The fourth-quarter and full-year numbers from Outback Steakhouse (NYSE:OSI) have been fully digested by now, and it might be causing some indigestion for some observers. Q4 was a disappointment, and the company created confusion for next year by changing its compensation program for restaurant partners to one that's cash-based rather than option-based. In general, and despite the confusion, I'm in favor of the cash-based program.
In most situations that involve disappointment and unexpected change, shares get pummeled. Outback wasn't an exception. But while I have to admit I wasn't impressed by the performance, I didn't think it was all that terrible. So I decided to review the quarter and the material from last week's analyst meeting. And I came away with largely the same thesis I went in with, only with the realization that the company's strategy might take a bit longer to bear fruit than I had originally expected.
Overall, the brands that have been performing well for the company, including Carrabba's, Bonefish, and Fleming's, continue to perform well. What's more, the company said it believes that the Carrabba's chain, which currently consists of 200 restaurants, still isn't halfway to its potential size. All three of these concepts are currently profitable, though combined they make up only about one-third of the company's total profits. The majority of the business is still the domestic Outback Steakhouse business, and since it has struggled in the past year, the total company financials have struggled as well.
The entire analyst day presentation was interesting, and it's worth listening to the recorded version if you're curious, but the most interesting discussion came at the end of the recording, when the question-and-answer session turned to the lack of growth in light of the company's cash profitability.
Quite simply, Outback has continued to increase revenues over the past few years, has attractive unit level volumes, and continues to spend on capital expenditures to open new restaurants, but net income has increased only 15% in the past five years. In comparison, Darden Restaurants (NYSE:DRI), Cheesecake Factory (NASDAQ:CAKE), and Applebee'sInternational (NASDAQ:APPB) have posted more impressive bottom-line gains.
While the sluggish net-income growth is a fact and lately a bit frustrating, it doesn't make sense to look at it in isolation. A large part of the increase in the company's expenses the past few years went toward putting a foundation in place from which Carrabba's, Bonefish, Fleming's, and Cheeseburger in Paradise can grow from. Those concepts are indeed beginning to grow and flourish. However, the Outback brand and all of the company's restaurants have had to deal with increases in labor and utilities as well, and these increases have come more quickly than have the growth in the new concepts. The question is when the newer concepts will hit critical mass and contribute in a way that overcomes increasing costs. I had initially assumed that would be soon, but it might be a year away.
However, in terms of valuation, Outback isn't unattractive. The company spends the majority of its capital expenditures opening new restaurants and the remainder on refurbishing existing restaurants. Looking at the trailing-12-month cash-flow data from the end of September shows that a total of $289 million was spent on capital expenditures, which is in line with the $255 million spent in 2004 and the $275 million to $325 million expected to be spent in 2006. Taking the $250 million of the total capital-expenditure spending for growth and removing it reveals that the company's underlying free cash flow in a non-expansion spending scenario is attractively valued at a 1% growth assumption. That's reasonable to me, considering that the rest of the capital expenditures are going into higher-than-average maintenance of the Outback concept to get that brand back on its feet.
Of course, that 1% growth hurdle still needs to be crossed. And with Outback being two-thirds of the business and currently in a slight decline, a pessimist has reason to be negative here. I'm still on the other side of the fence. I think that in the long term, this will work itself out. The company has a number of ways to return value to shareholders in the interim through share repurchases, dividends, and, if need be, a decision to set some of its higher-growth concepts free, the way McDonald's (NYSE:MCD) has done with Chipotle Mexican Grill (NYSE:CMG). In the meantime, I see a lot to like for a patient investor, if shares drift back below $40.
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Nathan Parmelee owns shares of Outback Steakhouse but has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.
