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Not Buying in on Dining Out

Being long restaurant stocks implies that the economy is going to get better sooner rather than later, which I see no reason to believe.
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As we have rallied off the market lows for the year set in March, restaurant stocks have gained significant momentum. It seems that almost daily I am seeing articles and posts in the blogosphere championing restaurant stocks as being oversold and cheap.

The performance off market lows of some of the stocks is this group has been stunning. Cracker Barrel (Nasdaq:CBRL), for example, has jumped 50% over the past two months and has tripled off the 52-week lows. Brinker International (NYSE:EAT) has risen 50% since March and has quadrupled form its December lows.

The bullish argument is that consumers will return to dining out when the economy improves. Further, the bulls do not think business is all that bad even during the current slowdown and the valuations were compelling.

The facts do not appear to bear this out. According to a recently released report by the National Restaurant Association, the industry has been contracting for 16 straight months and continues to do so. For the last 20 years the industry has grown twice as fast as the population it serves and contraction is inevitable in the current economy.

The simple truth facing the restaurant industry is that scared consumers do not eat out. When your house is declining in value and your 401K has dropped by half or more in value, it is a luxury you cannot afford. Unemployed people rarely hit the causal dining circuit and the unemployment rate is 8% and rising.

Restaurant stocks are not reflecting this reality. The S&P Restaurant Index was only down 13% last year and less than 5% in 2009. As I mentioned, much of the group has seen dramatic price performance in the recent bear market rally. In my opinion they are over bought and over valued at current levels.

In recent weeks several of the stocks have spiked on what was perceived as positive news. Ruby Tuesday (NYSE:RT) shares shot up 55% when the company did better than analysts expected -- through cost controls and store closings. The truth is same-store sales were down 6.8% and the company expects to lose money in 2009.

Brinker International announced that it expects to beat forecasts as well. Again, same-store sales were down in all four segments of the company and the gains came form cost controls, not an improvement in business conditions.

Looking at some specific stocks in the group, companies like Cracker Barrel strike me as extremely vulnerable. Back in 2006 the company began a quasi-LBO process, issuing large amounts of debt and buying back stock. As a result the company now has a debt to equity ratio of more than 7. The company has net profits of around $60 million and annual interest payments of $40 million.

If the company experiences continued revenue declines, that fixed payment could take a bite out of profits. The majority of its stores are located along major highways and are vulnerable to fluctuations in travel. With unemployment climbing, cutbacks in travel would seem very likely to me.

Please do not take this as a knock on the company. There is a Cracker Barrel fairly close to me and I stop in from time to time for breakfast. However, with its level of debt and vulnerability to consumer spending, I think the stock is overpriced right now. At 7 times enterprise value to EBITDA (EV/EBITDA) and 7 times book value, they can hardly be called cheap. Insiders are not bullish either. In recent months officers and directors have sold 136,000 shares.

Dine Equity (NYSE:DIN) is another stock where I think it makes sense to take profits if you own it and consider shorting it or buying puts on the shares. The combination of International House of Pancakes (IHOP) and Applebee's left the company with over $2 billion in debt and a debt to equity ratio of slightly more than 10.

The highly leveraged company is one of the most exposed to consumer spending in my opinion. Applebee's has been built on the neighborhood eatery model and that is the segment most hit by rising unemployment. Although the company reported an operating profit of $0.34 a share last quarter, if you include the writedown of assets resulting from the merger, the loss would exceed $8 a share.

Dine Equity is selling Applebee's locations to pay down debt. Same-store sales were down 4% at Applebee's for the quarter. The venerable IHOP chain did better with a decline of just 1%. Interestingly the average check size at IHOP actually increased but there was a dropoff in the number of folks dropping in for pancakes and eggs. The book value of the company is negligible due to the extensive debt. The shares look very expensive to me at 18 times earnings and an EV/EBITDA ratio of 6.7.

Buffalo Wild Wings (Nasdaq:BWLD) has been a market darling of late. The stock has performed very well and has had strong same-store sales growth. This stock was not really on my radar screen until I noticed a recent change in the company's advertising.

The chain has long promoted itself very successfully as a great place to have a beer, watch the game and enjoy buffalo style chicken wings. Advertising was aimed at the young adult sports market. In the past few weeks the ads I have heard are aimed at drawing in the family market. There was even a spot for a children's coloring contest at a Lexington, Ky., location.

I suspect this may be a huge misstep on Buffalo Wild Wings apart. The two market segments simply do not mix well: I do not want to watch a game in a place with families and children, and when my kids were younger I would not consider taking them to a sports bar for chicken wings and soda pop.

A little deeper look tells me that this has turned into a momentum stock and is vulnerable to earnings shortfalls. This could be a problem as the cost of their core chicken wing product (21% of sales) has been soaring this year. The stock is priced for perfection at 27 times earnings, an EV/EBITDA ratio of 10 and 3.9 times book value. It is also worth noting that insiders have been persistent sellers of stock so far in 2009. It has been a favorite of momentum and growth investors this year, so caution is advised in establishing an outright short position in the stock.

Being long restaurant stocks right now implies a belief that the economy is going to get better sooner rather than later. While I see some signs that the decline may be starting to decelerate a bit, there is no evidence that economic recovery lurks around the corner.

Restaurant stocks will not fare well for the balance of the year, in my opinion. If I owned them after the recent run-up, I would be looking to sell them. Aggressive investors may well want to consider establishing either outright short sales or put-buying on the stocks. Chicken short-sellers like me should be able to find put spreads that allow us to limit our losses if we should be wrong.

¿ The biggest problem facing restaurants is that people who have lost their jobs or watched their 401ks vaporize are too scared to eat out. ¿ Many restaurant companies are beating earnings forecasts through controlling costs and shuttering operations, not because of a change in operating conditions. ¿ More aggressive investors may well want to consider establishing either outright short sales or put-buying on restaurant stocks.