Tasty Values for Patient Investors [Fool on the Hill] July 20, 2000

FOOL ON THE HILL: An Investment Opinion
Tasty Values for Patient Investors

Neither value investing nor restaurant stocks have been in favor over the past few years, but such a combination can create lucrative opportunities for patient investors. You never know when such stocks will turn around, but the move can be dramatic when it happens. Three stocks I've been watching are Tricon Global Restaurants, Uno Restaurant Corp., and Ryan's Family Steakhouses.

By Warren Gump (TMF Gump)
July 20, 2000

Since several restaurant stocks on my watch list announced earnings this week, I have decided to do a quick overview of them for today's column. Tricon Global Restaurants (NYSE: YUM), Uno Restaurant Corp. (NYSE: UNO), and Ryan's Family Steakhouses (Nasdaq: RYAN) have caught my attention because I like the concept, changes in investor sentiment could provide a boost to the stock, and/or the stock seems inexpensive.

As most restaurant stocks have been out of favor with the market for the past five years, many people might think that these companies will never come back into favor. That may happen, but I have a hard time believing that companies creating value will be ignored forever.

It is important to note that all of these companies are facing challenges that their management teams will need to address. You don't need to go out and buy any of them today, tomorrow, or any day. In fact, I only own one of them right now -- Tricon.

This article is meant to introduce you to some companies that meet value criteria and could attract higher valuations sometime in the next three to five years. As always, one of the biggest challenges with value investing is figuring out when the value will be recognized. It could be very quickly, it may take years, or it might never happen. Extraordinarily patient value investors will dive in when things look too cheap to pass up, others wait until they see signs that operations have turned around, while quite a few people think value investing is bunk (the number of people in this last category has skyrocketed over the past five years; it'll be interesting to see what they think five or ten years from now).

Tricon Global Restaurants
Tricon operates three category-leading fast-food chains -- KFC, Pizza Hut, and Taco Bell. The company has been hindered over the past year because of concerns about same-store sales, particularly at Taco Bell and KFC. These challenges shouldn't be glossed over. During the second quarter, comps fell an unusually high 6% at Taco Bell and 3% at KFC. Taco Bell is suffering from weak advertising and strong competition, while KFC is being challenged with the rollout of new chicken sandwiches. In addition, Tricon's primary food distributor filed for bankruptcy, which has forced it to front suppliers money to ensure smooth deliveries.

The company is trying to address its challenges. Yesterday, it announced that Emil Brolick had been hired from Wendy's (NYSE: WEN) as Taco Bell's new president. It also switched the Mexican chain's advertising agency to Foote, Cone, & Belding, which created the "Run for the Border" campaign several years ago.

At KFC, advertising will be more balanced between the new chicken sandwiches and its other offerings, like chicken on the bone and chicken strips, two products for which sales have declined. The distributor problem will be a challenge, but can be addressed in time -- either by working with the current company or selecting another vendor.

On the earnings side, Tricon reported net ongoing earnings of $0.76 per share for the second quarter, up 26% from the prior year, as it benefited from selling poor-performing restaurants, reducing interest expense, and repurchasing shares. The company did warn that ongoing earnings growth would be tempered for the year, rising in the mid-teens (roughly $2.90 to $3.00 per share) rather than the previously expected First Call estimate of $3.14. Nonetheless, at 9x-10x current-year earnings, the stock is priced for virtually no growth.

The fast-food business is notoriously fickle. Every chain has its ups and downs, from McDonald's (NYSE: MCD) and Burger King -- a subsidiary of Diageo (NYSE: DEO) -- down to little Krystal. When you have an industry-leading brand, though, chances are that things will ultimately turn around. Tricon has three of them. When underlying restaurant performance once again improves, investors will likely pay more than the current price.

Before moving on to the next company, it's worth noting that international operations -- an area that will likely account for a significant portion of Tricon's long-term growth -- are producing solid results. Operating profits increased more than 20% (for the eighth straight quarter), and international net store count increased from the beginning of the year.

Uno Restaurant Corp.
Uno operates the Pizzeria Uno Bar & Grill chain. I think it sells the best chain pizza around. In addition to offering great food, the company has reported solid financial results over the past few years as it reenergized the chain (focusing on more than just pizza) and accelerated expansion plans. Trailing 12-month earnings per share (EPS) nearly doubled over the past two years, to $0.95 per share.

The stock hasn't moved anywhere over the past 12 months, but it's up 80% since I wrote about it in November 1998. Even with this rise, the company still sells for less than 13x estimates because of its strong earnings growth.

Reported results did slow down last quarter, rising only a penny to $0.23 per share. The combination of an infrastructure buildout to support more rapid expansion and the closing of two restaurants for remodeling contributed to this slower performance. These problems should be fleeting -- the two remodeled stores reopened to a nearly 50% increase in sales volumes, and accelerated unit growth over the next 15 months will leverage the higher infrastructure costs.

Uno plans to open 20 new company units next year, compared to 12 this year. In addition, the number of franchised units should increase 30% between now and next September. If this growth materializes as planned and moderate same-store sales increases continue, Uno could achieve its 20%-25% EPS growth objective next year. The stock should move higher if this is achieved and is then perceived as sustainable.

Ryan's Family Steakhouses
Before writing anything about Ryan's, let me say that I could have (in fact, I did) say many of the same things about this company four years ago. The only thing that's changed is that the company's valuation has gone down even lower. The stock price itself is unchanged over the past four years, although earnings are up nearly 80% -- leaving it with a price-to-earnings ratio of less than 7x. This company represents an instance where it is virtually impossible to know when (or if) the underlying value will be recognized. But, it's such a solid operation with such a low valuation that I keep it on my watch list.

Ryan's is one of those places with all-you-can-eat salad, bakery, and dessert bars ("Mega Bar"), as well as grilled hot entrees. The chain isn't sexy or glorious, but it seems to have a lot of appeal -- particularly in its Southeast trade territory. Same-store sales for the chain, which includes 295 company and 22 franchised restaurants, have increased for 10 consecutive quarters.

The company has noticed its low stock price and has voraciously repurchased shares. Since 1996, it has slowed net new unit openings to 9 or 10 a year from 30, so that more cash could be deployed into stock repurchases. In total, diluted share count has been reduced to 33 million last year from 52 million at the end of 1996 -- a 36% reduction. Share repurchases don't always make sense for companies, but they are a good move for Ryan's, given its strong operations and low valuation. Why build lots of new restaurants when you can get a 14%+ return on your own stock?

This share count reduction has had a dramatic impact on net income. During the second quarter, the company reported a 24% EPS increase. Behind the numbers, however, net earnings increased only 6%. The remainder of the jump was caused by a 14% reduction in outstanding shares. Ah, the advantages of repurchasing stock in a good company on the cheap.

Some people might be scared by Ryan's balance sheet, which has $199 million in debt (and has been increasing due to the share repurchases). While that would be a concern for many companies, Ryan's has a hidden asset in that it owns all but 12 of its restaurant locations (unlike many other chains that lease theirs). If the company ever hits turbulence, it can enter into a sales-leaseback transaction and easily cover its debt.

Given Ryan's low valuation, slow-but-steady operational improvement, consistent earnings growth, and real estate assets, someone should ultimately be tempted to buy some shares.