OSI: Australian For Cheap Stock

If you believe that the American consumer is drowning in debt, can’t afford $3 gas and will never go out to eat again, then this idea isn’t for you. 

However, if you think the 0% savings rate is inaccurate because it doesn’t include 401k contributions and balances, gas is going back to $2, and that going out to eat is still relatively affordable and "outsources" cooking for overworked families, then Outback’s stock is right up your ally. 

The Company

Outback Steakhouse has a portfolio of eight restaurant brands, including Carrabba’s Italian Grill, Bonefish Grill, and Flemings. The firm’s leading Outback concept has matured but throws off lots of cash to fund the growth of newer brands that have much less competition. 

Outback Steakhouse has a differentiated business model in the overcrowded restaurant industry.  Essentially, each restaurant is developed as a profit-sharing partnership with key personnel such as store managers and chefs. This model allows the company to build a team of invested employee owners and reduce employee turnover.  This structure is the company’s competitive advantage – anyone can open a steakhouse, but not everyone can open 30 a year with quality personnel that ensure a consistent, high-quality experience. 

In buying OSI’s stock, you’re betting that the company can find good managers for the new concepts and manage them as well as it did the growth of the Outback Steakhouses.  I would think that’s a decent bet to make, especially given the current valuation.

The Numbers

Valuation
Market Cap: 2.75B
Enterprise Value: 2.83B
Trailing P/E (ttm): 18.19
Forward P/E: 13.14
PEG Ratio : 1.04
Price/Sales (ttm): 0.80
Price/Book (mrq): 2.36
Enterprise Value/Revenue (ttm)3: 0.83
Enterprise Value/EBITDA (ttm)3: 7.205

Income Statement
Revenue (ttm): 3.41B
Revenue Per Share (ttm): 46.217
Qtrly Revenue Growth (yoy): 13.80%
Gross Profit (ttm): 519.16M
EBITDA (ttm): 392.69M
Net Income Avl to Common (ttm): 156.28M
Diluted EPS (ttm): 2.03

Balance Sheet
Total Cash (mrq): 72.94M
Total Debt (mrq): 171.10M
Total Debt/Equity (mrq): 0.148
Book Value Per Share (mrq): 15.535

Cash Flow Statement
From Operations (ttm): 339.17M
Free Cashflow (ttm): 111.28M

Share Statistics 
Average Volume (3 month): 756,631
Shares Outstanding: 74.62M
% Held by Insiders: 12.56%
% Held by Institutions: 82.40%
Shares Short (as of 12-Jul-05): 3.85M
Short Ratio (as of 12-Jul-05): 7.6
Short % of Float (as of 12-Jul-05): 5.30%

Dividends & Splits
Forward Annual Dividend Rate: 0.52
Forward Annual Dividend Yield: 1.40%

The Investment Thesis

Analysts think the company can develop another 200 Outback units over the next five years on top of the existing 750 units in existence and double the number of Carrabba’s units, now at about 170, over the next five years.  The company has 1,250 total restaurants.  According to my math, they will open between 70 – 80 new stores a year, which is about 7 – 8% growth.  Assume some improvement in comps and you can get to 10 – 12% revenue growth a year. 

The biggest upside comes from margin expansion.  The company used to have operating margins in the 11-13% range.  However, the new concepts are less profitable – start up costs are pretty significant.  Also, beef and insurance costs have been up significantly in the past two years.  The op margin is now only 7.5%.  If it can get back to 9.0% – 10.0% it would add $50 – $100 mln of net income.  It’s surprising the company hasn’t been able to get there already since average operating margins for Brinkers and Darden Restaurants are in the 9.5% – 10.5% range. 

According to the Prudential analyst –

Outback’s earnings model is very leverageable. We estimate a 1% change in comp-store sales (all brands) adds about $0.03 per share (excluding margin impact); and a 10 basis point change in margins adds about $0.04. We estimate a 1% change in Outback sales has a 15-20bp impact on company-wide margins. Our 2006 EPS would approximate $3.50-$3.60 if operating margins were to return to 2002-2003 levels.

Valuation   

OSI is starting to look interesting from a valuation perspective – without any improvements, I think the stock is worth about $35-40.  The financials are in good shape – strong FCF, pretty steady margins, some growth, virtually no debt.  The only negative is the SSS have been down for two quarters now, which is what is weighing on the stock.  And revenue growth has been lackluster at 7%.  However, the stock is trading at 10x operating cash flow, which is pretty darn cheap.  It’s trading about 30x FCF because the company is still opening stores at a fairly rapid pace.  I don’t know what a "maintenance" cap ex number would be but I would guess it would be much less than the $200 mln they spend now.  If you assume they stop growing the store base and just milk the company for cash, I would guess FCF would be about $250-$270 mln a year instead of the current $60 – $80mln.   That would put it at about 12x FCF. 

