Soured on Casual Dining

 | Dec 29, 2011 | 11:00 AM EST
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Here is the scenario. You are sitting at home getting ready to enjoy breakfast, and a headline blurts "XYZ firm launches coverage on the XYX sector." The enthusiasm attached to the statement is noticeable, as if they meant to say, "This firm may just launch a spacecraft later on the day, as well, so be on the lookout." Let's run through a couple buzzy variations of the ballyhooed analyst "coverage launch."

• Underperform rating: Stock is likely to trail the performance of a major index or a specific sector.

• Neutral rating: Analyst is unable to determine a clear course of action, so he or she assigns a modest upside or downside price target, with plans to revisit the call later.

• Outperform rating: This is a stock that's projected to win in a given period, usually six to 12 months.

• Intangibles that fill up 20 pages: This consists of management discussions, site visits, findings from internal team meetings and so on.

So, this is the coverage launch, unmasked. However, I am inclined to suggest that you, the average investor, disregard these things and place greater emphasis on trends within specific metrics. This requires some work on your part. While it's nice to have a comment from management stuck in a paragraph, observations of trends in data is a much more powerful tool in determining future stock performance. A few metrics on which I compile data include:

• Same-store and same-restaurant sales

• Inventory turnover

• Fundamental performance relative to Street expectations

• Revenue per unit of inventory

• Three types of profit margins: gross, operating and net

With that in mind, let me take you through a "coverage launch" of my own -- on restaurant stocks. Casual diners are of particular interest, given the relative month-to-date outperformance in shares of Cheesecake Factory (CAKE), Darden (DRI) and P.F. Chang's China Bistro (PFCB).

At first blush, I was keen on suggesting a short on Cheesecake Factory due to the valuation and fundamental trends of the company. Upon closer inspection, it's hard for me not to "launch" coverage with the entire sector at an underperform rating.

Understanding an Underperform Rating

There is no reason to pay up to own a restaurant stock at this point -- even cooling commodity costs wouldn't do it. Same-restaurant sales are badly trailing the broad consumer discretionary sector, and there is little opportunity to raise prices with any degree of sustainability. I was at least hoping for something encouraging in Darden, considering the valuation and yield, but I couldn't find it.

With that, let's run down the choices one by one, and see exactly what has gone into this rating.

Cheesecake Factory

• The latest rally in the stock, lasting from Dec. 9 to Dec. 27, is shorter in duration than the previous move, which began Nov. 25 and finished Dec. 5. This hints at waning interest in the stock.

• Same-restaurant sales have underperformed rivals in the past few quarters on pressured guest traffic. Due to a menu price increase, guests have begun to alter the number of items they purchase from the company's expansive number of dishes at Cheesecake Factory and Grand Lux. (More than 200 items are available at Cheesecake Factory and at Grand Lux, which is beyond inefficient, as far as cost-containing goes. Where is celebrity chef Gordon Ramsay when you need him?)

• Operating margins are contracting, despite the above-mentioned menu price increase.

• The Street is already modeling for fourth-quarter earnings per share above management guidance.

• Inventory turnover is slowing.

• Revenue per unit of inventory is slowing.

P.F. Chang's China Bistro

• The restaurant put in a big-time earnings miss in the most recent quarter, and has issued subpar annual guidance. Yet the stock trades at an aggressive 19x forward earnings.

• Same-restaurant sales are declining in all three segments.

• Good money is being tossed behind a bad concept -- Pei Wei Asian Diner.

• Menu price increases have turned off customers.

• Fundamental performance calls into question the sustainability of the dividend, which is 3.3% at the moment.


• Although the dividend yield is eye-catching, it's overshadowed by two consecutive earnings misses. Key thought: Will the yield become even more attractive?

• Olive Garden is really posting underwhelming same-restaurant sales, a trend that seems entrenched in the intermediate term.

In the end, these restaurant stocks are asking investors to pay a premium to own businesses that are fundamentally unimpressive at this point. Compound this with consumers continuing to allocate discretionary dollars to the most valuable experience or tangible good, and this niche of the sector just isn't tasting too great.

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