

The best restaurants aren't always the most crowded ones, and the best stocks aren't always the highest-priced. Discover Philip Durell's full menu of mouth-watering market bargains with a free trial toMotley Fool Inside Value.

Retail editor and Inside Value team memberDavid Meiertried the 'Shroom Burger the other day: Nice! He does not own shares of any of the companies mentioned. He is currently ranked 60 out of 12,408 investors in The Motley Fool's CAPS rating service. You can view his TMF profilehere. The Fool takes itsdisclosure policyvery seriously.


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