Good Enough to Eat

What sort of images come to mind when you think about burgers and dogs? Cookouts? A baseball game? The Fourth of July? Now picture a big bucket o' chicken wings. For me that brings back memories of a midnight dorm snack -- and dreams of having enough money to make them my sole source of nourishment. So why do I have you daydreaming about food? There happen to be three companies that have been benefiting from our love of burgers and wings, so let's take a brief look, do some comparison shopping, and see if they can fill our investing appetites.

Play Ball!
Batting leadoff, from Normal, Ill., we have Steak N Shake (NYSE:SNS), one of the oldest restaurant chains in the country. But this 70-year-old company is confined to the Midwest and South, meaning there's likely expansion potential lurking out there. The restaurants are open 24 hours a day and offer full-service, carryout, and drive-through dining. As you might have guessed, they are known for their Steakburgers ("Steakburger N Shake" apparently didn't have the ring the namers wanted) and shakes.

Second in the lineup is Buffalo Wild Wings (NASDAQ:BWLD), which can be found in most of the United States, although one third of the stores are in Ohio, mostly because the company was founded in 1982 near Ohio State University. So the potential for significant growth can be found here, too. Target customers are sports fans and families -- hence the multimedia gizmos, full bar, and open layout. Wings are the focus (just thought I'd clarify) and the restaurants provide quick casual counter service, casual dining table service, and take out.

Batting third in baseball requires a high average and lots of RBIs -- which Red Robin Gourmet Burgers (NASDAQ:RRGB) can make a case for with its $2.3 million in sales per company-owned store so far this year. That far surpasses the 2003 per unit sales for both McDonald's (NYSE:MCD) and Panera Bread (NASDAQ:PNRA) -- two of the biggest in that category. California and Colorado are the home states of more than a third of the Red Robins in operation, so once again we have the potential for significant growth -- catching a pattern here? The casual dining atmosphere appeals to families, women, teens, and tweens (kids eight to 12). Burgers are the main focus, and the restaurants' diverse selection of toppings justifies the "gourmet" moniker with which they have been christened (give me any of 'em that come topped with their crispy onion straws!).

But what about the stats?
Now that we've got a taste for the competition, we want to see if there is value to be found in the potential growth of these smaller restaurant chains (each has a market cap below $1 billion). One way to do this is to take a look at the market cap and compare it to owner earnings (OE), which can be calculated as follows:

OE = Net Income + Depreciation & Amortization +/- One Time Items - Capital Expenditures

To add another twist, when looking at growth-oriented restaurant companies, we need to think about building costs. Eventually, these costs will diminish, or at least take proportionately smaller bites out of the companies' cash flows, so removing them now give us a feel for how well the restaurants currently in operation are providing for shareholders. Computation is easy -- each of their annual reports lists how much it costs to build a new unit. So let's calculate our adjusted OE (AOE). Figures, again, are in millions.

Stripping expansion costs reveals the significant difference between OE and AOE -- and AOE representing a truer picture of these companies' underlying, and eventual (once growth levels out) operations. We could have passed right by Buffalo Wild Wings and Red Robin, as both have negative OE.

There are two factors I'd like to mention before we get to our final calculation. First, franchising is significantly different for each of these companies. Here is the breakdown of franchised and company-owned restaurants.

Franchisees can be a great source of income, income that usually takes the form of shared revenues. Other companies make even more money by requiring their franchisees to purchase equipment or other items from the company. Krispy Kreme (NYSE:KKD) does this, although this segment of its business seems to be struggling. Revenue sharing is the only franchise income for our three companies, but Buffalo Wild Wings and Red Robin require another percentage of franchisee revenues to be spent on advertising, lessening the corporate burden of brand name expansion.

Another worry of these restaurants is exposure to commodity prices. With significant increases in prices, chicken wings have risen to 35% of restaurant operating costs for Buffalo Wild Wings. Prices have pulled back from their record highs, but are still considerably higher than two years ago. Red Robin is just as exposed to beef prices, with gourmet burgers accounting for 45.4% of total food sales. These costs cut into profits quickly. As always, knowing the industries a company is exposed to will help you better understand the factors influencing performance.

Bottom of the ninth
Now on to the conclusion: calculating market cap/OE. Conventional wisdom tells us that we should be cautious of companies for whom expected earnings growth is lower than P/E; we can apply the same wisdom for market cap/OE, using the very broad assumption that OE growth will approximate the earnings growth Wall Street analysts are predicting. Finally we divide market cap/OE by growth and look for numbers less than 1.0.

No home runs here, but anything under 1.5 I would flag for further research, meaning that Steak N Shake and Buffalo Wild Wings make the team. On the other hand, unless you're holding out for quantum leaps in Red Robin's growth, that company looks to be priced for perfection. I may not be the only one seeing this, since Oppenheimer recently downgraded the stock from "buy" to "neutral" and a member of the board just resigned because the private equity investment company he is president of has divested all of its shares of the company.

Once you are familiar with a company, I suggest coming up with three numbers for potential growth: conservative, realistic, and optimistic. For example, when examining Steak N Shake, I consider 10% as conservative, 15% as realistic, and 25% as optimistic (earnings growth over the next three years). This releases you from the bondage of analysts, and exposes you to a broader spectrum of possibilities -- effects that have both good and bad consequences. I'd also suggest recording your pattern of estimates and supporting logic so you can keep track of the reasons and frequency you find yourself underestimating or overestimating future performance.

I love to use market cap/OE/G or any of the many various ratios using market cap or enterprise value in comparison to cash flow. Just remember that it is not a buy signal if you find a company with a number below 1.0. In Rich Smith's lesson in "Panning for Gold," he uses EV/FCF/G as one of the seven criteria for finding your own hidden gems. Since Buffalo Wild Wings is a Motley Fool Hidden Gems recommendation, it comes as no surprise to me that it provides both significant value and growth potential. So order up an annual report or two and top it with a burger or some wings (don't actually do this), and feed your mind and your body.

• Krispy Kreme in Denial
• A Stock From the Industry Side Out
• Panning for Gold

John Bluis dreams of the day when scientists discover a way to make burgers and wings good for you. He hopes that wings will be good for his portfolio since he owns shares of Buffalo Wild Wings. The Fool has a disclosure policy.