A couple of pieces of steak could add sizzle to your portfolio. In the
first part of my series on the best restaurant investments, I suggested Ruth's Chris Steak House ( RUTH) is the most attractive growth story in the sector. Now, I'm staying with the steak theme for my contrarian recommendation. Rare Hospitality ( RARE), owner of LongHorn Steakhouse and The Capital Grille, offers investors the opportunity to get into a stock before everyone expects some upside to its numbers. I like the steakhouse business for several reasons. According to research firm Technomic, the steak segment is growing at a 6% annual rate versus 5.1% for the overall restaurant industry. Steak can be a staple and an aspirational category. For some, eating a steak is as American as baseball and apple pie. For others, it's a meal to be enjoyed on special occasions. Rare's chains cater to both the casual steak eater and the more luxurious diner. LongHorn is an informal restaurant with an average guest check of $16.75, while The Capital Grille is more upscale, boasting an average bill of more than $67. Right now, Rare is appreciated on Wall Street about as much as an overcooked flank steak. Seven analysts rate it a buy against 10 holds. It didn't help that last month the company projected 2007 earnings per share of $1.62 to $1.68 -- well below analysts' forecast at the time of $1.81.
The guidance was affected by higher beef costs and lower same-store sales expectations. The beef costs are locked in, for the most part. Roughly 80% of the beef that Rare will purchase in 2007 is already under contract, protecting the company against further increases. It's unlikely, therefore, that investors will be hit with any more surprises on the cost front (barring any spikes in energy). That leaves sales and margins to worry about. Chris O'Cull with SunTrust Robinson Humphrey believes management's guidance was conservative and could lead to upside even if the company simply achieves flat traffic. He points to LongHorn's 1% traffic decline in 2006 compared to a 3% loss for its peers (through November) as evidence of its strong brand. He also is encouraged by the fact that new stores are outperforming existing stores, which is unusual in the industry.
Management MattersAccording to Zacks, in the nine years since CEO Phil Hickey joined the company, Rare went from a money-losing operation to "one of the most profitable, high-growth public chains in the industry." Zacks analyst Ann Northrop points out that during Hickey's tenure, Rare has achieved compounded annual revenue growth of 17.6% and 22.4% earnings growth. Additionally, O'Cull is impressed with Rare management's acumen when it comes to pricing. "They do a great job of understanding the elasticity of their menu items," he says. "They use more demand-sensitive approaches to pricing than anyone in the industry." O'Cull believes the company's pricing methods allow it to push increases through, where other firms might not have the confidence to do so in fear of losing customers. SunTrust has a non-investment banking business relationship with Rare Hospitality.
While LongHorn is trying to boost its performance, Rare has a gem in The Capital Grille. With 26 locations, The Capital Grille has some of the best unit economics in the business. Same-store sales rose 8.4% in the fourth quarter, while total sales jumped more than 21%. Rare has an enormous market opportunity. Though LongHorn has 276 locations, the restaurants are located primarily in the Southeast, north Atlantic and parts of the Midwest. That means there's still a lot of the country that has yet to see a LongHorn Steakhouse. Management plans to add 33 new locations in 2007, with 30% of them in new markets. Rare has a long way to go before it catches up to OSI Restaurant Partners' ( OSI) 953 Outback Steakhouses.
What a BargainIf Eddie Murphy was looking at this stock's valuation, it's not hard to picture him asking and exclaiming, "Say my man, how much for the Rare Hospitality shares? One times growth? What a bargain! That's a bargain for me. I think I will buy some." With a forward price-to-earnings ratio and long-term consensus growth rate of 18, the stock's P/E to growth of one times is the lowest of the $300 million-plus market cap publicly traded restaurants. It's also below the 1.5 times PEG average for the group.
Additionally, the stock trades at 2.6 times price-to-book, 0.9 times price-to-sales and 10.5 times price-to-cash flow, compared to the average of 3.6, 1.3 and 14.6, respectively. Assuming the company continues to outperform its peers, even in a difficult environment, the stock should at least trade in line with the group, roughly 20% higher. If the company can reverse the traffic decline, I suspect analysts will jump back on board and Rare will leave investors saying, "Well done."