High Valuations Served in Restaurant Sector Has Investors Saying "Send It Back"

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The tepid economic recovery has slowed the digestion of diners at steakhouses in the United States. Some mid-level and upscale restaurant stocks are reasonably valued while others are richly priced. Investors should wait for valuations to go on a diet before buying shares in an industry facing economic headwinds.

Upscale Eateries: Anemic Growth

According to the Knapp-Track Index of monthly restaurant sales and guest counts, the revenue of top U.S. steakhouses has been “more erratic” in 2012. When compared with the revenues of 2011, the revenue has declined as eating out at fancier eateries has become reserved for celebrating life events. Value has become part of consumer behavior both for out-of-pocket spending and spending from corporate expense accounts.

A further decline is expected in the fourth quarter as anticipated by Action Economics, a forecasting organization based in Colorado. Its chief economist Mike Englund said that there could be “waves of fear” that could slam U.S. discretionary spending. These fluctuations in steakhouse sales could have a “pretty sizable impact” on the restaurant industry as a whole.

There are around 100 Fine-Dining Restaurants owned by Landry’s, which also owns a number of fancy steakhouses like Morton’s, Vic & Anthony’s, and Brenner’s. Chief Executive Officer Tilman J. Fertitta noted that the lukewarm same-store sales growth in 2012 is not “near the growth of last year.”

Searching for Value in Restaurant Stocks

If sales are only weakly growing, shouldn’t mid-range and high-end restaurants be trading at price multiples that reflect lower growth expectations? They should, but they don’t.

Consider BJ's Restaurants (NASDAQ: BJRI) which trades at a price of roughly $40. These shares are trading at a lofty 34.71 price-to-earnings ratio, a price multiple more than twice the 14.1 PE of the S&P 500. This high valuation ratio is not dis-confirmed by the company’s mid-range 1.68 price-to-sales ratio. That would be an acceptable value in industries which have higher gross and operating margins, but not in the restaurant industry.

Valuations are equally unappetizing for the Cheesecake Factory (NASDAQ: CAKE). At $34 these shares have a price-to-sales ratio of 1.02, a fraction of the S&P 500 average. Again, this is cheap relative to the broader market, but is not that exciting for a restaurant stock given weak margins. Cheesecake Factory shares currently trade at a high 19.21 price-to-earnings ratio, a higher value than the 14.1 average of the S&P 500 index.

The Cheesecake Factory does offer a dividend, but at 1.40% it is lower than the 1.71% yield of the 10-year treasury. Sure, these are safe dividend payments because the company only pays out 0.06 of earnings as dividends, affording a huge cushion of earnings that would have to decline before a dividend cut was forced. However, there is no need to buy a stock at a high valuation for a small dividend payment.

Brinker International (NYSE: EAT) stock offers a similar value proposition. It trades around $33 per share and offers a dividend yield of 2.40% which is much higher than the 1.71% yield of the 10-year treasury bond. Future dividend payments are likely because the company pays out 0.34 of earnings as dividends. However, given its high 17.67 price-to-earnings ratio, income investors are better served looking for dividend yield elsewhere.  This is not an attractive valuation for a restaurant stock, regardless of dividend yield.

This might sound like a broken record, but the same song is playing for Texas Roadhouse (TXRH) at $17 per hare. Texas Roadhouse shares currently trade at a high 17.94 price-to-earnings ratio, a higher value than the 14.1 average of the S&P 500 index. This pricey valuation trumps the stock’s 2.14% dividend yield and reasonable 0.35 dividend payout ratio.

There are tastier valuations in the restaurant industry. Bloomin' Brands (NASDAQ: BLMN) stock is trading at closer-to-fair multiples at a price of roughly $15. When compared to the 1.29 price-to-sales ratio of the S&P 500 or its restaurant peers the 0.45 ratio of this stock is very attractive. Bloomin' Brands shares are trading at a fair 16.09 price-to-earnings ratio, in line with the S&P 500 average. Analysts view this as a growth stock with five-year estimates at 17.3% per year. These valuations are better than peer companies, but still not compelling.

A better restaurant stock income opportunity is being served up by the stock market, too. Darden Restaurants (NYSE: DRI) stock is trading around $55 per share. At a value of 0.87, this stock trades at a fraction of the S&P price-to-sales average multiple. Darden Restaurants shares are trading at a fair 14.96 price-to-earnings ratio, in line with the S&P 500 average.

This stock pays a hefty 3.65% dividend which is more than twice the 1.71% 10-year treasury yield. Future dividend payments are likely because the company pays out 48% of earnings as dividends, lower that the 60% rule of thumb threshold for precarious payouts.

Conclusion: “Send it back”

Investors should not accept valuations like these in a challenged industry. Instead, they should wait for lower valuations. In particular, they should keep their eyes on Darden Restaurants and Bloomin' Brands and consider buying on dips when their price-to-earnings ratios drop significantly lower than market averages.

BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of BJ's Restaurants and Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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