Casual Restaurant Stocks Rally Even With Weak U.S. Demand

Shares of casual-dining chains are rallying, even with Americans eating out less, as investors speculate about acquisitions and prefer holding stocks with little foreign exposure.

The Bloomberg U.S. Casual-Dining Restaurant Index (BNUSFSRS) — comprised of Darden Restaurants Inc., Brinker International Inc. and 14 other companies — has risen 2.7 percent since April 30, compared with a 2.9 percent decline for the Standard & Poor’s 500 Index. Meanwhile, sales at these types of restaurants fell 1.3 percent in May from a year earlier at locations open at least 16 months where customers pay after a meal, according to the Knapp-Track Index of monthly restaurant sales. The decline was the biggest since 2010.

Investors have been drawn to casual-dining shares because they’re “fearful” of holding companies that have a lot of business outside the U.S., said Rachael Rothman, a senior analyst in Bala Cynwyd, Pennsylvania, with Susquehanna Financial Group. Given risks associated with Europe — where Spain, Greece and Italy are among the countries in recession — and China’s slowing growth, investors are “hiding in purely domestic stocks,” including Darden (DRI), Brinker and Cheesecake Factory Inc. (CAKE), that generate “well over 95 percent” of their revenue in America, she estimated.

The perception is that “the U.S. might not be great, but it’s not terrible,” Rothman said. She maintains a “positive” recommendation on Orlando, Florida-based Darden. The operator of Olive Garden and Red Lobster is scheduled to release fiscal fourth-quarter earnings June 22.

‘Remains Lackluster’

Shares for these types of restaurants may be poised to underperform because discretionary spending, like dining out, “remains lackluster,” said Martin Leclerc, principal, chief investment officer and portfolio manager at Barrack Yard Advisors in Bryn Mawr, Pennsylvania. Fickle consumers and expensive valuations of some companies don’t make them attractive for investment right now, he said.

Even so, some investors remain bullish because of the premiums paid in recent acquisitions of Benihana Inc. (BNHN) and P.F. Chang’s China Bistro Inc. (PFCB), Leclerc said. The industry is trading higher than it typically would relative to the S&P 500 as talk of more possible deals persists, he said.

“People are speculating that other companies may be taken out at a big premium relative to their share price,” Leclerc said. That means these stocks now are overvalued, and given a demand environment that’s “not great,” Leclerc’s company has no plans to invest in this industry anytime soon, he said.

Acquisition Boost

Benihana, which operates 95 Japanese-themed and sushi restaurants in the U.S., agreed May 22 to be taken private by Angelo, Gordon & Co. in a deal worth about $296 million with an offer of $16.30 a share. This followed a May 1 deal valued at about $1.1 billion as competitor P.F. Chang’s agreed to Centerbridge Partners LP’s offer of $51.50 a share.

Benihana stock jumped 21 percent on the news to close at $16.12, up from $13.30 the previous day, while P.F. Chang’s rose about 30 percent to close at $51.48 compared with $39.69.

Dining out easily can be postponed, so these types of restaurants are a “very visible indicator” of what’s happening in the economy, said Malcolm Knapp, a New York-based consultant who created the Knapp-Track Index and has monitored the industry since 1970. Amid declining confidence and with the risk of a so- called fiscal cliff “top of mind,” consumers don’t have the appetite to eat away from home as frequently, he said.

Retail Weakness

The U.S. is facing more than $600 billion in higher taxes and reductions in defense and other government programs in 2013. U.S. retail sales weakened in May, falling 0.2 percent and matching an April decline that previously was reported as a gain, based on data from the Commerce Department. Meanwhile, consumer sentiment, measured by the Bloomberg Comfort Index, fell to minus 36.4 in the week ended June 10 from a four-year high of minus 31.4 in April.

“It doesn’t feel like we’re out of a recession for many middle-class American households,” Knapp said. In what’s become an “allocation nation,” consumers must choose between different categories of discretionary spending, and dining out is “very sensitive” to changing habits, he said.

Rothman lowered her same-store estimates for Darden, Brinker (EAT) and Cheesecake Factory on June 13 because of the slowing casual-dining results reflected by the Knapp-Track Index. Demand has had a “sharp deceleration” so far this quarter compared with the prior period, which creates underperformance risk for Dallas-based Brinker and Cheesecake Factory, based in Calabasas Hills, California — one reason for her “neutral” recommendations on these companies.

Losing Momentum

The recent outperformance of the casual-dining index is losing momentum, said Jim Stellakis, founder and director of research at New York-based research company Technical Alpha. This signals a lack of conviction by investors that these stocks can rally further, he said.

Darden, the only so-called blue-chip operator in this industry, is selling at a “reasonable valuation,” Leclerc said. “But given the economic environment, there may be better investment opportunities elsewhere.”

The stock is trading at 12.7 times Rothman’s estimate for fiscal-year 2012 earnings, a 20 percent discount to its peers, which shows that investors already are factoring in weaker demand for the company’s meals, she said. Darden reduced its annual sales-growth forecast to a range of 6 percent to 7 percent on Dec. 6, down from a previous forecast of 6.5 percent to 7.5 percent, causing the shares to tumble 12 percent that day to $41.82, the biggest drop since August 2008.

Less Pessimistic

There are some pockets of strength in the industry, Rothman said, noting that eateries like Cheesecake Factory tend to appeal to college-educated diners who have a higher income and are less pessimistic about the economy.

While Leclerc prefers opportunities in other industries, he understands why some investors are looking to eateries as a “pure-play” on the U.S., he said. This rationale for owning these stocks may disappear if investors become “more confident in having exposure to Europe again.”

There could be other risks to their performance as the November U.S. elections approach and eateries compete for consumers’ attention in an advertising environment emphasizing economic risk, Rothman said.

That might further damp demand for dining out, causing investors once again to “focus on how risky the domestic operating environment is,” she said. “These stocks could suffer if fundamentals remain lackluster.”

By Anna-Louise Jackson and Anthony Feld

Courtesy of Bloomberg News

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