The Real Story: P.F. Chang's Is Overdone

Marc Lichtenfeld

P.F. Chang's China Bistro (PFCB) is about as successful as a restaurant chain can be. Walk into your local P.F. Chang's at dinner time without a reservation and you'll likely go hungry for a while. However, loving a company and its stock do not have to go together like beef and broccoli.

The Consensus Story: P.F. Chang's remains a delicious growth idea. The company's casual Pei Wei concept will be the driver as new locations pop up all over the country. Earnings per share are expected to increase by only 9% in 2005, due to delays in construction of new stores. However, the consensus estimate for 2006 shows EPS growing 21% to $1.68, entitling the stock to a multiple in the low-to-mid $30s.

The Real Story: P.F. Chang's is operating on all cylinders and it will be quite difficult to surprise to the upside. In fact, there is a substantial risk that the company disappoints. Traffic growth is expected to be flat this year. The Street still views the stock as a go-go growth story, despite the fact that the days of 30%-plus annual earnings growth are over. Should the company fail to meet earnings expectations in 2006, aggressive investors could bail and the stock won't be rescued until the growth-at-a-reasonable-price investors step in.

What's reasonable? My model forecasts 2006 EPS of $1.61, which translates to a price of $38.64 -- assuming a P/E of 24 and that investors will still generously give the stock the 1.5 P/E-to-growth ratio that it currently enjoys. Of course, if P.F. Chang's disappointed investors again, would they be willing to continue to give the stock a PEG of 1.5? I'm not so sure. It's entirely possible that one more miss could change the P.F. Chang's investor profile completely; from those seeking aggressive growth to investors comfortable with lower but steady performance. The latter group tends not to bid up stocks and increase earnings multiples.

It's not often that I like to bet against good management teams, and there's no doubt about it, P.F. Chang's management is a skillful one. But the stock has now become a victim of the company's success.

The share price got walloped in late July when the company issued an earnings warning due to construction delays. The company said those construction problems are a thing of the past. But that doesn't mean it can't happen again, and investors have been selling the stock again lately. Even after a strong day Tuesday, P.F. Chang's is down 2.9% as of Wednesday's close since the company released lukewarm fourth-quarter sales figures on Jan. 5. (the S&P 500 is down 0.5% during the same timeframe).

Menu Offerings

P.F. Chang's operates 131 of its flagship China Bistros and 77 of its casual Pei Wei Asian Diners. Some on the Street believe there's room in the marketplace for 250 Bistros and 500 Pei Weis. The Pei Wei Asian Diner is a solid concept. The food is plentiful and reasonably priced. I conducted some "research" at one of the South Florida locations. An entree of Mongolian beef cost $7.95, while honey-seared chicken cost $7.25. It was interesting to note this location was half-full on a Wednesday at lunchtime. That was impressive because it had been open for just a month and was one of only two businesses that were operating in a shopping center that is still under construction.

I'm not arguing that the restaurants aren't popular and that the registers won't ring. What I'm concerned with is the slowdown in same-store sales, and flat traffic.

Since 2003, same-store sales at the Bistro have declined each year from 5.3% to 2005's paltry 1.2%; that 2005 figure included a 1% price increase, meaning organic traffic growth slowed to a trickle. In 2006, more of the same is expected. The company anticipates 1%-2% same-store sales growth with a 2% price hike at the Bistro and a 1.5% increase at Pei Wei -- indicating flat-to-negative traffic growth.

It could be argued: How can you increase traffic when every table is filled? Herein lies the problem. Bryan Elliott, who covers P.F. Chang's for Raymond James, pointed out that the company's $750 in sales per square foot is 50% higher than the average chain restaurant and is second only to The Cheesecake Factory (CAKE).

"The only way the Bistro can add capacity is if they can figure out how to get people to eat dinner at 3 o'clock," quipped the analyst, who does not own the shares. Raymond James does not have an investment banking relationship with P.F. Chang's.

Other Issues

P.F. Chang's faces several risks. A rise in utility prices, especially natural gas, is a significant one. Natural gas costs make up 1%-1.5% of cost of sales in a typical restaurant. Any increase in natural gas prices should ding operating margins.

The barrier to entry in its business is small. The company's founder, Paul Fleming, who left P.F. Chang's several years ago, has teamed up with Outback Steakhouse (OSI) to create Paul Lee's Chinese Kitchen. Currently there are only four locations; but you can be sure that Fleming and OSI didn't enter into this venture in order to operate four restaurants.

Additionally, there are more thanr 28,000 Chinese restaurants in the U.S, according to the latest census figures. If the local family-owned eatery has the best kung pao chicken in town, it too will likely enjoy an enthusiastic following. Is the local Chinese restaurant going to bring down $1.2 billion-market cap P.F. Chang's? No, but there is not much to stop competitors that can impact P.F. Chang's business from springing up all over the country.

Currently, P.F. Chang's has 10 buys, 10 holds and only one sell rating among Wall Street analysts. The bulls suggest that the shares deserve a 30 to 35 times earnings multiple based on an expected 20% growth rate. I question whether P.F. Chang's will achieve 20% earnings growth. Even if there isn't some sort of big, bad event like more construction delays from last year, I believe the risks outlined above could chip away at operating margins and earnings per share.

Keep in mind, P.F. Chang's is already a crowded short. As of Dec. 15, 4.9 million shares (or 19% of the float) have been shorted. That's down from its 12-month high of 5.7 million shares in October. Nevertheless, I believe the shorts have this one right and will be rewarded in the next 12 months.

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