Tasty Pickings In Restaurant Stocks

Investors in restaurant stocks have suffered through a bad case of heartburn lately. In the last half of 1996, the sector underperformed the Standard & Poor's 500-stock index by 17 percentage points. And so far, 1997 is even worse: On Jan. 28, weak sales and earnings from Brinker International triggered yet another sell-off. The Dallas-based casual-dining chain plunged 28% in a day, and restaurants overall ended the month five percentage points behind the market.

Yet for those on the sidelines willing to sift through the mess, some tasty pickings may await. In the midst of the many greasy spoons, a few four-star stocks are lurking. And with the bull market lifting so many other sectors, the slump in the food-service sector could provide a rare chance to pick up a fast-growing company relatively cheap.

Excess capacity is at the heart of most of the industry's problems. Restaurateurs from McDonald's on down have become gluttons for expansion, relying on super-sized building programs to keep up with Wall Street's aggressive sales-growth targets. As a result, the number of chain outlets will increase by an estimated 4.5% this year, while the industry's inflation-adjusted sales will grow by just 1.4%. It's a recipe for painful consolidation. "A lot of stocks out there are going to get cut in half, even though they might seem cheap now," predicts analyst Damon Brundage at NatWest Securities.

To make money in such tough times, investors need to be especially selective. For starters, forget about companies where operations have stumbled. Since every competitor is scrambling for sales growth, the odds are stacked against turnaround plays. That's why Brinker dropped so sharply when its numbers indicated the company had truly slipped. Other top casual-dining stocks face a similar tailspin, such as Darden Restaurants of Red Lobster and Olive Garden fame, and Apple South, a Madison (Ga.) operator of Applebee's restaurants. "It will be very, very difficult for these chains to grow their earnings," Brundage says.

Beware, too, of smaller chains that aren't ready for prime time. In a period of hot competition, companies with me-too concepts and overstretched managements can get flambeed faster than a crepe suzette. Take Italian Oven, which declared bankruptcy in October just 11 months after its initial public offering. And Quality Dining in Mishawaka, Ind., carried out three public offerings in less than three years before its shares plunged in the last half of 1996. "It's a minefield. You have to do your homework," notes consultant Ron Paul at Chicago-based Technomics.

IT'S WORTH IT. Instead of the lowest price, look instead for proven track records, especially sales growth at outlets that have been open more than a year. To obtain such quality, investors can expect to pay a premium over the sector's beaten-down average. Applebee's International in Overland Park, Kan., outperformed its peers last year, and hence looks more expensive. But its concepts, management, past performance, and national scope bode well for the future (better, in fact, than for its regional franchisee, Apple South). Another possible winner: Anaheim (Calif.)-based CKE Restaurants, known for reviving such chains as Carl's Jr. "It's one of the first real consolidation plays in the restaurant business," notes analyst Allan Hickok at Piper Jaffray. Just one catch: It soared 125% last year. But it's still undervalued, says Hickok, who expects CKE earnings to grow 25% annually.

To be sure, stocks of smaller restaurant companies can offer big potential, too. But they're volatile, usually rewarding those who trade in-and-out rather than buy-and-forget. These days, with smart investors getting wary of restaurant IPOs, the next hot stock could be an older name: Morton's Restaurant Group, a fast-growing upscale steak chain based in New Hyde Park, N.Y. Hickok pegs Morton's operating earnings per share at $1.20 for 1997, up from an estimated $1.02 in 1996, an 18% increase.

And what of McDonald's, the Big Mac of restaurant chains? Experienced management? Check. Proven concept? Check. Growth? There's the rub. In the U.S., McDonald's battles for every burger against Wendy's and Burger King. But its international business is solid. Plus the chain has a new, numbers-oriented manager leading its domestic business. If it continues to lag the market, as it did in 1996, McDonald's stock could become an attractive value play in a sector that otherwise promises to keep the antacid flowing on Wall Street.

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