Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver

There is a long list of things to like about the restaurant sector from an investment perspective. Secular trends such as dual-income households have led many families away from frequent home-cooked meals around the dinner table. The busier we are, the more likely we will rely on restaurants of all shapes and sizes. Add in low gas prices and one would think restaurant stocks would be among the stock market’s best performing groups. And yet it has been quite the opposite lately.

I have always liked to invest in the sector, not only for the reasons above but also because it is relatively easy to understand and analyze. Chains often try to differentiate themselves, but the general recipe is the same for most. Suffice it to say I am finding so many bargains in the sector lately it is difficult to choose which ones should make the cut in a portfolio. Valuations are about as low as I have seen them since I began investing more than 20 years ago.

So why are these stocks having so much trouble with both secular and cyclical tailwinds? I think a big issue has been a very strong market appetite for well-known restaurant IPOs. Consider that there are more than 50 publicly traded restaurant stocks in the United States, and more than 20 of them have IPO’d since 2010. Just as these companies are having to compete for customers, they are also competing for investors’ capital. Given that restaurants are a small subset of the consumer sector, there is a finite amount of investment dollars being allocated to the group. With more and more options boarding the public market train, many are simply being discarded.

And despite low gas prices and a propensity to eat out or carry out meals, there are operational challenges all of these chains are facing. The biggest in my view is simply the sheer number of new locations being opened by restaurant chains generally. The number of food options these days can often be overwhelming. At some point it is reasonable to assume the U.S. is going to be facing an overbuilt restaurant sector, at which point many will start to see material declines foot traffic, sales, and profits.

That said, I firmly believe that there are many attractive investment opportunities within the restaurant space. Within the small cap arena there are many companies that offer a compelling business model and meager valuation. A great example is Kona Grill (KONA), a sit-down concept that will deliver over 20% unit growth in 2016 and end the year with 45 locations across the country. The company averages $4.5 million in annual unit revenue and 17-18% unit level profit margins, with a build-out cost of $3 million per location.

At the current $11 share price, which is down a stunning 50% from its 52-week high, the stock trades at a total market value ($127 million) below its $135 million replacement cost (note: replacement cost is how much money it would take to replicate the company’s assets if you started from scratch today). Throw in a long runway of future expansion potential and you have a very attractive long-term investment that Wall Street is completely ignoring. And there are many other bargains out there to be found if you look closely.

Kona Grill (KONA) – 2-Year Chart

kona

Full Disclosure: Long shares of Kona Grill at the time of writing, but positions may change at any time

4 thoughts on “Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver”

  1. I don’t know anything about Kona Grill, but my thought is that investors are wary of non unique concept sit down type restaurant stocks in general because they, on an individual level, seem to fall in and out of fashion so quickly with consumers. Coupled with the rise of fast casual and the continued strength of fast food, and it’s easy to see why many investors wouldn’t consider them all that enticing. It is just really difficult for these guys to build moats around the business (even unique sit down concepts can be replicated).

    1. Perhaps, but the fast casual sector (especially recent IPOs) isn’t really faring any better. Plenty of bargains across the entire spectrum of service level.

  2. Hi,

    I’m a noob investor so please excuse any mistakes.

    “the stock trades at a total market value ($127 million) below its $135 million replacement cost.”

    Ok can we please clarify the significance of replacement cost? A lot of investors throw around this term but I don’t think it holds much significance by itself. An offshore rig might cost a lot to replace but can it earn its cost of capital over a full cycle? Maybe it isn’t worth its replacement cost…To me, an asset is only worth equal to (or more than) to its replacement cost if it earns its cost of capital.

    Now please check this math –

    Per latest report, they have 37 restaurants (costing $111M at $3M at cost/unit).

    They would have $166M revenue, $28M in unit operating income.
    Subtract the SG&A of $3.5M = $24.5M pretax income = $15M net income.

    So ROIC = 15M/111M = 13.5% ? And so if your discount rate is around 7%, this company is worth approximately 2x replacement cost?

    Thanks (and would love other restaurant stocks you could point to).

    1. Given that Kona earns high returns on their units, I would not use replacement cost to value the company. But it does give you an idea of how little credit the market is giving the company right now. At $11 per share, the consensus view is that Kona cannot earn a positive return on these locations. The numbers clearly show otherwise. The actual intrinsic value will depend on what you believe the long-term sustainable margins to be. A per-unit value of $6M might be a little high, but the current share price is ignoring the underlying profitability of the company.

      As for other attractive stocks in the sector… that info is reserved for my clients. 🙂

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