High stock prices pose risk, opportunityHigh stock prices pose risk, opportunity

Restaurant stocks have been on a tear this year.  The NRN Restaurant Index was up about 16 percent as I wrote this — in line with the 15-percent gain in the Standard & Poor’s 500 Index.

Still, the industry’s relative performance remains understated because the stock price of the largest company in the group, McDonald’s Corp., has risen only 11 percent, and the stock price for Yum! Brands Inc., the group’s second-largest company, has edged up only 4 percent.

Stock prices for many companies, however, have risen dramatically. Among them, the price for Bloomin’ Brands Inc., parent of Outback Steakhouse and other chains, is up 50 percent year to date, and Chuy’s Holdings Inc. is up 48 percent. Both Red Robin International Inc. and Ruth’s Hospitality Group Inc. are up 53 percent, and Fiesta Restaurant Group Inc., parent of the Taco Cabana and Pollo Tropical brands, is up 139 percent.

Of course, with excellent performance have come higher valuations. A few weeks ago, an old friend and I commiserated about the current bull market for restaurant stocks, recalling the hot stock market of the early 1990s. We focused on valuations then and now.

Our memories on the specifics were a little hazy, but we recalled that the best and most rapidly growing companies had price-earnings ratios of upward of 30 times estimated earnings, and cash-flow multiples in the low to mid-double digits. Needless to say, those were pretty heady valuations. Relative to anticipated growth, the PE ratios for those more rapidly growing companies were in the area of 1-to-1.

To test our memories, I looked at valuations in the mid-1990s for Papa John’s International Inc. and The Cheesecake Factory Inc. At the time, Papa John’s probably had the strongest fundamentals of any restaurant company and was growing earnings 30 percent to 35 percent or more, with same-store sales increases near double digits and unit expansion of 30 percent or higher. That growth was reflected in its valuation, as the stock sported a PE ratio of 30 to 35 times estimated earnings and a cash-flow multiple in the high teens.

The Cheesecake Factory had only 17 restaurants at the end of 1996. Its fundamentals were also strong, with same-store sales up in the mid-single digits and unit growth of more than 30 percent. The stock was selling for 25 to 30 times estimated earnings and about 10 times estimated cash flow.

Our thesis that the higher-multiple stocks were selling for approximately one times their growth rates was confirmed by these two stocks.

I also looked at the valuations of Outback Steakhouse and Brinker International Inc., both of which were high-flyers in the early 1990s but had issues by the mid-1990s. Their valuations were below those of The Cheesecake Factory and Papa John’s, selling for seven to eight times forward cash flow.

Then and now

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So how do today’s valuations stack up to those of the 1990s? On an absolute basis, not much differently. According to Raymond James Financial Inc., the forward PE ratio for a group of growth restaurant companies averages in the mid-20-times area, and the cash-flow multiple is about 10. The comparable valuations for a group of mature chains average in the mid-teens and upper single digits.

What is different, however, is the PE ratio relative to the companies’ growth rates. According to Raymond James, average projected earnings growth from 2013 to 2014 for the growth group is about 20 percent, resulting in a PE-to-growth relationship of about 1.25-to-1 — well ahead of the relative valuations in the mid-1990s.

The mature group, according to Raymond James, is selling, on average, for a 15-percent premium to its growth rate. One could argue that valuations today should be higher because interest rates are so low. A counter argument is that interest rates are likely to rise at some point, causing valuations to decline.

Another factor posing a risk to high valuations is that returns on capital at the restaurant level today are lower. For example, average sales of an Outback Steakhouse in 2012 approximated the average in 1996. Outback is not unique in that situation, which plays into the modest unit expansion plans of many mature chains. Industry maturation and increased competition have restricted sales, while investment amounts have gone up over time as a result of inflation.

There are a few exceptions, such as Chuy’s, that have unit-level economics rivaling those of the hotter growth concepts of the 1990s. Those high returns may justify  high valuations. History has proven, however, that growth inevitably slows, leading to lower valuations.

What should investors and company executives do in this environment? Investors should monitor sales and earnings trends closely, paying special attention to return on investment at the restaurant level, in particular for the growth chains. Companies that can sustain high returns have proven that they can buck the trend of significant multiple contraction over a long period of time. When returns begin to falter, however, stock prices follow; from the current peak, the risk is great.

Meanwhile, company executives should take advantage of these valuations to raise capital.  Even those that have no real need for capital should consider taking advantage of the strong market. As they say, the time to raise capital is when you can, not when you need to. And be on the lookout for more initial public offerings.

Steve Rockwell has 30 years of experience in the restaurant industry, including as a restaurant analyst, finance executive, investor and consultant. He is a partner in Results Thru Strategy, a consulting firm based in Charlotte, N.C., and can be reached at [email protected].