Sunday, April 26, 2009

"Operation Dinner Out"

Operation Dinner Out is a Go!

Just thought I’d highlight the action in one of my favorite sector of the US economy. For those who don’t pay much attention to this group, the stocks of American Casual Dining chains have been on fire for the past two months. What’s going here? Granted some of these stocks fell too far too fast, but by in large most of them were stil a little pricey before this rally started. So, how does one rationalize these multiples? It is not like we are dealing with some sort of groundbreaking technology or potential revolutionary business model here. And this is not the financials; you don’t need to worry about lack of transparency on the balance sheet or off balance sheet obligations. The valuation game here should be pretty cut and dry.

Ahh, but this is the stock market and rarely does anything make sense. One would think that with unprecedented unemployment and an overleveraged US consumer that casual dining chains would be facing less foot traffic in the immediate term and the prospects of continuing declines in foot traffic over the long haul, a shrinking pie if you will. And one would further conclude that any group facing a shrinking pie is going to have a hard time generating any meaningful earnings growth, and thus should trade at below the average market multiple and also below historical multiples for the peer group. One would be Wrong!! Well, at least for now.

What has transpired with this group is in my personal opinion nothing more than a basic short squeeze, and is by in large completely unjustified. There are those that will argue that people are trading down into this group, and that they are thus not as affected as upscale dining chains or high end retail in general. I agree with this argument to the extent that on a relative basis I’d rather be buffalo wild wings or Chipotle Mexican grill over let’s say Ruth's Chris or Morton’s, but that doesn’t mean I want to pay anything over 15x earnings for either of them. There are others that will argue that this bunch has been cutting costs and that this will allow them to drive compelling eps growth despite declining comps. This argument probably by in large sparked the momentum trade in this sector. Once people started realizing that q1 was going to be better than analysts expected because cost cutting more than offset declining sales, the whole group went parabolic. I won’t deny that the sell side (and many of us who tried to short) clearly missed how much operating leverage some of these chains would see in their first quarter because of declining commodity prices, lower rents, reduced wage expenses, lower advertising spending (in some cases mgmt pushed the majority of ad spending into q2 or q3), and in some instances the carryover effect from small price increases that were put in place early q4. Management at all these chains(I expect the story at the ones who have not reported yet will be the same) has responded fast and taken out costs, and in this business that means they will see the bulk of these savings immediately feed through into the bottom line because declining sales trends in casual dining are a long-term phenomena. However, at the end of the day the average name in this group is trading at above 20x earnings and not below 10x. This means that without very strong long-term growth they will need to be re-priced sometime in the near future. The sales trends from almost every name in the group are nothing to write home about. Comparables are mostly down year over year, and consumers clearly seem to have begun a trend of making fewer visits and spending less money at these chains. Not what you want to see when you are paying over 20x earnings.

To be clear when I recommended betting against this group last year I did not think we were going to see numbers fall off of a cliff. That was not what this trade was all about. What I was betting was that the multiples in this group needed to decline to quickly reflect the fact that it was becoming patently obvious that the whole sector was going to be facing a challenging sales environment for the next few years. (I define challenging as the exact opposite of the sales environment over the past 20 years) I expected this to be a gradual story that played itself out over the next 12-24 months. Instead, I ended up with a momentum short trade as everyone started to assume that this group would collapse as quickly as every other cyclical sector tied to the US consumer. And when a bunch of people who have been shorting a group start seeing the exact opposite of what they had expected they start running for the hills, and when they start running for the hills, a whole new momentum trades surfaces to squeeze the life out of them. Again, all psychology, very little fundamentals.

So, after 6 months most of these stocks are right back to where they were before this whole mess started. Some are even close to all time highs. The trailing multiple on the bunch probably has not been this high since sometime in 2006 or 2007. What’s changed since then or since the time I felt shorting these stocks was a good idea? The entire global economy fell off a cliff, US unemployment took off, and financial markets nearly ceased to function.

Doesn’t make much sense does it. But then again these things can happen once a trade gets too crowded. In my personal opinion, what you have now is more evidence of weakening sales trends going forward which should allow you to make an even stronger case for long-term multiple compression in this group. Moreover, the market has already responded to and management has already taken advantage of aggressive cost reductions to protect the bottom line. This means that going forward the entire focus will be on sales and that q1 2010 will offer for very tough year over year comparisons as the huge boost in operating margins we just saw won’t be there. I don’t know if there is an etf for this group, but if there is one I’d be looking to buy May 2010 puts sometime soon.

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