Lone Star Steakhouse (STAR) and Outback Steakhouse (OSI) were each off 2%-3% today. My only reaction is to wish for another large drop, and then another. You see, when you are a value investor and have a large cash position (like most value investors do right now) you pray for prices to drop, so you can get some great companies "on sale." Both of these companies' prices need to fall, because I like them, although for very different reasons. These steakhouses also make a great study in contrasts, and show why the quality of the company and the price of the company can never be considered in isolation.
"So," as I like to say, "what do these companies do, anyway?"
Lone Star is a smallish mid-priced chain with about 269 restaurants. There is not a lot of brand recognition, and the company is not adding any new sites.
Outback is a 1,100 site behemoth with a well-known brand, a national ad campaign and plans for international expansion as well as branching out into new concepts (including one sponsored by Jimmy Buffett.)
Here are some stats (source:Yahoo Finance and company press releases):
ROA ROE Ops Margin (EBIT/Sales) Systemwide Comps (4Q)
STAR 9.8% 11% 11% 4.7%
OSI 12% 16% 10% 4.1%
Easy call, right? "No rules, just right!" beats up on "Lone Star what?"
Wrong.
Not "Wrong, Lone Star is the better investment" but "Wrong, it's not an easy call - both companies are tempting"
The reason is price.
Using my private market value ratio, EV/EBIT ((Market value of equity + market value of debt - cash)/EBIT), the picture gets a little muddy.
If you believe both companies will make the same operating profit next year as this year, you need to pay twice the cash for each dollar of operating profit for Outback as you do Lone Star:
Company EV/EBIT (ttm)
STAR 7x
OSI 14x
"But Outback is growing" the OSI bulls (no pun intended!) say. Indeed they are! Outback is plowing a lot of cash into new restaurants. The way I measure expansion is by comparing the current year's depreciation charges (a proxy for the capital base) with the year's capital spending. Any ratio of capex/depreciation greater than 1 indicates rapid expansion.
Company Capex/Depreciation
STAR 18%
OSI 240%
Lone Star is barely keeping the lights on, while Outback is going full speed ahead!
So you have a rapidly growing company demanding twice the price of a slow (but still profitable) grower. Which one, if any, do you buy? You need to crunch some numbers.
One way that I like to look at companies is to treat them like 5 year bonds, with coupons (dividends) paid every year, plus the ending value returned in year 5. Look at the "Yield to Maturity" and see if you feel comfortable. The problem is that you don't know what that ending value is going to be, since companies don't determine par value - Mr. Market does. What mood will Mr. Market be in in 5 years? Will he pay you 30 times earnings or 10? I really don't know, and neither do you! This is where "margin of safety" comes in.
Looking at STAR's financials, they generate massive amounts of cash that are either used to buyback stock or pay a dividend, but not build new stores. In fact, they bought back 8% of their stock last year, and currently pay a 2.7% dividend yield. They are probably trading at a small discount to private market value, so the EV/EBIT ratio may rise over time.
Lone Star Steakhouse 5 year financials
Year 0 1 2 3 4 5 Growth Rate
EBIT 3.63 3.45 3.27 3.11 2.95 2.81 -5%
Shares 1.00 0.92 0.85 0.78 0.72 0.66 -8%
EBIT/shr 3.63 3.75 3.87 3.99 4.12 4.26 3%
Multiple 7------------------------------------> 9
Dividends 0.70 0.74 0.79 0.83 0.88 0.94 6%
Cash Flow (25.39) 0.74 0.79 0.83 0.88 39.26
IRR 11.4%
The spreadsheet assumes a slight downward EBIT trend, but strong cash flow enables rich buybacks, which actually increases EBIT/share and dividends/share. The multiple corrects to a still undervalued 9x. The important line is the bottom one, which shows a large cash deposit, followed by some dividends and a cash return at the end. The IRR (Internal Rate of Return) is the "yield" for our "bond." An 11% yield is pretty good, considering 5 year government notes are yielding just over 3%. Of course, a 3% note as guaranteed, but equity returns are not!
Outback cuts a different profile - less buybacks (2%) low yield (1.1%) but fast (12%), compounding growth. The problem is the price. 14x EBIT is a little rich, and may not hold up in 5 years, especially if their growth starts to slow.
Outback Steakhouse 5 year financials
Year 0 1 2 3 4 5 Growth Rate
EBIT 3.23 3.62 4.05 4.54 5.08 5.69 12%
Shares 1.00 0.98 0.96 0.94 0.92 0.90 -2%
EBIT/shr 3.23 3.69 4.22 4.82 5.51 6.30 14%
Multiple 14------------------------------------> 12
Dividends 0.52 0.55 0.58 0.62 0.66 0.70 6%
Cash Flow (45.21) 0.55 0.58 0.62 0.66 76.25
IRR 11.9%
Well, look at that! 5 year profit growth of 12%, increasing dividends and buybacks, and a yield very close to STAR's! As you can see, even 2 points of valuation can make a big difference. This is why price is so critical to long term success! I don't deny that people made big money buying Starbucks at 45x or Microsoft at 35x, but catching one of those rockets is tough! The other point is that Outback is playing a big game of "trust me" with their investors when they retain so much of their cash flow. They obviously found a profitable, repeatable formula, but when does the model break down from saturation? I guarantee you won't be the first to know!
I don't mean to sound negative about Outback. They have a great brand, the lines are out the door every night, and they generate fantastic returns on capital. In fact, Warren Buffet likes them so much, he owns 2.5% of the company! I'm guessing that he paid considerably less than 20x earnings, though. (No one remembers that he paid 15x EPS for Coca-Cola.)
So, which one to buy? That is for you to decide. If you are confident in Outback's prospects, you probably would favor them, since the compounding effect of retained earnings could really be big in the long run. If you are more cautious, you might pick STAR, since they give lots of cash to their shareholders and have a much smaller price tag.
I am rooting for both of them to drop some more, so I get them on sale!
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