Restaurants- Too many seats, not enough...?

Historically, I have not been a fan of restaurant stocks. I can think of few industries that have such ease of entry. I can recall the story of one restaurant chain’s CEO who proclaimed at his retirement party (after far too much libation) that there is one problem in the restaurant business, too many seats and not enough a##holes! The chain would likely prefer that both it and he remain anonymous. Despite his admonitions of some years ago, a lot of smart money has been looking at this industry.

The spectacle of McDonalds and Wendys is very well documented by others far more talented (see Shai Dardashti Value Hedge Funds focusing on Burger Joints). These investments are predicated by reallocation of capital resources to recognize value.

How wide is the moat for the successful chains? For example, Domino’s (DPZ) at first brush, I would believe to have almost no moat. Yet, this has been a spectacularly successful investment since its IPO. Return on invested capital has been 37% in its TTM period. Debt/ total cap is still uncomfortably high for me. The moat seems to be a function of three things, first, the product seems to represent great value; second, the reliability of delivery time, something the chain is noted for, and finally, its relationship to its franchisees. The franchisees’ willingness to shift more of its revenues to national advertising in 2005 and to repeat it again in 2006, underlines franchisees faith in the parent company. In addition, franchisees seem to love the distribution system, something you rarely hear from a franchisee in any business. Dominos is being a good partner in buying back stock as well as having a healthy dividend.

Cracker Barrel (CBRL) also intrigues me. Compared to DPZ, this is a much cheaper stock with EV/EBITDA less than 7 times versus DPZ at 10 times. Where is the moat here? I guess, compared to most restaurant chains CBRL just leaves their consumer with a better taste in their mouths! During 2005, for the 15th consecutive year, Cracker Barrel was named the "Best Family Dining Restaurant" in the Restaurants & Institutions magazine "Choice in Chains" annual consumer survey. For the 12th consecutive year, Cracker Barrel was ranked as the "Best Restaurant Chain" by Destinations magazine poll. In the 2004 J. D. Power and Associates' inaugural study of customer satisfaction in the restaurant industry, Cracker Barrel scored the highest among family dining chains in overall customer satisfaction in its core market regions and the second highest in those regions among all family and casual dining chains.

Last year, the company reported net income of $126.6 million of which $108 million was free cash flow. In the last five years, the company has bought back $441 million of stock. The company has always focused on treating shareholders well with a ten year dividend growth rate (CAGR) of 37%. Though recent earnings have been affected by high gas prices and some merchandising mistakes in the front-end general store, the merchandising issues are being addressed. This has generally been a 15% return on invested capital business.

In short, though I remain quite skeptical of most restaurant chains as having real franchise value because of the lack of competitive advantage, I am spending some time mulling over these names as possible purchases.