FOOL ON THE HILL
An Investment Opinion
A Hunger for Restaurant Companies
By
Warren Gump (TMF Gump)
December 28, 1999
Looking at the performance of restaurant company stocks, you would think that eating out is no longer a major part of American society. Of the eight large industry players that pop up on a basic Bloomberg quote screen, only one shows an increase greater than 1% for the year: McDonald's (NYSE: MCD). Returns from the other companies -- Tricon Global Restaurants (NYSE: YUM), Outback Steakhouse (Nasdaq: OSSI), Darden Restaurants (NYSE: DRI), Wendy's (NYSE: WEN), Brinker International (NYSE: EAT), Starbucks (Nasdaq: SBUX), and Papa John's (Nasdaq: PZZA) -- have been flat to down significantly.
In a year where the overall stock market as measured by the Standard & Poor's (S&P) 500 Index is up almost 20%, this performance is awful. Even gains from "the winner" were meager when compared to the market -- McDonald's is up only 10%.
Despite this dreadful stock market performance, the overall restaurant business seems to be in pretty good health. All of the aforementioned companies are expected to show earnings-per-share growth of more than 10% during calendar 1999 thanks to strong sales resulting from extremely high consumer confidence and low unemployment. Profitability has also been boosted by generally lower food prices and a slowdown in the growth of new restaurants (with less new competition, sales at existing units tend to strengthen).
The most significant obstacle for many of these companies is that the economy is too strong -- unemployment is so low that the companies aren't able to find enough workers. The industry has responded by increasing wages and in some cases slowing down unit growth rates, but most companies say that attracting employees is still difficult. Staffing will likely remain the biggest challenge facing industry players.
With this year's price declines and rising earnings, valuation levels -- relative to the market -- are hovering at some of the lowest levels I've seen in the past 10 years. While the S&P 500 is trading at about 29x earnings estimates for the year, the eight previously mentioned companies sport an average price-to-earnings ratio (P/E) of 20x.
Based on these valuations and the fairly bright earnings prospects, it seems to me that this sector might offer some appetizing stocks. One stock that looks particularly interesting -- I didn't consider Outback since it was discussed in a September column -- is Brinker.
Brinker is one of the biggest conglomerations of restaurant brands in the land. On top of its flagship 641-unit Chili's concept, the company is also involved with Macaroni Grill (137 units), On the Border (98), Cozymel's (13), Maggiano's (10), Corner Bakery (51), Eatzi's (5), Wildfire (3), and Big Bowl (4). Despite strong earnings growth -- quarterly earnings have increased at a 17% or better pace since the middle of 1997 -- the stock is trading at a P/E of 16x calendar 1999 estimates and 14x projections for the next 12 months.
You can't look at this company without acknowledging the importance of Chili's since the chain represents 66% of Brinker's overall unit count. Some people may think that the brand is a little tired and boring, but recent results suggest that is not the majority opinion. During the three months ended in September, the chain experienced a same-store sales gain of nearly 7%. Those results are on top of strong results during the prior year, when the chain's average weekly sales increased 3%. Management attributes these results to its focus on total guest satisfaction.
Although the company's performance is heavily reliant on Chili's, other brands are becoming an increasingly important part of the business. The non-Chili's brands now account for about 33% of the company's unit count, up from 20% two years ago. It wouldn't be surprising to see this percentage continue to increase.
Over the past couple of years, Brinker has aggressively rolled out new Macaroni Grill and On the Border locations. It has also worked with partners to create new concepts such as Big Bowl ("contemporary Asian") and Wildfire (1940s steakhouse). It's too early to tell whether these newer chains will be significant contributors to the company's growth, but continual innovation is a trait of many successful organizations.
Brinker has been aggressively repurchasing its own shares over the past two years. A $50 million stock repurchase program announced in January 1998 has been expanded twice -- first to $85 million and more recently to $110 million. At the end of September, the company had repurchased 3.7 million shares for $83 million. (It should be pointed out that a lot of these repurchases simply offset dilution from option grants -- the overall share count has actually increased slightly from 66.9 million in December 1997 to 67.8 million at the end of September 1999.)
I like what I see at Brinker -- a strong history of earnings growth, great performance from key brands, a strong financial structure, a low price-to-earnings valuation, and a willingness to innovate. If you agree, you might want to take your own look. Don't feel like you're stuck with Brinker, though. Virtually all of the publicly traded restaurant companies have been ignored over the past year or two. Some of them deserve to be left alone, but many look like they'd add some beef (or possibly a veggie burger) to future portfolio returns.
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