Monday, February 27, 2006

Is Outback Out of Luck?

Restaurant chain Outback Steakhouse (OSI) was upgraded by Morgan Stanley Monday morning.

We're less optimistic about Outback's prospects. The steak space is getting too crowded for our liking and Outback's newer themes (like Bonefish Grill) are far less proven concepts to bet the ranch on.

We expect Outback will continue to tread through choppy waters for the remainder of 2006. This stems from our view that there really is no veritable brand connection between Outback and its customers -- one recent channel check confirmed that Outback has low "stickiness factor," especially within its steakhouse segment, whose 900 restaurants comprise the bulk of Outback's sales.

Outback continues to suffer from below industry margins, as well. Its balance sheet is anything but clean ($44M cash paired with $200M in debt & leases) and a recent management change (the co-founders took a hike) may still have some investors on edge. There are just too many question marks hanging around, as well as better stocks to focus on.

Our restaurant pick remains Darden Resaurants (DRI), which we brought your attention to last December (with the stock at $35). Darden enjoys modest growth, double digit operating margins, and heightened brand awareness. Darden focuses on getting a lot of out what they've already got (resulting in an impressive 25% ROE) and we like how its CEO spares investors the tiring "sales were soft because of hurricanes" routine that so many of his colleagues have succumbed to.

We believe 2006 will be a litmus test year for Outback, which could easily topple under an economic downturn, rapidly evolving consumer tastes, and the spillover effects associated with higher commodity prices (squeezing margins even further -- ouch!) Because Outback isn't in the position to leverage off its name, the stock could quickly deteriorate under strenuous conditions.

If steak is your thing, we suggest a look at Morton's (MRT) -- although it just went public, we like the 13% operating margins they've been cranking out. If you want growth, look no further than specialty dessert purveyor The Cheescake Factory (CAKE), which operates at full capacity and has massive room for growth. Although its trailing P/E may seem a bit high to some, we believe that Cheeesecake's growth prospects and clean balance sheet (ample cash with zero debt) justify the valuation. Should the restaurant industry stumble, we believe Cheesecakes's strong niche makes its less susceptible to earnings erosion.

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