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Conclusion: The quadrant chart posted below portrays a clear picture of the current situation for restaurant stocks.  A disproportionately large number of companies are operating in “Nirvana”; comparable restaurant sales are growing year-over-year and restaurant operating margins are expanding year-over-year.   The valuation multiples in the chart are assigned by the Street and a clear relationship can be seen between valuation assigned and operational performance (different quadrants).

The following companies are currently operating in Nirvana as of the most recently reported quarter: CMG, BJRI, YUM, SBUX, MCD, PNRA, CAKE, DIN, TXRH, DRI, BWLD, RT, MRT, and PFCB.  With the exception of DIN, DRI, BWDL, and PFCB, all of these companies were in the same quadrant as of the prior reported quarter also.  On a NTM EV/EBITDA basis, the group is trading at an average of 9.4x.  If we remove CMG from the list the multiple falls to 8.9x.

I would like to highlight several names that are, in my view, facing a possible move out of Nirvana in the next quarter or two.  Yum China, TXRH, MRT, CAKE, BWLD, MCD, CMG, PNRA and RT are the primary names I am watching in this regard.

Yum China has performed will over the last number of quarters and exceeded my expectations.  That said, I firmly believe that the company will find it difficult to extend their stay in Nirvana more than another quarter or two.  As I posted earlier today in my note titled, “YUM – WATCH CHINA CONFIDENCE”, consumer confidence is a key driver of top line trends for Yum China and took a sharp turn down in the third quarter.  Where that metric trends from here is a key question going forward.  Additionally, McDonalds announced that the company has raised prices in China due to higher raw material costs.  If Yum experiences the same pressure, it could either translate into margin pressure or, in the event of an ill-received price increase, additional drag on sales.

TXRH and MRT are obviously highly exposed to rising beef costs and many companies in the restaurant space, in the Casual Dining and Quick Service concepts, have highlighted elevated beef costs as a key concern going forward.  Additionally, for Morton’s, layoffs (that many are expecting) in the financial sector could have an impact on sales trends.  This is not helped by the fact that a sharp step up in comparable restaurant sales from 3Q09 to 4Q09 will present MRT with a far more difficult compare in the last quarter of 2010.

CAKE’s average check problem remains a concern and comps are more difficult to lap in 4Q than they were in 3Q when the company barely comped the restaurant operating margin from the year prior.  Despite the implicit message embedded in the fact that customers are trading down to smaller plates and snacks, the company implemented a 1% menu price increase in August.

Food inflation could possible take CMG out of Nirvana.  In line with its “food with integrity” mantra, the company purchases its food on the spot market and is therefore vulnerable to volatility in the foodstuffs markets.  CMG is lapping declines in food costs of 218 and 207 basis points, respectively, in 4Q10 and 1Q11, respectively.  I would consider it more likely that the company would leave the Nirvana quadrant in 1Q11 than in 4Q10.  The same is true for MCD.  The company has not yet discussed inflation trends in 2011, but they are likely to trend higher with beef prices.  Like CMG, I see MCD likely falling out in 1Q11 due to year-over-year decline in restaurant operating margin.

I remain cautious, as I was a quarter ago, about RT’s ability to maintain its operating performance in Nirvana in 2QFY11.  As I wrote in my note titled, “RT: IMPROVING BUT THINGS SHOULD SLOW”, momentum will likely slow after the first quarter of FY11 for RT.  This could mean RT moving to the “Deep Hole” quadrant, negative comparable restaurant sales and contracting restaurant operating margins.

BWLD has been enjoying favorably commodity prices since chicken wing prices peaked in January and sales in the most recent quarter were an upside surprise to me.  As the commodity tailwind goes away, it may be difficult for the company to maintain margins in positive territory on a year over year basis.  Additionally, the company has many underperforming, lower volume stores to close down and this process of “right-sizing” may take some time. 

The “Deep Hole” quadrant is populated by companies that are operating with negative comparable restaurant sales and negative year-over-year changes in restaurant operating margins.  From a QSR perspective, MCD is causing a lot of pain for its competitors.  Additionally, higher protein prices will begin to be felt on the bottom line in the upcoming quarter.  This has been called out by several QSR management teams.  The following companies are currently in that category: SONC, WEN, JACK, KONA, and RRGB.  Emerging from this quadrant is quite difficult in that it requires patience; management teams cannot take short cuts or rely on short term fixes. 

RRGB is one company that I believe has been taking the wrong approach for several quarters now. They have been under pressure from a check average perspective and management was recently moved to state on their 3Q earnings call that “competitive encroachment” and the concept not being “differentiated” enough is negatively impacting the business. 

EAT, on the other hand, has emerged from the “Deep Hole” quadrant thanks to a measured plan on the part of management to increase restaurant operating margins and improve sales on a sustained basis.  The former has already occurred; EAT is now in the “Life-line” quadrant and – per my recent notes on the name – I expect sales to pick up in the upcoming quarters (EAT – A BADGE OF HONOR, 11/14) and move into nirvana by FY3Q11. 

Overall, a brief glance at the quadrant chart below is enough to tell anyone that restaurant stocks performed well over the last quarter.  However, this can only persist for so long and I expect to see a more even distribution among the respective quadrants of this chart over the coming quarters.

RESTAURANT SIGMAS - OVERCROWDING IN NIRVANA - RESTAURANT SIGMA

Howard Penney

Managing Director