Again from the Prudential analyst

Over the next 12-24 months, we think Outback could unlock its pent up earnings power, which could be as much as $3.55-$4.20 in 2006-2007 (including options expense). This suggests OSI shares may be worth as much as $55-$75 each assuming a 16x-18x P/E multiple, causing us to raise our price target to $60 from $54. Our EPS power thesis is based on three factors. Commodities are the largest part; but there’s also earnings potential from recapturing lost margin from below plan sales at Outback and investments in growth.

The only valuation problem is that the stock is still pricing in some margin improvement.  On a Price to Sales basis the stock has never been cheaper.  However, on a P/E basis, the stock is still trading in the middle of the historical range.  That means if margins don’t improve at some point in the near future, the stock will go down no matter what. 

The other problem is that the restaurant group is still trading at the middle of the range in valuation but the results are going to come in at mult-year lows.  So there’s probably some more downside.  The Sun Trust analyst says –

We believe that while EV/EBITDA valuations have come in meaningfully, we are not certain that (1) we have reached trough valuations and (2) the consumer will have the disposable income to spend on dining out given gas prices above $2.50 a gallon and most likely high heating oil prices as we enter winter.

In addition, we have concerns over (1) margin pressure in the 2H05 due to fuel surcharges associated with food and beverage deliveries and (2) lower than expected margin expansion in 2006 due to lower food cost savings y/y, especially beef, as well as continued cost pressures from minimum wage rate increases, utilities and credit card fees.

In short, we believe restaurant shares should be trading at or very near trough EV/EBITDA multiples for the following reasons (1) the likelihood that consumers will adjust their dining out frequency lower on a permanent basis due to structurally less disposal income associated with higher gas prices and upcoming higher heating oil prices, (2) concerns over the restaurant industry’s ability to take some level of price in 2006 due to more aggressive price increases in the last two years and the consumer’s lower disposable income, (3) a higher level of re- investment spending by the more savvy and sophisticated restaurant management teams to drive a higher price/value equation and (4) our belief that margin expansion expectations for 2006 are too high and must come down.

Q2 Results
Average unit volume at the flagship steakhouse chain declined 1.3% at company-owned units, while same-restaurant sales declined 0.9%. The negative comparable-store sales were caused by a decline in traffic and softness in per-person check averages at steakhouses in the Midwest.

At the firm’s other chains, namely Carrabba’s Italian Grill and Fleming’s Prime Steakhouse & Wine Bar, average unit volume and comparable sales showed strong gains. The firm’s gross margins also improved from the previous quarter, primarily from lower food costs. Total revenue increased 13.8% to $915.7 million from the year-ago quarter, while net income was down 6.7% to $40.4 million, including an impairment charge for some former Outback sports assets.

Reward
The core Outback steakhouse throws off enough cash to fund the development of newer brands.  The company is using the same business model to build the new brands that it used in building the original Outback concept. 

The company acquired the designation rights to 76 Chi-Chi’s properties at auction for $42.5 million. Outback expects that this deal will help offset increasing construction costs.

Outback limits the use of franchise licenses so it can maintain operational control over the majority of its restaurants.

The new concepts are doing well, which adds some addition growth and upside.  New concepts are at higher price points and could get higher margins. 

The company launched a 2.5 mln share buyback in 2003.  The company has a clean balance sheet and could lever up to buy more shares if it wanted to.

Risks
The other reason the stock is attractively priced right now is that it has lost its CEO and CFO in the past six months.  Both of the founders stepped down from operational roles in recent months, and the firm’s CFO since 1990, Robert Merritt, resigned in April because of frustration over increasing regulatory demands.   A couple of analysts think that the company is rethinking the current business model and that will make significant changes in the coming months. 

Obviously, the steakhouse market is saturated, so growth will depend on smaller, less-proove brands.

The Chart

Quite frankly, OSI’s weekly chart couldn’t look worse.  That said, it is still hanging out in an area of long term support and is oversold on almost every measure.  If I believe in the underlying fundamentals of a company, I love buying stocks with ugly charts like OSI.  No techncial analyst in their right mind would buy a chart that looks like this.  And that’s contrarian investing at its best.