Here's a question to ponder: When you sell an investment, do you continue to follow it, or do you pretend it never existed? I've owned shares in a couple of dogs that I'd like to forget, but I'm most interested in companies where I may have sold early, which brings me to Outback Steakhouse (NYSE:OSI).
In 2002, I made what I consider to be a smart decision: to become debt free. I had enough of moving debt from card to card for the lowest rate, annoying interest charges, and due dates to remember. In the final stage of my debt-free plan, I decided I was willing to sacrifice an investment for peace of mind. I decided to sell my stake in Outback. Today, Outback's shares sit almost exactly where I sold them a little more than two years ago, and I believe the market is offering up a very attractive opportunity.
Today's problems, tomorrow's rewards
Like Lone Star Steakhouse (NASDAQ:STAR), Outback's current problems are primarily related to increasing costs for meat, dairy, and produce. (Matt Richey made an excellent case for Lone Star recently.) It's tough when a business has to manage increasing costs for core inputs, but as recently as 2001, Outback has wrestled these demons and come out on top with a mix of price increases and costs for certain goods falling back to normal levels. Let's look at this from another angle. I believe Outback's consistently long wait times point toward a business with pricing power that can stand up to increasing costs. But more importantly, Outback is structured in a way that motivates all levels of management to respond to any challenge in a shareholder-friendly way. (We'll explore this point in a bit.)
Past performance
Outback's past performance has been stellar. For the last 10 years, the sales growth, return on equity, and return on assets have consistently been in the low to mid-teens. The bottom line has been nothing to scoff at, but for reasons we covered above, the earnings have been briefly held in check twice in the last decade.
In Outback's case, this doesn't trouble me at all -- instead, at a certain level, it is reassuring. Rather than pursuing a growth-at-any-cost strategy, such as Krispy Kreme's (NYSE:KKD), Outback has chosen to follow the route of gradual, controlled growth. This strategy has not delivered the one-to-two-year stretches of 20% growth that sets investors' hearts aflutter, but it does create a business with a strong balance sheet that grows at a solid but more pedestrian pace.
Unique management structure
As I mentioned earlier, I'm a big fan of Outback's business and management structure. For starters, the company franchises a small percentage of its restaurants, and in about 40% of the cases it owns the land and buildings as well. By owning most of the restaurants, Outback had to invest a larger sum up front, but in return, it now has greater control over the business, including branding and pricing.
What I admire most about Outback's management structure is that it makes sure the general manager of each restaurant is motivated the same way an individual owner would be. This is accomplished by requiring general managers to purchase a 10% stake in the restaurant for $25,000 and sign a five-year employment agreement. At certain concepts, such as Fleming's Prime Steakhouse and Wine Bar, Outback takes this a step further by requiring chefs to also purchase a small stake and sign a five-year employment agreement. An additional benefit of this structure is that it provides a level of stability in the management ranks and holds down employee turnover.
New concepts and international growth
If you browse through the last few years of Outback's filings, you'll see there are a number of restaurants besides Outback and Carrabba's under the Outback umbrella. While Outback Steakhouse already has a large domestic presence, future growth in the U.S. is highly dependent on concepts such as Roy's (Hawaiian Fusion), Paul Lees Chinese Kitchen, Cheeseburger in Paradise, and Fleming's (an upscale steakhouse). All of these concepts have the potential to be winners, but only one or two of these concepts has to become the next Carrabba's in order for Outback to continue its success.
To complement domestic growth, Outback has been opening new steakhouses around the globe and plans to continue the expansion. If you're curious, you can already order your favorite Outback dinner in the U.K., Germany, South Korea, Brazil, Japan, and other far-off lands. Having done a bit of Peter Lynch-style international research, I can tell you that you're just as likely to encounter a wait for a table overseas as you are stateside.
Valuation
Outback is a great business, but the important question is, "When should a value investor move in?" With a P/E of 17, Outback is at the low end of its five-year range of 13 to 30. To make sure I'm paying a reasonable price, I look for whether the return the business earns on equity is greater than the current multiple of earnings or free cash flow. With a P/E for 2003 of just more than 17 and a historical average closer to 18, Outback squeaks by.
But what about that free cash flow? After all, when coupled with enterprise value, it's a better metric than P/E, right? Outback's traditional enterprise value-to-free cash flow is not terribly impressive, because it is still opening a large number of restaurants each year. However, if you back out the capital expenditures related to opening new restaurants -- which I estimate to be just less than $2 million per restaurant -- Outback's enterprise value-to-free cash flow is a very intriguing 12.
I don't always put a lot of weight behind a calculation of capital expenditures that includes only maintenance expense. However, with Outback's solid balance sheet, high return on equity, growing dividend, and gradually decreasing share count, I feel more comfortable doing so.
Risks
With Outback funding expansion primarily from cash flows and keeping a consistently clean balance sheet, I see minimal business-specific risk at today's prices. I do think there is a certain amount of risk to the casual restaurant industry in general because of today's overextended consumers. At some point, consumers will need to tighten their belts, and that could very well have an impact on Outback as well. However, for those with an eye on long-term ownership, Outback's business model and balance sheet are strong enough to ride out any tough economic times.
Final thoughts
Like Philip Durell in the Fool's Inside Value newsletter, I'm always searching for a great business at a great price. Such situations are often difficult to find but not impossible. With its solid balance sheet, cash flow, and potential for growth from Carrabba's and other concepts, Outback meets the great business requirement and sells for a reasonable price.
Where to from here?
- Searching for undervalued stocks? Take a free test drive of Motley Fool Inside Value
- Outback's Anemic Outlook
- A Stock for Dad: Outback Steakhouse
- Did You Overpay?
Fool contributor Nathan Parmelee owns shares in Lone Star Steakhouse and really loves Outback's Bloomin' Onion. The Motley Fool has a disclosure policy.
