A Closer Look at Restaurant Stocks
Andrew Leckey

The restaurant industry, hit hard by recession and high unemployment, is seeing less investor appetite for its stocks.

While people must eat, they are increasingly careful about how they spend their money to do so.

As in any severe shakeout, some types of restaurants and individual brands have used the opportunity to re-examine and perfect their businesses. They've shown gains in an industry still offering investment opportunities in 2011.

"The strong growth in demand in restaurants is the 'quick-casual' sector that is positioned between fast food and casual dining," said Bryan Elliott, restaurant analyst with Raymond James in Atlanta, Ga. "These restaurants have no 'wait staffs' (table servers) and are perceived to offer better food quality and a better buying experience than fast food, which helped them do well during recession and continues to help now."

Smaller staffs at these restaurants mean lower labor costs, while customers consider them not only convenient but also economical because there isn't any tipping.

The leading companies of quick-casual dining have posted strong results and powerful stock-price gains over the past two years:

-- Chipotle Mexican Grill Inc. (CMG), which has more than 1,000 restaurants in 35 states, Canada and the U.K., benefits from its emphasis on fresh natural ingredients, a basic menu and assembly-line preparation that aids during busy traffic times. It has considerable potential for expansion of its Mexican food concept, especially since it has a strong balance sheet and cash flow that can fund its growth.

-- Panera Bread Co. (PNRA), with almost 1,400 bakery cafes in shopping malls under the Panera Bread, Paradise Bakery and Saint Louis Bread Co. brand names, has developed an excellent supply chain for delivery of fresh dough and other food items to its locations. About 600 of these are company-owned and the others pay franchise fees. Its strong balance sheet and cash flow position it to expand internally or make acquisitions.

"Not only are companies like Chipotle and Panera believed by consumers to have better food quality, but they cater to a more affluent customer," noted Steve West, restaurant analyst with Stifel Nicolaus in St. Louis, Mo. "If you look at all areas of retail -- not just food -- it is the more affluent customer who is driving the recovery we've been seeing."

Both Elliott and West recommend shares of Chipotle and Panera.

Some gains are being made at the expense of traditional sit-down casual restaurants, which had grown considerably in the early 2000s by expanding into more moderate-income areas than they had in the past. High unemployment hit those communities especially hard, and the spending power there diminished considerably. Dining out was considered too much of a luxury.

Since 2004, the bar-and-grill segment of casual restaurants has reported negative traffic for every single quarter, West said. He believes the segment has too many stores, doesn't have enough differentiation among competitors, allowed its service quality to slip and trained its customers to only come in when discounts are in effect.

Despite that sector worry, finding a way to be unique that keeps bringing customers back again and again can still provide a road to success.

"Some concepts will continue to weather the storm, do well and take market share away from competitors," said Greg Ruedy, restaurant analyst with Stephens Inc. in Little Rock, Ark. "Good examples are Texas Roadhouse Inc., BJ's Restaurants and Cheesecake Factory, which offer unique experiences that permit them to increase their menu prices and not have their guests push back."

Each of those three has a distinct personality that differs somewhat from their competitors, as well as a loyal customer base. But it is their growth potential that has investors most interested in them, according to Reudy:

BJ's Restaurants Inc. (BJRI), with 55 casual dining restaurants in the western U.S., serves its own micro-brewed beer, pizza, pasta, sandwiches and salads; Texas Roadhouse Inc. (TXRH), with 330 casual dining restaurants in 46 states, offers steaks, ribs, seafood, salads and sandwiches; and Cheesecake Factory Inc. (CAKE), known for a diverse menu of about 200 items, has more than 160 upscale casual dining restaurants under the Cheesecake Factory and Grand Lux Cafe names.

Stock of BJ's and Cheesecake Factory are also recommended by West.

Fast-food chains have had a difficult time lately.

"The only fast-food chains really doing well this year are YUM! Brands (YUM) and McDonald's Corp. (MCD), and that is really driven by international business," observed West. "McDonald's has a really good U.S. business as well, but when we talk about YUM it is all about China and its 3,000 KFC stores and its 500 Pizza Hut stores there."

The No. 1 issue for restaurants in 2011 and 2012, West believes, is pricing power. Inflation is here and restaurants are going to have to be able to pass those increases on to their menus, he believes. Some will be able to do so, and others won't.

An investor has the opportunity to sample a restaurant's menu before deciding to bite into its stock. Corporate America is loosening its expense accounts and fine restaurants are beginning to benefit from that new largesse, but the American consumer will be the deciding factor in the industry's revival. To eat out or not to eat out, that is the question.

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