"A Clean, Simple Cash Business"

Investors can find tasty plays in casual restaurant chains

Inside the Cosi restaurant in Arlington, Va., with its muted brown tones, high-backed booths, and sultry mood music, Oscar Padilla settles in with his notebook PC and one of the chain's signature square bagels. Padilla, a 38-year-old Web consultant, often eats there three times a week. "I hang out in the morning with my notebook and have thinking time, then invite clients for lunch meetings," he says. Padilla, who was burned on tech stocks, may buy Cosi's stock when it goes public in late July.

With tech and telecom in continued free fall, chastened investors such as Padilla are seeking refuge in restaurants. Thanks to strong runups in such companies as Lone Star Steakhouse & Saloon (STAR ), Panera Bread (PNRA ), and Wendy's International (WEN ), the 27 stocks in the Standard & Poor's restaurant index have risen 16.9% over the past year and 8.7% annually since 1997. By contrast, the S&P 500 has plunged 18.9% in the past year, and is up an average 3.7% over the past five years. That performance is fueling a revival in restaurant IPOs, with trendy private chains such as Cosi and Red Robin rushing to go public. Why? After a brief pullback in dining out after September 11, consumers have returned in droves, prompting Technomic, a Chicago consulting firm, to raise their 2002 industry-sales-growth estimate to 4.3%--up from 2% in January. "The truth is, we're a generation that doesn't know how to cook or doesn't have the time to cook," says Andrew Barish, a restaurant analyst at Banc of America Securities.

What's more, the industry fundamentals seem to be improving. The overbuilding of the mid-1990s--when the number of outlets grew an average 5% each year--has abated as lenders have tightened credit. In addition, labor shortages that forced the industry to hike pay an average 6% a year in the late '90s have eased, with wages on pace to rise just 2% this year. "The quality of labor is getting better, which reduces turnaround and training," says Merrill Lynch analyst Peter Oakes.

Against that backdrop, analysts believe there's further upside. Barish says the industry still trades at just 17 times consensus estimated earnings for 2002 and 15 times projected profits for 2003. (In contrast, S&P 500 stocks trade at 20 times projected 2002 earnings and 18 times next year's earnings.) Few restaurants can deliver tech-style growth, but then again, you don't need a computer-science degree to understand their business models. "Restaurants are a clean, simple cash business," says Allan Hickok, who follows the industry for U.S. Bancorp Piper Jaffray.

Still, restaurants are vulnerable to changing consumer tastes and razor-thin margins. Indeed, a spate of lawsuits alleging that major chains have forced managers to work unpaid overtime--which a few, including Shoney's and Starbucks, have settled without admitting guilt--could lead to higher labor costs and put pressure on margins. Given the challenges of managing growth in this sector, some analysts vote against chasing highfliers such as Panera, P.F. Chang's China Bistro (PFCB ), and Cheesecake Factory (CAKE ), which trade at more than 40 times projected 2002 earnings. "Investors have priced in 30% growth for each of the next three years for these stocks. This is too tough a business to do that," says Jay Burnham, an analyst at New York hedge fund Rocker Partners. And there is a risk the runup may have played out, given that the industry traded at a 12 p-e in the late 1990s.

Wall Street pros also caution investors about plunging willy-nilly into IPOs. Harry Milling, a restaurant analyst at Chicago researcher Morningstar, advises against buying New York-based Cosi, a sandwich chain known for its flat, fresh-baked bread. He notes that its 68 mostly East Coast outlets aren't generating positive cash flow: Cosi recorded a $42 million loss in 2001 on sales of $70 million due to the cost of opening new units, closing poorly performing ones, and absorbing its acquisition of the Xando coffee chain. Cosi warns in its prospectus that it can operate only until late 2003 without the IPO. "I don't want to invest in the kind of company that says, `If we don't pull off this IPO, we're gone in a year or we have to make big changes to our business plan,"' Milling says.

Instead, the best bets may lie in casual dining chains such as Brinker International (EAT ), Darden Restaurants (DRI ), and Applebee's International (APPB ), which own and operate most of their restaurants. With average checks below $20, they have benefited from the trend among consumers to spend less. Should the current credit crunch persist, analysts also believe that chains that can fund expansion out of profits, such as Darden and Applebee's, would gain market share on weaker rivals.

Hickok's favorite play is Applebee's, whose shares have soared tenfold over the past decade. Yet at $22, it is trading at just 15 times this year's projected earnings of $1.43 per share--a modest premium to its projected five-year growth rate. He believes sales will accelerate once its 1,400 casual sit-down units add take-out service. And he applauds Applebee's long-running TV campaign that promotes special dishes, such as fajitas. It gets across the message that the menu is constantly being updated.

Barish believes there's opportunity ahead for both Sonic Restaurants, a 1950s-style drive-in chain complete with carhops, and Yum! Brands (YUM ), the PepsiCo spin-off that owns Pizza Hut, Taco Bell, and KFC. He says Yum's success at co-branding--putting a Pizza Hut under the same roof as a Taco Bell--saves on real estate costs and boosts traffic by providing choices for groups with divergent tastes. The result: Same-store sales have risen 8% this year at Taco Bell and 4% at KFC. But Barish believes the real play is Yum's international business, which contributes one-third of pretax profits and is still growing better than 15% a year. "They're where McDonald's (MCD ) was 10 to 15 years ago," he says.

For investors with an appetite for turnarounds, Burnham suggests Rubio's Restaurants (RUBO ), which operates roughly 140 Mexican eateries on the West Coast. After two years of flat sales, it last year shut 11 outlets and redesigned its remaining units by putting grills and see-through refrigerators out front to reinforce its focus on freshness. Burnham says at its current share price of $9, Rubio's is valued at $500,000 per unit--a third of the $1.5 million Wendy's just paid for each of 169 Baja Fresh Mexican Grill outlets. "Baja Fresh still has better [financials], but Rubio's is closing the gap," he notes. As a result, Burnham is betting that Rubio's could be worth $20 to $30 a share. If he's right, the best investments may be on the plate in front of you.

By Dean Foust

With Brian Grow

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