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Hungry for a Restaurant Stock?

By Emil Lee – Updated Apr 5, 2017 at 3:52PM

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It's a challenging sector, but this restaurant stock is serving up an appetizing investing opportunity.

It's no secret that the restaurant business is tough. Thirty percent of restaurants don't even make it to their second anniversary.

Competitors can learn from many of your trade secrets by simply walking through the door, capital costs are high, and random events like poor weather can wreak havoc on same-store sales and margins. Further, the strength of the general economy plays a large role in the performance of food retailers, and, given current conditions, things aren't looking too good for this sector.

A pizza deal too good to pass up
During times like these, restaurant stock prices become depressed as consumer spending temporarily slows. Put down your forks and pay attention, Fools, because this presents an opportunity for investors to scope out solid restaurant concepts and buy in at a value price. One restaurant worth a second look is California Pizza Kitchen (NASDAQ:CPKI).  

The company operates and licenses 226 restaurants and owns 85% of them. Unlike most pizzerias, such as Yum! Brand's (NYSE:YUM) Pizza Hut, the menu focuses on nontraditional toppings such as buffalo chicken. It also includes pasta and salad dishes.

Scoping out the competition
Here's how CPK stacks up against high performers like Cheesecake Factory (NASDAQ:CAKE) and P.F. Chang's (NASDAQ:PFCB). Although CPK isn't blowing them out of the water, it generally seems to hold its own. I chose to use the following metrics because:

  • Cash is king, and EBITDA is an apples-to-apples way to measure cash flow.
  • To figure out what kind of growth we can expect, we need to know what each additional restaurant (unit) costs, and the return on investment of the additional cash flow that unit will throw off (CFROI).

Keep in mind, some of these figures are estimates, given the companies' different levels of disclosure.

CPKI

CAKE

PFCB

Unit Level EBITDA Margin

19.0%

19.0%

17.0%

Unit Cost

2.8

8.5

2.9

Average Unit Sales

3.4

10.8

5.0

EBITDA/Restaurant

0.6

2.1

0.8

Cash Flow ROI

23.0%

24.0%

29.0%

How much is a slice of this pie worth?
In addition, CPK stock seems pretty cheap on a free cash flow basis. Performing a very conservative valuation, I assume that management stops growing the company and pays out all cash flow in the form of a dividend, in order to get a "steady state" free cash flow yield.

Under the no-growth assumption, I estimate the company could earn around $77 million in EBITDA. Subtracting cash taxes and a maintenance capex of $65,000, the company would earn around $50 million per year in free cash flow. With a $465 million market cap, the company would be yielding approximately 11.5% in free cash flow, which isn't too shabby. And don't forget, we earlier estimated that California Pizza Kitchen was earning 23% on investment for new stores, so adding high returning growth prospects makes the company even more attractive.

Further, the shares have recently been beat up and now trade near the level they did back in 2004, when the company owned 20% fewer restaurants. So it isn't too surprising that savvy hedge fund Farallon Capital Management recently announced a 5.3% stake in the company.

This pizza party doesn't come without risk
Of course, just because the company appears to be undervalued, there are still risks to consider. Because the company's income comes primarily from company-owned stores, its results will be much more volatile than a restaurant like McDonald's (NYSE:MCD), which earns a much larger percentage of its revenue from stable franchisee fees.

For example, when franchises pay a percentage of their sales to McDonald's as a royalty fee, a small percentage increase or decrease in sales has a minimal effect on the company, since McDonald's doesn't have the fixed overhead to pay on those sales. One the other hand, if a company-owned unit of California Pizza Kitchen experiences a sales decrease, fixed costs that must be paid regardless of the level of sales and the bottom line will be hit hard, and will be a bit more volatile during times of unsteady consumer spending.

In addition, the average check at California Pizza Kitchen was $12.85. And there are plenty of lower-price alternatives -- including Panera (NASDAQ:PNRA), Domino's (NYSE:DPZ) and Papa John's (NASDAQ:PZZA) -- if California Pizza Kitchen's customers want to further tighten the reins on their eating-out budgets because of a slowing economy and housing problems,

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Panera is a Motley Fool Hidden Gems Pay Dirt recommendation. Try any of the Fool's investing services free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and even your complaints. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Panera Bread Company Stock Quote
Panera Bread Company
PNRA
Yum! Brands, Inc. Stock Quote
Yum! Brands, Inc.
YUM
$110.65 (-0.13%) $0.14
Papa John's International, Inc. Stock Quote
Papa John's International, Inc.
PZZA
$75.15 (1.39%) $1.03
Domino's Pizza, Inc. Stock Quote
Domino's Pizza, Inc.
DPZ
$330.00 (3.08%) $9.86
The Cheesecake Factory Incorporated Stock Quote
The Cheesecake Factory Incorporated
CAKE
$28.43 (-2.44%) $0.71

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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