Restaurant Stocks: Not As Tasty As They Look
By Herb Greenberg

(FORTUNE Magazine) – Restaurant stocks often look appetizing, but it seems as if investors always take a place at the table at the wrong time or stay way too long, only to leave with a horrible case of indigestion. Think back to the Mylanta moments of the past: Planet Hollywood, Rainforest Cafe, and Koo-Koo-Roo. Each one, at some point, was a Wall Street darling before becoming an investment disaster. Remember those names in months to come, as investment banks, looking to fill the gap left by the lurch in technology, start chatting up restaurant stocks, especially IPOs of small, popular regional chains.

That doesn't mean investors should avoid restaurants altogether. But it does make sense to follow a few basic principles, starting with the all-important Rule No. 1: Just because you like the food doesn't mean you should buy the stock. The best menu can't counter bad fundamentals or a sloppy economy. Ask anyone who bought into the IPO of the Smith & Wollensky Restaurant Group, which owns upscale steakhouses around the country and a smattering of other high-end eateries in New York City. After it went public last May at $8.50, Smith & Wollensky's shares tumbled to their current price of around $3.84, the victim of an economic downturn that has taken a bite out of business dining.

Rule No. 2: A long line out front doesn't necessarily mean sales are booming. Lines matter only if they're getting longer, and the one real way to measure that is through same-store sales, i.e., sales of stores open a year or more. The signs aren't encouraging here: For the better part of a year, growth rates have been falling at some of the hottest chains (with some of the longest lines), including Buca di Beppo, Cheesecake Factory, and P.F. Chang's. The numbers at older stores are especially important, as they can signal what's ahead for newer ones. Take Asian eatery P.F. Chang's, for example: Sales at stores open since 1996 actually fell 2.6% in the second quarter. "A warning flag is when things slow, but when they go negative, all bets are off," says money manager Rick Shea of Vardon Capital. And a slowdown is the least you can expect at all fast-growing chains, he says, because "it's the law of big numbers."

Speaking of big numbers, here's Rule No. 3: Don't get taken in by analysts hyping a new concept with grandiose forecasts. Robertson Stephens analyst Paul Westra recently stirred investor enthusiasm for P.F. Chang's when he claimed that its three-unit Pei Wei Chinese fast-food operation "may have an ultimate U.S. sales potential of $1.5 billion." Pretty impressive, until you realize that's five times the current sales of the entire 52-unit P.F. Chang's operation. Over at Buca, meanwhile, CEO Joseph Micatrotto brags that his company, with 68 stores in 21 states, is "firmly convinced" that it will eventually have 450 units nationally. Good luck! Says one former brokerage industry analyst who now works as a hedge fund manager: "I would be very careful of any management team that thinks it can build a 'national brand.' It just will not happen."

That leads to Rule No. 4: The faster a chain grows, the more likely it is to stumble. Expansion is a double-edged sword for public restaurants. Investors demand sales and earnings growth. But once a market becomes saturated, companies are often forced to pick second- and third-tier locations for their new eateries--which inevitably produce second- and third-tier results. "There's a point at which you simply run out of places with the population density necessary to support additional stores," Shea says. Joey Crugnale, ex-CEO of Bertucci's Brick Oven Pizzeria, marvels how in one year he opened 18 restaurants in seven new markets outside his company's Northeast stronghold. "Wall Street gave us the money," he says. "We had to do something with it." Now restaurants in many of those markets have been closed, and Crugnale says he has no intention of taking his new chain, the Cuban-themed Naked Fish, public anytime soon.

Finally, Rule No. 5, or the golden rule of making (or not losing!) money in the restaurant business: Follow the money. In recent months insiders have been selling or registering to sell shares of Cheesecake Factory, P.F. Chang's, and California Pizza Kitchen. At California Pizza Kitchen, in fact, controlling investor Bruckman Rosser Sherrill & Co. has peeled off a substantial part of its holdings this year. The message for investors: If insiders are bailing out, maybe you should be too.

Herb Greenberg is a senior columnist for Questions? Comments? Contact him by e-mail at