Shares of steakhouse operator RARE Hospitality (Nasdaq: RARE) spiked more than 20% yesterday after the company served up a thick, juicy pre-earnings release, dripping with upbeat expectations. All three of the company's major chains -- LongHorn Steakhouse, Bugaboo Creek, and Capital Grille -- extended a recent pattern of quarterly up-ticks in same-store sales growth, achieving 6.8%, 9.5%, and 11.8% increases, respectively. Notably, the most upscale (read: highest margins) member of the trio, Capital Grille, booked the biggest increase.
As a result of this stronger-than-expected growth, RARE expects to deliver Q1 diluted earnings per share of $0.55 (before one-time charge) versus the First Call mean estimate of $0.44. As if this main course isn't filling enough, the company offered some tempting dessert, too, declaring that a late March legal settlement will pave the way for expansion into some attractive -- but previously restricted -- Eastern U.S. markets.
Now, I've shied away from restaurant stocks in the past few years, still gun-shy from the abuse I've absorbed since convincing my old investment club homies to buy Buffets (Nasdaq: BOCB)four years ago. Humbled by this less-than-steller stock-picking performance, I spent some time -- before taking on this story -- reading through an excellent series of articles on the industry, penned by my Foolish colleagues (and listed at the end of this article). I learned that there are some general themes in the industry:
Even more than most companies, restaurants are constrained by cycles of supply and demand. A strong economy begets more disposable income (high demand), but it can also spark overheated industry growth (too much supply). Good times also create a tight market for moderately priced management candidates, the lifeblood of restaurant operations.
There are inherent limits to same-store restaurant sales growth. A good retail operation -- like Wal-Mart -- can reasonably target multiple weekly trips from dedicated customers, but this is a much more difficult proposition in the restaurant industry (a guy can only eat so much steak). There are also inherent limits to domestic new-restaurant expansion and not all restaurant concepts translate well into overseas markets.
Finally, as Bill Barker explains in this article, how management handles the rate of new restaurant expansion is often the key to success or failure. Investors should keep a close eye on how much debt is being tapped to fuel expansion and whether profit margins from existing stores are keeping up with the cost of this debt.
With this third point in mind, I decided to take a look behind the scenes at RARE's blowout results. Is this news too good to be true? Let's check. (Note for anyone learning along with me: To obtain average equity for the year, I just averaged the end-of-year values for the current year and the past year.)
RARE's Return on Average Shareholders' EquityYear ending 12/26/99 12/26/98 12/28/97
Pre-charge earnings 14,424 8,753 (12,232)
Shareholders' equity 137,584 120,618 111,980
Return on avg. equity 11.2% 7.5%
So the rate of return on shareholders' investments is improving. This is certainly a good sign. But, as pointed out in the return on equity (ROE) series in the Fool's School, it is possible for a company to build up their ROE by simply reducing equity (i.e., borrowing and otherwise building liabilities with little associated growth in assets), and this is certainly not what we want to see in the restaurant business. So let's break up the ROE calculations into three pieces, as suggested in the School's primer:
No sign of weakness here. RARE has improved ROE the old-fashioned way, by increasing net margins from 2.7% to 3.8% and turning total assets into sales 1.68 times in 1999, vs. 1.54 times in 1998. Most importantly, they have held the line on financial leverage, as debt reduction (down 17%, from $48 million to $40 million in '99) has kept pace with the rate of increase in assets.
So, based on this one Fool's improved restaurant vision, there is no obvious sign of "too good to be true" in yesterday's RARE announcement.
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