Ideas for the next market-beating investment are everywhere. To build on a recent article discussing potential opportunities in the fast casual dining market, the restaurant industry is filled with stocks that famed investor Peter Lynch would suggest that the average investor could enjoy more success than large institutions. After all, a person can learn a lot of great information simply by sitting down for a meal at a restaurant. Food quality, service, customer traffic, and overall experience are great qualitative indicators of whether a restaurant may be worth consideration for investment. If the experience is good, it is time to look more closely at the financials.
Small cap, large opportunity
For an investor that is seeking market beating returns, it makes sense to start the search with smaller companies. In the restaurant industry, this would include companies that have a limited geographic footprint or a single brand concept. This article will look at the following small-cap restaurants and discuss some preliminary observations for potential investors:
- BJ's Restaurants (NASDAQ:BJRI)-BJ's operates pizza and brewhouse-focused restaurants under the BJ's brand. Since its founding in California, the company has expanded to 136 locations in 15 states.
- Bravo Brio Restaurant Group (NASDAQ:BBRG)-Bravo operates 46 BRAVO! restaurants, 56 BRIO restaurants, and one Bon Vie restaurant in 31 states that focus on Italian food.
- Chuy's Holdings (NASDAQ:CHUY)-Chuy's originated in Texas and operates 45 Tex Mex restaurants in 12 states.
- Del Frisco's Restaurant Group (NASDAQ:DFRG) - Del Frisco's operates 35 high-end steak houses under the Del Frisco's and Sullivan's names. Since its founding in Texas, Del Frisco's has expanded to 19 states and Washington D.C.
- Ignite Restaurant Group (NASDAQ:IRG) - Ignite owns or franchises 205 Romano's Macaroni Grill restaurants as well as 134 Joe's Crab Shacks and 16 Brick House Taverns + Taps.
|CAPS rating (out of five stars)||4 stars||2 stars||
|Market capitalization (in millions)||$886||$300||$580||$438||$388|
|Number of locations||136||103||45||35||355|
|Debt to equity ratio||0.00||0.15||0.05||0.00||0.99|
|TTM price to earnings ratio||29.63||20.69||63.03||32.68||420.00|
|Forward price to earnings ratio||24.54||15.62||41.82||16.88||23.26|
|Five year expected growth rate||17%||12%||25%||20%||N/A|
|Source: Yahoo! Finance-9/7/13|
The ability for each of these companies to grow the number of locations provides significant opportunity. For example, BJ's management expects that it can reach 425 locations across the country. The company just began expansion into Florida, and has not opened a single location elsewhere on the east coast; as a result, tripling the number of locations seems quite reasonable when you consider the tremendous market size of states such as New York, Pennsylvania, and Virginia.
By comparison, Darden Restaurants, owner of a portfolio of restaurants including Olive Garden and Red Lobster, operates 2,100 locations. As a result, even 425 locations should by no means be considered a ceiling for a company like BJ's.
Thoughts on valuation
Each investor has different criteria for an appealing investment opportunity. In the table above, the debt to equity ratio is a popular way to assess the strength of a company's balance sheet. It also provides insight into whether the company has funded past growth with earnings or debt. Each of the companies discussed in this article has a manageable amount of debt, but Ignite's $105 million in debt does limit the company's flexibility more than the other companies.
The PEG ratio is a great way to measure the current valuation of a company relative to its current earnings and growth estimates in a single data point. This metric relies on analyst estimates for future growth, so is by no means perfect; however, it is a good starting point to understanding whether a stock is cheap or not. Based on this metric, BJ's and Chuy's seem a bit expensive with ratios of 1.7 and 2.0, respectively.
A compelling opportunity
The one stock in this group that stands out is Del Frisco's. The company has no debt and is expected to grow at 20%, yet it trades at just 17 times next year's earnings. Plus, with just 35 locations there is tremendous room for growth; in the most recent quarterly results, management increased its growth guidance to include six new locations during 2013.
In addition to a huge growth opportunity and a reasonable valuation, there's another aspect to Del Frisco's that Peter Lynch would love: the company is followed by so few people that it hasn't even earned a rating in Motley Fool CAPS with just nine picks at the time of this article. By comparison, BJ's has roughly 500 CAPS picks.
There are of course a few risks to understand. First, Del Frisco's operates high-end steakhouses. This market has stiff competition from brands such as Ruth's Chris, Flemings, Morton's, The Palm, and others. Second, the pricey nature of Del Frisco's meals limits the number of markets that can support a successful location; these locations will likely be limited to affluent areas in large cities. As a result, there should be no illusions that the company's ceiling can be measured in thousands of locations; several hundred is all that should be expected.
Even with these risks, Del Frisco's is a compelling investment opportunity today given its growth potential and reasonable valuation. To measure this "buy" recommendation, I will initiate an outperform CAPScall.
Take a test drive
For investors that live near one of the brands mentioned in this article, some of the best research can be derived from an actual trip to the restaurant. As mentioned above, the overall experience can speak volumes regarding the strength of the restaurant concept and the potential to expand the concept nationally.
This firsthand experience dining at one or more of the concepts owned by each of these companies helped me arrive at the conclusion that Del Frisco's is worth further consideration; the food and customer experience are great whether it is a dinner for two or a large corporate event, and I'd argue that the overall experience is better than the competition.
Brian Shaw has no position in any of the stocks mentioned in this article. The Motley Fool recommends BJ's Restaurants. The Motley Fool owns shares of BJ's Restaurants and Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.