Editor's Note: Jon D. Markman writes a weekly column for
that is republished here on
In a couple of weeks, most Americans will sort through recipes, lay siege to the supermarket, fire up their ovens and prepare to enjoy one of the most gloriously nonsecular, apolitical, communal events on the calendar. That would be Thanksgiving, not the Super Bowl.
What's amazing about this nationwide retreat to the kitchen is just how unusual it is for today's busy families. Three-fifths of Americans eat out every day, and for a remarkable number of families, a local restaurant is the place where they take most meals. In fact, many new homes are built these days without any dining room at all, as buyers rank it near the bottom of spaces they consider important in a dwelling.
In about a generation's time, restaurants have become accepted as the third place of American life, after home and office, whether it's
for breakfast or
for dinner. By the end of this year, industry surveys show that there will be 215,000 full-service restaurants in America and another 250,000 fast-food joints that will collectively generate a stunning $560 billion in sales.
Feeding an Obsession
With so much money pouring into the industry from overworked moms and dads, competition is escalating. Yet it's a tough business in which to make money. Not only is every street strewn with rivals, but raw-material and labor costs are beyond your control, marketing expenses are high and government health regulators are relentless and capricious.
This week, in a measure of frustration over the difficulty of achieving consistent profitability, owners of the popular Outback Steakhouse chain,
OSI Restaurant Partners
( OSI), threw in their dishtowels and sold the company to a private equity fund.
Still, it's as American as deep-fried turkey and pumpkin pie to want to make a buck in the restaurant business. So how can you exploit the American obsession with dining out? I've got three ideas to share with you, so get out your knife, fork and calculator, and let's dig in.
First, you need to realize that the big idea in small-restaurant investing is to find some unique dining concept that has proven itself popular and profitable in one region of the country and figure out how it can expand into a national service.
There are not a ton of success stories. The greatest example of all time, of course, is
, which started off as a burger stand with outstanding milkshakes in Southern California. If you had bought shares in its initial public offering in 1970, you'd be 18,760% richer today. Shares of Seattle-based coffee specialist Starbucks haven't done too badly, either, with a gain of 5,300% since it started trading in 1991.
After that, the field narrows to a lot of roadside restaurant chains like Cracker Barrel of Tennessee-based
, up 3,100% since going public in 1984, or Oklahoma-based drive-in
, up 1,700% since going public in 1991.
Which small chains today have the stuff to join this pantheon? One of my top choices, unfortunately, started its public life as a rather large newborn, and that is
Chipotle Mexican Grill
. It's unlikely to ever rise 1,000% from its IPO price of $45 in January this year, but it could certainly eventually triple over the next half-dozen years from its current level, around $58.
Chipotle, which was spun out of McDonald's, operates in the fast-growing niche known as "fast casual." That means it offers faster take-out service than a "casual" restaurant like an Applebee's, but it offers better-quality fare, and nicer in-store dining, than a fast-food joint.
It specializes in creating flavorful, healthy burritos made from high-quality meats and veggies at a bar within view of customers. Upbeat music, hip decor and well-trained staff make it feel more like a high-end local hangout than a fast-service shop. There are just over 500 restaurants now around the country in 22 states, mostly company-owned.
Chipotle, which is my family's favorite fast-casual restaurant, reported third-quarter earnings of 36 cents a share, which blew away professional analysts' expectations of 27 cents. The difference came from terrific operating margins at individual outlets of 21.5%, vs. expectations of around 17%. Sales at stores open at least a year were up 11.6% over last year, which was the best result in the industry in the last quarter.
Chipotle has the potential to be one of those once-in-a-decade specialty restaurant stocks, as it plugs into so many of the strong themes in America today: better-quality food at reasonable prices in a Mexican theme, just as the country is becoming increasingly influenced by our Latin neighbors to the south. The Seattle area alone could support as many as 10 Chipotle outlets, up from the two here now, so there are ample growth opportunities. I am looking for the stock to get to $110 by 2009 from its current perch around $58.
For my next pick, I want to get away from beef and chicken because there is a growing chance that rising livestock feed prices are going to drive meat prices a lot higher over the next year. Feed prices are charging higher because of the increase in demand for corn and soybeans to produce ethanol as fuel, and as a result, many cattle ranchers are actually thinning their herds because they can't afford to fatten them for sale. This has happened in the past, and the end result is usually a pinch in profit margins at meat-focused restaurants.
That's why I'd like you to take a look at
McCormick & Schmick's Seafood Restaurant
( MSSR), an Oregon-based chain of high-end seafood restaurants that's risen 90% since its IPO in 2004 to a $320 million market capitalization.
Restaurants catering to business and wealthier clientele are generally hit less hard during economic slowdowns than fast-food companies that focus on lower-income customers, so I am not as worried about next year as skeptical traders who have kept a lid on prices lately.
McCormick has stalled a bit in the low $20s, but its third-quarter earnings report last week and strengthening same-store sales trends suggest to me that this is another restaurant company that can double in value over the next three to four years.
The company says it has 20 new locations planned over the next two years, which means you'll get square-footage growth of around 15% through the end of the decade to go with earnings growth in the mid-teens. The restaurant has a limited footprint in several major cities, so there is ample opportunity to leverage its smart, simple concept of offering fresh fish in a clubby atmosphere with good service at high but not crazy prices. I'm looking for share prices around the price of a good halibut dinner with a glass of wine by 2009, which would be $45.
And lastly, for a much more speculative play on the American palate venturing out to include Asian flavors, consider
. This Arizona-based micro-cap focused on "fusion" recipes and unique sauces and dishes has just 10 restaurants in seven states so far, but it plans to grow fast.
Its third-quarter report, released last week, showed sales up 46% to $13.8 million, beating estimates handily. That makes it one of the few restaurant companies in the country with revenue growth higher than 20%. Margins are also strong, at nearly 20% at individual units, in part because its business model focuses on serving a lot of alcohol and sushi, which are both highly profitable, and in part because management keeps overhead expenses down.
Kona management has said it plans to open six restaurants in 2007, which would put revenue for next year at around $80 million and should allow the company to turn its first profit. Fast-growing restaurant companies generally sell at better than two times sales, so that puts a potential valuation for Kona at around $30 by 2009, or 85% above the current quote.
Eat your heart out, McDonald's. The small fries are gaining on you.
At the time of publication, Jon Markman owned shares of Starbucks.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider McCormick & Schmick's Seafood Restaurant and Kona Grill to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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