Diners Declining P.F. Chang's?

By its own accord, P.F. Chang's (NASDAQ:PFCB) reported disappointing results in the second quarter, dismaying investors and management alike. The company missed its own sales and earnings forecasts, mainly because of traffic shortfalls at both its P.F. Chang's China Bistro and Pei Wei Asian Diner segments.

In this Fool's view, Chang's woes aren't isolated to the restaurateur entirely, nor to the Chinese food segment. Many of America's casual-dining chains are showing weakness; industry leader Darden Restaurants (NYSE:DRI) recently announced store closures and a plan to sell its Smokey Bones unit. Popular theory holds that mounting pressures on consumers, including higher gasoline and food costs, reduced home equity values, and in some instances, upward-adjusting mortgage payments, are throttling Americans' discretionary spending.

Chang's still managed 18% revenue growth, driven mostly by its greater store count, but the Asian cuisine pioneer missed its own forecast by $3.9 million. The Bistro grew revenue 13.3%, but a 1.3% same-store sales decline left it $1.8 million short of its forecast. At Pei Wei, revenue rose 38.7%, benefiting partly from 1% same-store sales growth. However, the company had expected 1.7% comps growth, so sales still missed the company's forecasts by $2 million. During the conference call, the operating segment head took some of the blame, explaining that he had perhaps set expectations too high for new stores.

However, the call provided some anecdotal evidence suggesting that housing woes may be partly to blame. PFCB's weakest operating regions in the quarter included California, Nevada, and Arizona, areas with some of the hardest-hit housing markets. Roughly 28.5% of the company's restaurants are located in those three states, leaving Chang's no escape from the regional softness.

With revenue off forecast by nearly $4 million, the income statement deleveraged, reducing margins. The operating margin narrowed by 30 basis points, to 5%, and missed forecast by 50 points. Management specifically cited minimum-wage rate hikes across states as an extra factor driving labor costs higher. While cost of sales increased as a percentage of sales, the company didn't note any effect from rising food prices, and it was well-hedged for that this year. However, protein price fluctuation could hurt 2008 forecasts, depending on the degree of corn planting and demand. If feed costs continue to rise, so should the cost of chicken and other proteins.

Despite the lighter margins, management noted three factors that helped spare the company from an even greater earnings miss:

• The elimination of corporate-level incentive compensation.
• An improved tax rate.
• Favorable partner investment expense on the buyouts of partner interests.

While this is a testament to management's savvy, this Fool wonders how many more tricks remain in its bag. Ultimately, Chang's $0.36 of quarterly earnings per share still represented respectable 20% growth year over year.

Looking ahead, management fine-tuned its forecast a bit. Assuming that its slump will continue, the company now anticipates making $1.34 per share in 2007, versus the $1.38 it saw earlier this year. P.F. Chang's seems to be assigning little blame for its downturn internally, but the company is probably correct in attributing the weakness to consumers' overall spending patterns.

The overall revenue forecast calls for continued weakness in the Bistro segment in Q3, but makes no adjustment for Q4. The company's new-store-opening schedule was back-end-heavy to begin with, so perhaps there's more than comps to the company's overall sales outlook. Of the 19 restaurants the company plans to open this year, only five were introduced in the first half. Still, Chang's also sees same-store revenue declining 1.6% now, versus 1.2% before.

Concerns about new Pei Wei production will delay expansion of the concept into new markets and limit new stores to areas where they can better benefit from infrastructure already in place, market awareness, and advertising leverage. This year, the company still plans to add 37 stores, with 19 already in place. While revenue expectations have been ratcheted down, management still sees positive same-store growth measuring 0.8%, where it previously expected an increase of 1.4%.

Operating within the Asian niche may be both beneficial and limiting for PFCB. The less often you go out to eat, the more likely you are to seek a unique experience. Americans can eat burgers at home, and despite progress and penetration of Asian foods into traditional supermarkets, many people are still intimidated by cooking Asian from scratch. There are some prepared-food options available, but perhaps not enough.

The argument that Chang's niche could limit the impact of reduced restaurant dining is admittedly dependent on the amount of people who enjoy Asian food within any given market. However, Americans are adventurous, especially in the markets Chang's has initially targeted. I suspect the company could gain share from both fellow Asian restaurants and chains with more traditional offerings.

As a result of its recent drop in earnings estimates and price, Chang's P/E ratio is nearly unchanged. At 24.4 times the company's guidance of $1.34 for 2007, the shares trade at a slight premium to analysts' five-year growth expectation of 20%. A PEG ratio of 1.2 isn't all that bad, but concerns remain about the accuracy of growth and earnings estimates, considering the company's recent slump. In addition, the analysts' typically understated consensus growth outlook for 2008 is lower than their five-year number. This Fool would surely label that as analyst conservatism, if not for the company's recent reduction in its own forecast.

Using the table below, Chang's matches up well with the group, in line with peer Cheesecake Factory (NASDAQ:CAKE). Adjusting comparisons to line up the firms' fiscal calendars, Applebee's (NASDAQ:APPB) valuation offers some insight into what Chang's might go for if it were bought out. At Applebee's 1.5 PEG ratio, Chang's would be valued at $41 -- 24% greater than its current value.

Despite its valuation fit, investors must consider the accuracy of any estimates here, given the company's reduction of its own forecast. In a softening dining segment, the whole industry's valuation may be ratcheted down as well. However, if you have to own a restaurant in your diversified portfolio, Chang's still looks like a decent relative choice.

Further MSG-free Foolishness:

• Fool on the Street: Grilling Darden Restaurants
• Just Lukewarm at P.F. Chang's: Fool by Numbers
• Back on the Chain Chang's

Fool contributor Markos Kaminis has no ownership interest in any of the companies discussed here, but he once followed P.F. Chang's as an analyst on Wall Street. The Fool's disclosure policy recommends the crispy orange beef.