Markets & Finance

A Steak-House Stock with Sizzle


S&P likes Rare Hospitality's growth potential and valuation, and rates the shares a strong buy

From Standard & Poor's Equity ResearchWe expect Rare Hospitality International (RARE: $27) to continue to expand its two restaurant concepts, LongHorn Steakhouse and Capital Grille, as part of an expansion strategy designed to nearly double its number of restaurants over the next five to seven years. We think this will drive strong earnings growth as well.

Rare's shares recently traded at 17 times estimated 2007 earnings per share (EPS) of $1.57, in line with peers. However, we believe the stock, which was down 18.9% through July, vs. a 2.6% decline in the S&P Restaurants index, merits a premium due to the company's attractive growth prospects.

In our judgment, Rare offers superior growth potential through the expected expansion of its two restaurant concepts. We believe the decline in the company's share price so far this year has left the shares a compelling value, and we have a ranking of 5-STARS (strong buy) on the shares.

Company Background

Rare owns, operates, and franchises 317 restaurants as of July 1, 2007, including 287 LongHorn Steakhouse restaurants, 28 Capital Grille restaurants, and two additional restaurants: Hemenway's Seafood Grille & Oyster Bar, and the Old Grist Mill Tavern. On June 21, 2007, the company sold its 30-unit Bugaboo Creek Steak House chain for $24 million.

LongHorn Steakhouse restaurants, located throughout the eastern half of the U.S., are casual-dining, full-service restaurants that serve lunch and dinner, offer full liquor service, and feature a menu of fresh-cut steaks, as well as salmon, shrimp, chicken, ribs, pork chops, and prime rib. Average weekly sales per unit were $57,850 in 2006, up 1.7% over $57,000 in 2005. Through company operations and franchise royalties, LongHorn accounted for 78% of revenues in 2006 and 79% in 2005 (as restated for discontinued operations).

With locations in major metropolitan cities throughout the eastern and central U.S., we believe the Capital Grille restaurants boast an atmosphere of power dining, elegance, and style. They are fine-dining restaurants, with menu offerings including dry-aged steaks, chops, large North Atlantic lobsters, fresh seafood, and a wine list with more than 300 selections. Average weekly sales per unit were approximately $157,500 in 2006, up 5.7% from 2005. The Capital Grille restaurants accounted for 21% of revenues in 2006, up from 20% in 2005.

Rare is a partner in a joint venture that owns three LongHorn Steakhouse restaurants. In addition, four LongHorn Steakhouses located in Puerto Rico are owned by an unaffiliated franchisee. All other system restaurants are owned and operated by the company.

Company Outlook

We estimate revenue growth of about 10% in 2007, reflecting expansion of both concepts, as well as average unit volume (AUV) growth of 2.0% at LongHorn Steakhouse and 4.0% at Capital Grille. The year-to-year comparison is understated, as 2006 included a 53rd week. Assumptions in our AUV forecast are for nominally positive comparable restaurant sales for LongHorn and 3% same-store sales growth at Capital Grille. We expect Rare to end 2007 with 296 LongHorn restaurants, 31 more than at the end of 2006, and 30 Capital Grilles, four more than a year ago.

We project 2007 EPS from continuing operations of $1.57, up modestly from $1.54 in 2006, exclusive of a 9¢-per-share nonrecurring charge for impairment of assets, as well as results of discontinued items. The company determined it would sell its small Bugaboo Creek chain during 2006, and the sale was completed in June, 2007.

Our forecast assumes some pressure on margins, particularly from higher beef costs in the second half of the year. Additional cost pressures from higher self-insurance costs and wage costs have occurred.

These costs should result in moderate operating deleveraging at LongHorn, An average year-over-year increase in menu prices of about 2%, coupled with flat to slightly lower traffic, will likely only partly offset cost increases through the remainder of 2007.

Similar price increases along with modestly higher traffic should result in flat to higher margins at Capital Grille. However, we think that based on the unit's momentum out of the second quarter, in which it reported a 6.9% increase in same-store sales, there is the potential for same-store growth to be better than the 3% we have built into our model for the second half.

For 2008, we project total revenue will increase 15%, reflecting continued expansion, and moderate same-store sales growth averaged across both chains. We expect five new Capital Grilles and 33 to 35 LongHorns to open.

