P.F. Chang's: Hot Now, but May Go Sour

For one brief, irrational moment, SARS threatened one of this bear market's few true successes, P.F. Chang's China Bistro (PFCB ) Would diners, fearful of the virus that causes severe acute respiratory syndrome, stop lining up outside the fast-growing chain's restaurants?

Never mind that Chang's is a thoroughly American outfit based in Scottsdale, Ariz. CEO Rick Federico found the question kept coming up in an Apr. 23 conference call with investors. "Frankly," he finally said, "I have no idea."

Now, as new SARS cases -- and public worries -- seem to be ebbing, little is hindering Chang's stock. At highs near $44 (chart), it's up 20% this year, after a gain of 53% in 2002 and 50% the year before. Propelling it have been steady expansion (104 outlets, with another 24 by yearend), growth in sales (32% in 2002), and profits, which are seen leaping this year by 31%, to $1.06 a share. Yet to wary investors like me, Chang's looks like an increasingly risky bet.

I venture this appraisal after having enjoyed a delicious lunch (hot and sour soup, $2.95; Sichuan shrimp, $12.25) with flawless service at an Orlando Chang's. Conceived in 1993 by serial restaurateur Paul Fleming, Chang's has built a strong following by presenting traditional Chinese dishes amid what it calls "American hospitality" -- big, comfortable dining rooms, attentive service, and a long wine list. Chang's also is developing the cheaper, quicker Pei Wei Asian Diner (pronounced "pay way") in hopes of extending its laudable growth record.

Naturally, rivals have noticed Chang's good fortune. One, SensAsian, opened its first outlet in Irvine, Calif., in March and is set soon to open a couple more in California. Backed by Hong Kong-based Favorite Restaurants Group, a large KFC and Pizza Hut franchisee in Asia, it's being marketed under the aegis of chef Martin Yan, host of TV's "Yan Can Cook." In addition, Favorite has a 50-50 joint-venture with Yum! Brands (YUM ), parent of KFC, Taco Bell, and Pizza Hut, to develop a Pei Wei-like quick-service chain called Yan Can. It has opened five outlets and expects to open another five or so this year, 18 more in 2004, and ultimately as many as 2,000.

Chang's also will likely soon face a rival it knows well. A spokeswoman for Chang's founder, Paul Fleming, who already has gone on to launch an eponymous steakhouse chain, confirmed he will unveil plans for yet another chain, this one Chinese, "in the near future." Others say he has recruited a key executive from Chang's and is positioning the new venture between Chang's and Pei Wei, potentially eating into sales of both.

All of these chains can coexist. The problem is how they may hurt Chang's ability to lease the best locations in new markets, hire the best managers and chefs, and keep profits growing fast enough that investors will still pay a premium for the stock.

How big is that premium? A wrinkle in Chang's structure offers a clue. All of Chang's chefs and top operating managers must buy a 2% to 7% stake in the restaurants or regions they're responsible for. These "partnerships," as Chang's calls them, "are very important to our business and have helped in our success," Chief Financial Officer Kristina Cashman told me. Chang's keeps an option to buy them out at fair value, usually after five years. Last year, for example, it bought back six stakes for $4.5 million. I wondered, what multiple of sales, earnings, or cash flow did Chang's pay? Cashman noted partnership stakes reflect only restaurant operations, not those of the whole company, which as the developer of new concepts such as Pei Wei holds more growth potential. That said, Cashman told me that for partnerships, Chang's has typically paid four times cash flow. Now let's be generous and suppose Chang's as a whole is worth, say, three times that multiple, or 12 times cash flow. In the past four quarters, Chang's generated cash of $2.40 a share. Use a calculator, put pencil to paper, try an abacus. Anyway you figure, Chang's is too much.

By Robert Barker

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