An Industry Where the Bubble Burst

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

Sometimes investors get so enamored with a particular industry that every company is lifted by the rising tide. One such industry where this played out was restaurants, where seemingly every restaurant growing at a fast pace was bid up to the sky. One such example is BJ's Restaurants (NASDAQ: BJRI).

Prior to the company's most recent earnings, the stock was selling for a forward P/E ratio of over 32. While it's still true that analysts expect 20% growth over the next few years, it is hard to justify this type of a premium for many restaurants. We've seen the same sort of overvaluation happen at competitors Buffalo Wild Wings (NASDAQ: BWLD) and Chipotle (NYSE: CMG) as well, and we all know how those have turned out. That being said, if the bubble has burst BJ's could represent a good value since some of the steam has been let out of the stock price.

For those who don't live closer to a BJ's, the concept is primarily located on the west coast. Menu updates recently included expanded pizza and beer offerings, indicating a chain that should appeal to a broad cross section of America. The question for investors is, does BJ's represent a good value after the recent price correction, or are there better opportunities elsewhere?

Primarily because of its growth rates, I always compare BJ's to Buffalo Wild Wings and Chipotle. All three chains are expected to see 20% or better EPS growth in the next few years. All three chains are expanding, and restaurants compete with each other for diner's money no matter whether it's fast casual or a traditional sit down restaurant. However, I also like to compare these fast growing concepts with a more established company like Brinker International (NYSE: EAT). The for this reason is that Brinker is more established, and yet the company continues to find ways to grow. Before we get to some comparisons, let's quickly look at BJ's results.

In the current quarter, BJ's saw revenues increase 16%, and diluted EPS increased 9%. The company is fighting the same challenge that seems to be an issue industry-wide: input cost inflation. While the chain has seen 11 consecutive quarters of positive comparable store sales increases, this quarter represented a different kind of increase. The company benefited from a 3.4% increase in menu pricing, but saw a decline of 1.1% in guest traffic. This worries me, since true organic growth means more people eating at your restaurant, not charging more for less people.

In BJ's earnings call, CEO Gregory Levin said he expects menu pricing to have a positive effect of 3.4% in the fourth quarter, and a 2.5% positive effect in the first two quarters of next year. However, unless guest counts turn around, after the second quarter of next year, comparable sales growth could be harder to come by. Looking at the company's performance, investors should consider a few things when looking at BJ's versus some of their peers.

One concern BJ's investors should have is the company's performance versus analyst estimates over the last few quarters. Look at how BJ's has performed versus its peers:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Beat Estimates</strong></p> </td> <td> <p><strong>Missed Estimates</strong></p> </td> <td> <p><strong>Avg. Beat Or Miss</strong></p> </td> </tr> <tr> <td> <p>BJ's</p> </td> <td> <p>1</p> </td> <td> <p>2</p> </td> <td> <p>-2.80%</p> </td> </tr> <tr> <td> <p>Brinker International</p> </td> <td> <p>3</p> </td> <td> <p>1</p> </td> <td> <p>3.53%</p> </td> </tr> <tr> <td> <p>Buffalo Wild Wings</p> </td> <td> <p>2</p> </td> <td> <p>2</p> </td> <td> <p>-0.80%</p> </td> </tr> <tr> <td> <p>Chipotle</p> </td> <td> <p>2</p> </td> <td> <p>2</p> </td> <td> <p>2.75% </p> </td> </tr> </tbody> </table>

Do you see the problem? BJ's has the worst relative performance of its peer group, and this calls into question if the company will meet the 20% growth projections that analysts have given the company over the next few years.

The second worry I see is the company's free cash flow situation. I use free cash flow per $1 of sales as a way to compare companies of different sizes in the same industry. The arguable industry leader in free cash flow generation is Chipotle. The company generated $0.20 of free cash flow per $1 of sales in the last quarter. Brinker generated $0.06 of free cash flow, Buffalo Wild Wings generated $0.03 by this same measure.

BJ's, on the other hand, actually reported negative free cash flow over the last three months. In fact, over the last few years BJ's has been running very tight when it comes to free cash flow. The company has been able to continue expanding, but their balance sheet has gotten weaker since the beginning of 2012 in particular.

BJ's expects to open about 17 new restaurants in 2013, and this would indicate about 13% new restaurant growth. If the company can achieve low single-digit positive same-store sales, revenue growth should be in the high teens. However, the recent decline in guest counts makes me worry that comps next year might not be as strong. If the company's comps were to come in negative, 20% EPS growth will be a stretch.

Looking at the industry, investors looking for similar growth would probably be better off with either Chipotle or Buffalo Wild Wings. Each company sells for a forward P/E ratio that is similar to BJ's, and each company is expected to see similar growth in EPS. The difference is, Buffalo Wild Wings has been averaging about 6% growth in same-store sales, and even in Chipotle's recent “disappointing” quarter, same-store sales increased almost 5%. In addition, both companies generate positive free cash flow, something that BJ's can't consistently claim. Investors looking for growth and income might consider Brinker International and their 13.5% expected EPS growth and 2.6% dividend.

No matter which other restaurant you choose, it seems like since the bubble burst, there isn't a lot of reason for investors to re-inflate BJ's anytime soon.

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MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of BJ's Restaurants, Buffalo Wild Wings, and Chipotle Mexican Grill. Motley Fool newsletter services recommend BJ's Restaurants, Buffalo Wild Wings, and Chipotle Mexican Grill. 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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