Thursday, December 28, 2006

2006 Restaurant Year in Review and The Menu for 2007

This article was originally published including charts courtesy of CTS Trend on The’s Street Insight Long/Short Trader on Dec. 26, 2006.

So what's on your menu this week? Some left over latkes from Hanukkah? Perhaps some smoked ham cold cuts from Christmas? Looking into 2007, there are several themes in the restaurant sector that will continue to create investment and trade opportunities. So, without further ado, here is my restaurant year in review and outlook for the year ahead.


There were several high-profile restaurant IPOs that took place in 2006. First came Chipotle Mexican Grill (CMG), which soared from the get-go and remained a Wall Street favorite for the balance of the year. The stock even caught on Friday.

The other restaurant spinoff IPO was Tim Hortons (THI). While THI had some success out of the starting gate, the stock has pretty much leveled off and has not found a strong following from analysts or investors.

Finally, Burger King (BKC) came public to join the quick-service ranks along McDonald's (MCD) and Wendy's (WEN), both of which were the source of the two above mentioned spinoffs. BKC stumbled out of the gate, but management appears to be making operational headway and also benefited from the substitution effect.

Look for continued activist shareholder activity in 2007. Don't be surprised if you see a private equity or leveraged buyout deal. CKE Restaurants (CKR) is a good trading stock that rises and falls with such speculation.

Casual Dining

It was a real up and down year for the casual dining segment. A strong start to the year was thwarted in the spring by a market correction, spiking energy prices and the fear of inflation. These companies were hit hard as traffic migrated down the food chain to the quick-service restaurants as the substitution effect took hold. Not until energy prices peaked, the market correction ended and the Fed finally pushed pause in the middle of the summer did the casual dining chains begin to rebound. OSI Restaurant Partners (OSI), which operates the Outback Steakhouse chain among others, managed to get a recent private equity buyout offer. All of the popular casual dining chains had similar chart patterns during the year. Here are some of the favorites: Applebee's (APPB), Darden Restaurants (DRI), Brinker International (EAT) and Ruby Tuesday (RI) all charted together.

Casual dining will struggle in 2007 as the concepts out there are just too homogenous. There are no new offerings that I see on the horizon. Rather, you will have to play this sub-sector as trades, looking to take a lead from economic signals. Commodity costs -- namely, energy and food -- should be watched most closely. There are some potential turnaround stories as well that could provide opportunities. One name that comes to mind is Red Robin Gourmet Burgers (RRGB), which is a great concept that has long suffered from managerial mismanagement and misdeeds. We need to watch RRGB but not rush to act.

Substitution Effect Bolsters Quick-Service Names

The quick-service restaurants were the beneficiary of the substitution effect. The stock that not only weathered the spring squall but managed to be one of the best performers of the year was McDonald's (MCD). Not far behind was Yum! Brands (YUM). I continue to like both of these stocks, especially as they both continue to expand overseas, specifically in China. YUM took a little bit of a hit in December because of an E. coli outbreak at some Taco Bell restaurants, but I believe that to be a short-term issue, and this has presented a good entry point or level at which to add to positions.

The year ahead will be all about international expansion - China, to be exact -- for quick-service names. I continue to like MCD and YUM, which are positioned for this theme. Starbucks (SBUX) is also a China play, but I am not convinced that Howard Schultz can deliver the same level of tremendous growth in 2007 as SBUX has exhibited in the past. Headwinds to SBUX include rising coffee prices and the lingering question, How long can SBUX continue to push up prices to consumers before they revolt?


The steakhouses were problematic this year. The reason for this was the same woes that hurt the casual dining stocks in the spring and early summer (as I mentioned above). Adding insult to injury, these stocks could not rebound because they were hit with the double whammy of higher beef prices. I traded out of and then back into Ruth's Chris Steak House (RUTH) during the year, managing to sell just at the top and then reentering back in the fall at dramatically lower levels. I am still holding my new positions today. Here is a combined chart of RUTH and its closest high-end steakhouse rival Morton's Restaurant Group (MRT).

I really like the premium steakhouses in 2007. My favorite name remains RUTH. RUTH continues to expand not only from coast to coast but internationally in major financial center cities and high-end resort destinations. The spike in beef prices from last summer has subsided, and prices have now abated for several months. The impact of the spiked prices will have worked through the system by the first quarter of 2007. I think that estimates for 2007 are still low and that the company will grow by at least 20% in 2007 and over the next few years.

Who Wants Pizza?

The one group I played wrong this year was the quick-service pizza sector. I was long Domino's Pizza (DPZ) coming into the year and sold too early. On the other hand, I do have pizza exposure through my YUM holding, so I did not totally blow it.

When it comes to pizza, I think that this is a crowded and competitive market, and it will continue to be throughout the new year. Look for cheese prices and the economy as a gauge for trading opportunities. If you want the best of both worlds, own YUM, which has both Pizza Hut and the China growth story all wrapped up in one.

At the time of this Blog entry and the article, Scott Rothbort, his family and or clients of LakeView Asset Management, LLC were long shares of McDonald's (MCD), Yum Brands (YUM) and Ruth's Chris Steakhouse (RUTH) although spositions can change at any time.

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