We think cost pressures will moderate in 2008, and we have assumed further modest margin compression. Pre-opening costs will likely continue to rise on a per-unit basis, reflecting wage pressure for construction workers and higher material costs. We expect EPS to increase to $1.75.

Looking ahead to 2009, we are modeling flat restaurant margins with revenue rising 15% to 16%. Our model looks for EPS to increase 17%, slightly faster than revenue, to $2.05, due to some modest leverage of corporate costs.

We assume RARE will not substantially alter its current capital structure, with debt and capital leases equal to 32% of invested capital. In 2006, Rare repurchased approximately 3.6 million of its common shares for $120 million with funds raised from the issuance of $125 million of 20-year bonds. The company may buy back more shares, as on Apr. 24, 2007, the company's board authorized the repurchase of up to $55 million of its common shares through May 1, 2009, although we think it will primarily use operating cash flow to expand its two restaurant concepts for the foreseeable future.

Industry Position

The casual-dining restaurant segment enjoyed strong growth during the first half of this decade, as a long-term trend toward more meals away from home continued. Americans now spend about as much on meals away from home as they do at home.

However, during 2006, guest traffic growth slowed, and fell at some chains within the casual-dining group. Traffic has remained a challenge through the first half of 2007. We expect this trend to continue into 2008, despite the fact that results for many companies will be compared to already weak postings from a year earlier.

Costs, meanwhile, are rising across most input categories: food, labor, energy, insurance, etc. We estimate that food inflation is running at 2.5% to 3.5%, based on reports from companies S&P follows. In turn, most companies are raising prices 1% to 3%, with the trend being toward the upper end of that range.

With flat to negative traffic and menu price increases unlikely to fully offset cost inflation, most restaurant chains that S&P follows experienced margin pressure in the first half of 2007.

We believe LongHorn compares favorably in its 2007 first-half performance to most other casual dining concepts and to other steak-house chains in particular. The Capital Grille continues to be a bright spot in the restaurant industry, in our judgment, strongly outperforming its peer group.

Valuation

At a recent level of about 17 times our 2007 EPS estimate of $1.57, Rare stock trades in line with casual-dining peers in our coverage universe. However, based on an 8.3 times estimated 2007 earnings before interest, taxes, depreciation, and amortization (EBITDA), we believe the shares are valued well below the casual-dining peers we cover.

Until very recently, there has been a takeover premium in the valuations of a number of restaurant stocks, by our analysis. However, we believe that the late-July market correction effectively took out much of this premium. For example, Nelson Peltz has continued to pressure the board of Wendy's International (WEN; $34) to enter into talks for the shareholder activist to buy the company for as much as $41 a share, although to our knowledge he has not made a formal offer.

We believe Rare shares merit a premium valuation that reflects its strong sales momentum at the Capital Grille concept, good expansion prospects for both of the company's restaurant concepts, and Rare's conservative use of debt; long-term debt and capital lease obligations as of July 1, 2007, were 1.5 times estimated 2007 EBITDA. Our 12-month target price of $35 implies a forward p-e of 22 times our 2007 EPS estimate.

Our target price is based on our discounted-cash-flow model, which assumes average annual revenue growth of about 15% for the next five years that gradually declines, a perpetual growth rate of 2.5%, and a weighted average cost of equity of 9.6%, rising to 10.2% after five years.

Corporate Governance

We have a generally favorable view of Rare's corporate governance. Chairman and Chief Executive Philip Hickey Jr. is a 25-year restaurant industry veteran. Hickey joined the company as president in October, 1997, and was appointed CEO in 1998. He became chairman in 2001. The company's board of directors consists of nine directors divided into three classes of three directors each. Two of the nine directors are company executives, with the other seven holding positions or having experience in a variety of industries, including the restaurant, food distribution, banking, and investment industries.

One aspect we view unfavorably is that the chairman and CEO positions are both held by Hickey. We would prefer that Rare move to appoint a separate board chairman who is not a company employee, a practice that is becoming more common among publicly held companies.

Investment Risks

Risks to our recommendation and target price, in our view, include the possibility that rising food costs will narrow operating margins more than expected, that fuel costs will continue to rise, negatively affecting customer traffic, and that the company's concepts will not find acceptance in new geographic areas of expansion. Our assumptions regarding the expansion and growth of Rare's business are predicated on S&P's economic forecast, which calls for moderate growth with consumer spending adjusted for inflation continuing to increase within a range of 2.5% to 3.5% annually.


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