A Restaurant Chain with a Different Flavor
By Markos Kaminis
This week's S&P Focus Stock of the Week, P. F. Chang's China Bistro (PFCB ), was recently initiated into coverage with S&P's highest investment ranking of 5 STARS (buy).
Driven by the economic stimulus of six interest rate cuts this year buy the Federal Reserve, we believe that companies that compete for consumer discretionary dollars should do well in the next twelve months. In addition, restaurant stocks like P.F. Chang's stand to benefit from federal tax relief, which should begin arriving soon in mailboxes across the country in the form of tax refund checks. With all that, we at Standard & Poor's believe P.F. Chang is an appealing concept.
An operator of restaurant concepts in the Asian niche, P.F. Chang's believes its recipe for success is a blend of traditional Chinese cuisine and American hospitality, served up in a sophisticated, contemporary bistro setting. Formed in 1996, the company embarked on a strategic expansion of the concept targeted at major metropolitan areas throughout the U.S. We believe the company's opportunity is significant, with the Asian niche remaining as one of few yet untapped segments by national chains. It is our view that continued operational success in its expansion effort could generate interest in the company from larger restaurateurs in search of new growth vehicles.
ROOM TO GROW.
The Asian segment is large and fragmented, as evidenced by P.F. Chang's leadership with 52 locations. The company plans to follow 2000's new opening schedule of 17 restaurants, with the addition of 18 eateries in 2001. Restaurants are planned for seven new cities and seven existing markets across the country. A high degree of P.F. Chang's established locations are in the Southwest, Florida and Texas, however, the company's restaurants are spread throughout the country.
The menu selection at P.F. Chang's focuses on dishes designed to replicate the flavors and styles of China's five major culinary regions: Canton, Hunan, Mongolia, Shanghai and Szechwan. The menu adheres to the Chinese culinary concepts of fan and t'sai, a balance of rice, noodles and grains with meat, seafood and vegetables. Each P.F. Chang's restaurant features a display kitchen and exhibition wok cooking areas, and is decorated with terra cotta replicas of Xi'an warriors and narrative murals depicting 12th century China. The size of a typical Bistro will range from 6,000-7,000 square feet. Entrees at the restaurant range in price from $8 to $13, and appetizers range in price from $3 to $8. The average check per guest, including alcoholic beverages, is approximately $17 to $18.
Though all of P.F. Chang's stores are owned and operated by the company, an important cog in the company's operating strategy involves the empowering of its managers. In order to provide incentive to key management personnel, the company enters into partnership agreements with its regional managers, certain of its general managers and certain executive chefs. These agreements entitle the managers to a percentage of the cash flows, typically 2-7%, over which they hold responsibility. The agreements are for a five-year term, after which, the company holds the right to buy back the minority interest. The minority partner is not entitled to transfer their ownership before the five-year period has elapsed. It's our view that this arrangement enables the company to better insure a consistent and quality experience across stores as it grows.
The company has been testing a second concept, Pei Wei Asian Diner, which caters to a quicker, more casual dining experience. The first Pei Wei was opened in July 2000, and the company has committed to opening another four locations in 2001. The capital requirements for opening a Pei Wei are $700,000, with pre-opening expenses of $80,000 per location. This compares to $2.1 million and $325,000 outlays necessary for the average Bistro. Pei Wei also offers take-out food, with approximately 35% of its business currently derived in that manner. We at S&P believe that early success with initial Pei Wei locations will translate into an intensification of the rollout of the concept in 2002.
It is our view that the ingredients necessary to establish a successful restaurant company, are to first develop an appealing concept that will continue to draw repeat business, and then to manage growth carefully enough not to lose its character along the way. P.F. Chang's management and board, which carries experience from Brinker International, Ruth's Chris Steakhouse and other restaurant and retail companies, is experienced enough, and has a viable business model in place to do so. The company has relatively negligible debt ($1.4 million, vs. $32 million in cash at the end of the second quarter), and has necessary capital resources already in place to finance its path to positive cash flow, which it expects in 2003. We estimate that P.F. Chang will attain initial positive cash flows in late 2002.
S&P feels that it is important for investors to be aware of risks before they commit capital. In the case of P. F. Chang's, we feel the most significant company specific risk is geographical concentration. Approximately 20% of the company's restaurants are located in California. Economic weakness or energy restrictions could impact operating results. Though we warn of this potential, we recommend purchase of the shares based on our view that the economy will benefit from tax relief and Federal Reserve action. Also, P.F. Chang's California locations are relatively well spread, which should lesson risk related to energy shortages.
Revenues have grown at an average annual rate of 81% over the past three years. As the store base grows, and with a conservative expansion plan, revenue growth rates will decelerate. We project average annual revenue growth of 25% over the next five years. On July 5, 2001, the company announced that second quarter revenue growth of 43% had surpassed its expectations for 34%-38% growth; we had forecasted a 37% increase. In addition, the company provided guidance for the third quarter of 2001, stating that it expects revenues to rise 26%-30%, with comparable store growth of 2%. S&P views the company's guidance as conservative, and projects revenue growth of 33% in the third quarter.
We at S&P expect the company's revenues to climb 35% in 2001, driven primarily by the opening of new restaurants. We anticipate same-store sales growth of 2-4%, compared to 11.7% in 2000, as the entire industry is impacted by a weaker U.S. economy. However, we expect an improved economy and a growing awareness of the company's brand to boost same-store growth in 2002. The restaurant operating margin should narrow in 2001, due to higher utility, food and labor costs. Labor costs will be impacted by an early 2001 increase in California's minimum wage rate. Over time, we at S&P expect the margin to widen, as P.F. Chang gains power over food and supply purchases. With leverage over restaurant pre-opening costs and G&A expenses, the EBITDA margin should widen about 40 basis points. We expect the net margin to widen to 4.9% in 2002, compared to 4.1% in 2000. Following depreciation charges, minority interest, and a lower effective tax rate, EPS should climb over 37% in 2001, to $1.18. We forecast EPS growth of 32% in 2002, to $1.56.
The shares have progressed upward since their late 1998 IPO, and were recently up 19% in 2001, compared to a 9.7% decline in the S&P 500. Even so, we believe P.F. Chang shares have room for further upside. The company's p-e multiple of 32 times our 2001 EPS estimate is above the 19X multiple of companies in the S&P 1500 restaurant index, but our EPS growth expectation of 30% annually for the next five years (35% over next two years) is also superior to consensus long-term industry growth expectations of 16%. Based on our valuation of projected future free cash flows from operations, we value the shares at $52, or 37% above the current market price.
Kaminis is an equity analyst covering emerging growth stocks for Standard & Poor's