Fool on the Hill: Looking Through the Outback

An Investment Opinion

Looking Through the Outback

By Warren Gump (TMF Gump)
September 21, 1999

Outback Steakhouse (NYSE: OSSI) is a restaurant enterprise for which I have the utmost respect, both as an investor and a customer. By offering customers quality meals at reasonable prices, the company has been able to grow steadily and rapidly throughout the decade, providing an excellent shareholder return. Every time the stock is knocked down to a seemingly reasonable valuation level, I like to revisit the company and see what's happening. Now seems to be one of those times, with the stock off 30% from its June high, a price-to-earnings ratio (P/E) of less than 18, and a P/E-to-estimated-growth ratio around 1.0.

When a stock of a quality company falls substantially, one has to ask what's going on. Is the company facing any problems? I can't detect any serious problems for the company based on recent results and trends. Its second quarter earnings per share (EPS) were up 21%, driven by new unit growth and strong comparable sales gains for its two concepts, Outback Steakhouse (comps up 6.1%) and Carrabba's Italian Grill (6.6%). Operating margins hit 14.3%, up from 13.1% the prior year as the company raised prices modestly and costs for many commodities food items like beef, produce, and butter fell. These results are fairly consistent with those from the past several quarters, and most analysts are looking for 15-18% EPS growth to continue.

Given that information, Outback's reported results don't do a heck of a lot in explaining why the stock is not in favor. Recent earnings announcements are positive and everything points to continued strength. Stepping back a couple of steps to look at the casual dining industry rather than Outback, it becomes clear that the overall sector has been out of favor. Two other big industry players, Darden Restaurants (NYSE: DRI) -- operator of Red Lobster and the Olive Garden -- and Brinker International (NYSE: EAT) -- which operates Chili's, Romano's Macaroni Grill, Cozymel's, and On the Border -- have also fallen from their highs earlier in the year.

One concern for many restaurants is that they are facing increasing labor costs, but they are unable to pass higher costs through to consumers via price increases without losing business. You'd have to have your head stuck in the sand not to know that restaurateurs are struggling to find enough bodies to operate their businesses. With the economy booming and jobs plentiful, many people are attracted to positions outside foodservice that are considered more lucrative. The result has been that most restaurants are paying more than ever to attract staff -- and they're still coming up short in many locations.

Outback has been impacted by this trend toward higher compensation, but it has not become too severe. In the latest quarter, labor and related costs increased slightly to 23.5% of sales from 23.4%. From an operational standpoint, a more important issue is finding and retaining quality general managers to help oversee each restaurant. Outback has an unusual management structure that helps mitigate this problem. If you want to become a manager of an Outback, you need to sign a five-year employment contract and invest $25,000 to acquire a 10% interest in the restaurant.

This structure gives Outback a leg up over its competitors. By sharing a significant portion of restaurant profits with each general manager, the company can attract some of the best people in the business and keep them motivated. On top of that, the five-year employment contract helps minimize turnover, which is a major problem for many restaurant chains -- particularly as the tight labor market makes finding quality general managers even tougher to find.

On the issue of raising prices, Outback has been one of the few chains that has been willing to pass through small increases to customers. Last fall, the company instituted a 1.5% increase at Outback and a 2.0% increase at Carrabba's. Considering the strong same-store sales that have been achieved since that increase, it doesn't look like the higher prices significantly altered customer demand. This attests to the brand's strength and demonstrates that the company has a little pricing power in an industry where none was thought to exist.

A big question for Outback is where it will grow next. Rising from one steakhouse 11 years ago, the company now operates 565 Outbacks (437 owned, 128 franchised and joint ventures) and 66 Carrabba's (53 owned and 13 joint ventures). According to one report, the company thinks that the U.S. market will support a total of 650-700
Outbacks, leaving only another couple years of growth at the chain's current expansion rate of roughly 75 units a year. The company recognizes this challenge and is prepared to address it.

International opportunities would seem to provide plenty of room for growth. While there is a vast world out there, results from current international units are mixed. To minimize risk and get a better feel for various markets, the company is cautiously expanding into different worldwide markets using joint ventures. Management has said that they view Hong Kong and Brazil as two of the more promising markets. As operations are refined and improved, the company might develop a substantial international presence, but it's way too early to count on that. Casual dining restaurants are very difficult to export.

Carrabba's is an obvious expansion vehicle, but the company hasn't yet been able to get the returns to a level that justify a rapid rollout. The chain will likely continue to grow, but it won't provide nearly enough oomph! to maintain the company's rapid historical growth rate. To do that, Outback is looking at several growth vehicles. The company has recently created a joint venture with Roy Yamaguchi to expand his successful Roy's Restaurants that serve Euro-Asian cuisine. In addition, the company is developing both an upscale steakhouse and a Creole/New Orleans concept to provide growth opportunities.

Growing or developing a new chain is going to be more challenging that rolling out a proven concept, but Outback has the financial resources to develop or buy something that will work. During the first six months of the year, cash generated by operations stood at $75 million, while capital expenditures totaled only $45 million. Much of that difference was used to pay down debt, of which there was only $2 million at the end of June. With debt paid down and almost $76 million in the bank, the company has extraordinary financial strength that is not matched by many competitors.

You never can be certain about a stock's future performance, but Outback the company has a lot of great attributes. It has a management team that has successfully managed rapid growth, at least two more years of solid unit growth from the Outback chain, a stellar balance sheet, and numerous growth opportunities lurking under the hood. Given those characteristics and the company's valuation, this is one stock I wouldn't mind welcoming to my portfolio with a hearty "G'day, Mate."