Monday, November 23, 2009

Stock Focus: Red Robin Gourmet Burgers

By Eric Jackson Senior Contributor

11/19/2009 1:15 PM EST
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One of the more surprising sectors of 2009 has been casual dining restaurants. At the start of the year amid concerns of consumer deleveraging, some analysts were expecting a prolonged battering of any stocks with consumer discretionary exposure. Yet restaurants have held up very strongly, especially snapping back from the March lows. It turns out Americans like eating out -- even when times are tough -- and I've identified a stock poised to benefit from the casual-dining trend.

The Powershares Dynamic Food & Beverage (PBJ - commentary - Trade Now) ETF is up 9% for the year, but many specialty restaurant chains have far outpaced that. PF Chang's Bistro (PFCB - commentary - Trade Now) is up 53% so far this year, and Buffalo Wild Wings (BWLD - commentary - Trade Now) is up an even more impressive 64% year to date. The well-regarded restaurant conglomerate Darden (DRI - commentary - Trade Now) is up a more modest 15% YTD (after a very strong recovery in the spring that has since tailed off).

Rather than recommend one of these names and risk chasing performance, I'm going to discuss a restaurant stock that's been tossed in the markdown bin: Red Robin Gourmet Burgers (RRGB - commentary - Trade Now).

Red Robin focuses on high-end burgers and fries, but it's still burgers, so the average check size for families is extremely low ($11.57 in the last quarter). The company has more than 430 restaurants in the U.S. and Canada. Its primary competitors are the general chains Applebee's (owned by DineEquity (DIN - commentary - Trade Now)), Chili's (owned by Brinker (EAT - commentary - Trade Now)) and TGI Friday's.

First, let's discuss the positives of a Red Robin investment. This is a valuation story: The stock is down more than 6% for the year after disappointing on its two most recent earnings calls. The stock is simply too cheap relative to its peers. Its forward P/E ratio is currently at 11 times, while other specialty chains (which Red Robin is) like Buffalo Wild Wings and PF Chang's sport forward P/Es at 17 to 20 times. Brinker and DineEquity have forward P/Es of 11.5 times, but they are both generalist chains.

Red Robin hasn't run heavy discounting to lure customers over the last six months, as Brinker and DineEquity have done, so cash flow has held up well. The company has generated $91 million in cash flow over the past 12 months, compared to $152 million for DineEquity (which also includes IHOP in those numbers) and $287 million for Brinker (which also includes several smaller chains besides Chili's), but DineEquity and Brinker are two and four times the revenue size of Red Robin, respectively. Many analysts expect Red Robin will have an easier time keeping its prices higher going forward relative to competitors who have heavily discounted.

Red Robin has also generated this cash flow growth in the face of falling traffic over the past two quarters. The company has done little marketing over this time period, a negative that has hurt sales and margins, but management will presumably correct this deficiency in the months and quarters ahead. If sales rebound, Red Robin's earnings will go up at an accelerated pace. Its competitors have continued heavy spends on marketing throughout the year, so I expect Red Robin to see a much greater return on its incremental marketing dollars spent in the next year compared to those peers.

As for the risks, Red Robin's management appears to be weak, especially the vice president of marketing. I have no clue why the company would just shut off the marketing valve over these past six months with no plans to increase this spend until new product rollouts in February. This value stock will be a falling knife until it proves to the market that dropping sales have bottomed and are rebounding. At the moment, you're taking a bit of a leap of faith, and that's dangerous. I would be more comfortable with some clear marketing direction from the company. At the moment, that's this company's biggest hole, and CEO Dennis Mullen owns that weakness until he corrects it.

Unlike many other specialty casual dining chains, Red Robin carries debt: $200 million worth. Perhaps it's that debt that is causing them to penny-pinch on marketing. It's a manageable debt load, especially with the company's strong cash flow, but it puts even more pressure on this management team to perform.

Additionally, I also was left scratching my head following the last earnings call about managing commodity costs. Commodities are generally way down from a year ago, and just a few days prior to the Red Robin third-quarter call, Texas Roadhouse (TXRH - commentary - Trade Now) announced an earnings beat that it primarily credited to declining commodity costs. (Texas Roadhouse's stock has jumped 15% since that announcement.) Red Robin, whose commodity-use profile is very similar to that of Texas Roadhouse, announced that gross margins were flat sequentially, although it alluded to the prospect of commodity costs declining in the next couple of quarters as some contracts roll over.

The bottom line is that I expect Red Robin's management team to start aggressively marketing again relatively soon and to benefit from an uptick in resulting traffic and those expected declining commodity costs. After two recent quarterly misses, the company is certainly due for an earnings beat and a surge in the stock price. Investors might have to wait for the first-quarter call before that happens, but a long position now in an unloved stock like Red Robin will likely be rewarded over the next six to eight months.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Red Robin Gourmet Burgers and DineEquity to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Jackson's fund had no positions in the stocks mentioned. Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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