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Cash In On Eating Out

Jason is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The U.S. restaurant industry contracted for three years, over the recession. However, the National Restaurant Association's Restaurant Performance Index, or RPI, has shown two years of steady industry growth since the recovery started. In 2013, the RPI has been at or above 100 (indicating expansion) in every month except February, continuing the trend of positive momentum after a stumble last fall. While it's been bumpy, the trend is for continued, moderate growth, especially among chain restaurants. 

And with the market at or near all-time highs, finding great companies at good prices can be difficult. Investing in an industry with sustained growth can net strong returns for patient investors.

It's too expensive because it costs too much

Darden (NYSE: DRI) has a lot of qualities investors like: It pays a 4.4% dividend with a low 63% payout ratio indicating that income investors should feel plenty confident that it will continue. The recent 10% dividend increase is strong evidence that management is dedicated to its shareholder-friendly policy of capital returns. And while this is good, there are a number of headwinds that appear to be limiting the company's ability to grow those profits in the coming years. 

A 6.9% growth in revenue for FY2013 didn't translate to the bottom line, as net earnings fell by 12%. Per CEO Clarence Otis:

…we expect a macroeconomic environment that is similar in fiscal 2014 to what it was in fiscal 2013, with slow and uneven recovery in both the overall economy and our industry … That means many guests will continue to need and expect us to emphasize affordability. At the same time, the generational, multicultural and other dynamics that are changing tastes and preferences in a host of areas, including what consumers want from restaurants, will continue.

Competition, changing tastes, and downward pressure on prices will continue to weigh on the company's profitability. While acquisitions such as Yard House will offer some room for growth, it takes a lot to move a behemoth like Darden and its 2,100 locations. Lastly, both TTM and forward PE ratios are above 15.5, which is on the high side for Darden's recent history. Mr. Otis said it himself: Darden's just too expensive today.

Something to "Chuy" on

It may sound hypocritical to call Darden expensive at a PE of 15, and then recommend Chuy's (NASDAQ: CHUY) with its forward PE of 55, but that ignores a serious opportunity to invest in a chain with only 45 locations to date. 

The company is operating profitably, having generated $5.8 million in net income for the first six months of the fiscal year, more than double the $2.1 million from the same period a year ago. Its ability to open new locations at a 20% annual rate without having to incur debt or dilutive equity offerings makes the valuation well worth considering. But there's more to what makes this concept so attractive:

$13.26.

That's the average check at Chuy's; well below (opens pdf; go to page 11) the $16.25 and $20.50 at Olive Garden and Red Lobster. And with more than 90% of the items on Chuy's menu below $10, the value -- especially for a full-service restaurant -- is in direct contrast to the pricing pressure that Darden is facing right now. 

And if it sounds counterintuitive, the results of Chuy's value proposition are hard to ignore. The average Chuy's generates over $4.9 million in annual sales. Darden's Olive Garden and Red Lobster bring in $4.6 and $3.8 million per location. And it gets worse for Darden with both chains reporting negative comps, more than 1% down for Olive Garden, and a nearly 3% decline at Red Lobster; while Chuy's comps are consistently growing by more than 2%. 

Who says chickens can't fly?

Buffalo Wild Wings (NASDAQ: BWLD) keeps growing, both through expansion and comparable store sales. Comps of 4%, after more than 5% growth last year, is a real testament to the "stickiness" of the brand, especially with sports fans. With football season upon us, the company is expecting continued strong performance for the foreseeable future. Additionally, the 41% increase in net income -- even more impressive than the company's 27% sales growth -- is largely attributable to two key changes. CEO Sally Smith, from the press release: 

"...we rolled out a new menu strategy of selling wings by portion at all of our restaurants ... We expect this strategy, along with lower traditional wing costs versus last year, to improve our cost of sales percentage."

The chain has almost 1,000 locations, but as Ms. Smith stated on the Q2 earnings call, the company is "actively building the infrastructure" to support another 700 restaurants in North America. And it does carry a PE ratio of close to 33, a tick above its historical average; however, at the current rate the company is growing, paying a little bit of a premium should give you market-beating returns for years to come. 

2 restaurants to buy, 1 to watch

Profitable growth is central to sustained returns, and Chuy's is well positioned with its menu strategy and a compelling concept that draws a lot of foot traffic. Similarly, Buffalo Wild Wings is evolving its pricing strategy to be both more customer friendly and profitable as chicken prices fluctuate. The main message is that both offer substantial future growth.

Darden, on the other hand, is caught in a defensive position. It will be challenged to compete on price to the detriment of the bottom line -- as evidenced by falling net income and operating margins -- for the foreseeable future. As one of the best operators in the industry, it’s worth watching, but it’s no blue plate special at today’s prices.

 

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Jason Hall has no position in any stocks mentioned. The Motley Fool recommends Buffalo Wild Wings. The Motley Fool owns shares of Buffalo Wild Wings 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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