Description

Outback Steakhouse Inc. (OSI)

I am sure most people are familiar with the Outback Steakhouse restaurant, so I won’t provide as much background on the concept. It is the largest steakhouse chain that operates at the higher end of casual dining and has an Australian Outback theme. There are currently 670 company owned and 105 franchised units in the domestic market. There are also 88 company owned and 51 franchised units internationally. The primary competitors are Lone Star (STAR), Longhorn (RARE), Logan’s (CBRL) and Texas Roadhouse (TXRH) in the steak category and Applebee’s, Chili’s, Olive Garden, and Red Lobster (DRI) in casual dining. With an average check of $16.09, they are priced higher than most of their competition since they serve a higher quality product and it tends to be more special occasion for many of their customers. With average annual unit volumes of about $3.5 million, 17.7% restaurant level margin, and $2.3 million in total fully capitalized cost, the unit level return is about 27%.
The Outback brand is clearly the critical part of the company’s current earnings, but it is becoming less important going forward. The brand accounts for about 72% of their sales and even greater 83% of their earnings. They are only opening about 20-25 new units a year or 3% growth. Management is acknowledging that the current prototype is almost saturated and they are looking at a smaller prototype for more growth in appropriate markets.

Outback
Average Unit Volume ($000's) $3,541.0
Cost of goods sold 38.2% 1,352.7
Labor 24.1% 853.4
Other 20.0% 708.2
Restaurant Level Cash Flow 17.7% $626.8

Fully Capitalized Investment $2,300.0

Return on Capitalized Investment 27.3%

Carrabba’s is an Italian concept positioned in its category about the same way as Outback. Carrabba’s has had a mixed history after acquiring the brand through a JV in ’94. They struggled for a few years after a promising start, but have now been showing strong results again over the past year. They lowered the investment cost of their prototype without affecting sales and are seeing higher returns now. Effective tests of advertising have the brand poised for very strong growth and they are taking advantage of it with a faster pace of new openings. Growth should be about 15% next year on top of 199 company owned restaurants. The brand accounts for about 13.3% of their sales and 12.2% of earnings. The current unit level returns are below and these results should improve with their strong same store sales results.

Carrabba's
Average unit volume ($000's) $3,100.0
Cost of goods sold 32.2% 998.2
Labor 26.7% 827.7
Other 20.7% 641.7
Restaurant level cash flow 20.4% $632.4

Fully Capitalized Investment $2,680.0

Return on capitalized investment 23.6%

The more exciting part of the story is the emerging growth concepts. While the growth outlook is less promising for Outback, they are growing overall units at about 11% a year because of these smaller concepts.

Bonefish is a higher end fresh fish concept that is positioned in the “polished casual” category along side brands like PF Chang’s. This is the brand that management and the investment community are the most excited about given its niche and very strong unit level returns. They have a higher average check of about $25/person and higher alcohol mix. The more refined concept allows them to avoid the head to head competition with the ubiquitous casual dining category. While they have opened in many markets throughout the country, the focus has been on the East Coast. Rapid expansion of the brand has muted its earnings impact, but the brand should still be slightly profitable in ’05 and grow quickly from there. Sales mix for the company is about 6% and earnings mix is just 2%. New unit openings should be about 30% growth next year on just 94 units.

Bonefish
Average unit volume ($000's) $3,151.0
Cost of goods sold 35.5% 1,118.6
Labor 23.8% 749.9
Other 20.3% 639.7
Restaurant level cash flow 20.4% $642.8

Fully Capitalized Investment $2,060.0

Return on capitalized investment 31.2%

Fleming’s is a high end steak concept that is very profitable, but has less potential given its niche. One strong point of differentiation is its appeal to women that is partly attributed to their extensive wine by the glass program. There are only 36 units and to open about 8-9 next year. The brand accounts for about 4.7% of company sales and 4% of earnings.

Fleming's
Average unit volume ($000's) $4,527.0
Cost of goods sold 32.0% 1,448.6
Labor 24.8% 1,122.7
Other 21.2% 959.7
Restaurant level cash flow 22.0% $995.9

Fully Capitalized Investment $3,650.0

Return on capitalized investment 27.3%

Outback’s other brands have more question marks and will either provide a lot of upside if they work or free up more capital for shareholders or growing more profitable concepts if they are jettisoned.

Cheeseburger in Paradise is a Jimmy Buffet, tropical themed hamburger concept. While early volumes have been promising, they are working on getting margins inline as well as lowering investment costs. I am pretty skeptical of this brand since most brands that lack broad appeal have failed. I am also critical of their growth plans that they backed into after acquiring Chi Chi’s real estate out of bankruptcy. They are planning on opening another 20 units in ’06 on top of the 35 they should have at the end of the year. Given ‘05’s very rapid growth and the issues being worked out, I don’t think this was the most conservative use of capital.

They also own a concept called Roy’s which is a high end Hawaiian seafood themed concept. Recent trends have been strong, but this concept has struggled over its life and will never be important enough in my opinion to warrant much investment. There are 20 units and another 2 planned for next year.

Paul Lee’s is a mid-scale Chinese concept created by Paul Fleming (founder of PF Changs) that was created to compete in between PF Chang’s and Pei Wei (both owned by PFCB). The concept has some potential, but early results have been disappointing and planned investment has been curtailed so they can continue to work on it. There are 4 units with just one planned for next year.

Current issues/problems – Outback’s stock has gone no where over the past 3 years and it has significantly underperformed its peers. Some of the turnaround potential is being priced in at these levels, but there is tremendous upside in both earnings and their multiple if they can get the company back on track. I discuss the risks in greater detail at the end, but the stock has not done much for good reason. Same store sales for the Outback brand are just up slightly in total over the last 3 years while they should be averaging about 3%+ a year to achieve their EPS growth targets. The source of the weakness has been widely debated, but two clear issues have been stale marketing and menu. Casual dining has become much more competitive and these are the areas that must be used for differentiation. Outback has failed to deliver this to their customer and they have been losing market share because of it. To make matters worse, they have been one of the more aggressive companies in taking price. When you are struggling to achieve traffic gains, increasing menu prices by 3-4% is not likely to have a positive outcome. Management has been coy in discussing traffic and this has been my biggest complaint with the company. Over the last several years, they have tried to explain away weak sales as a function of mix on the menu due to smaller steaks, more takeout kid’s meals, and other excuses. They have finally recognized that the main problem is traffic. After adjusting for price and menu mix, traffic has been down about 5% year over year and this is on top of traffic declines last year as well. Fortunately the recognition of the problem has allowed them to put in place a plan for recovery that should begin in Q1 next year.
Much of the blame has to be put on management. While guys like Chris Sullivan (founder and former CEO) and Bob Merritt (former CFO) were extremely successful and built an amazing company, they have failed to deliver over the past few years. This may just be a function of them “checking out” after achieving their success, but new management was/is necessary to take this company to the next level. They have subsequently brought in a new CEO, COO, and CFO in the past year. All three are well respected in the industry, but especially Bill Allen and Paul Avery. They have taken a fresh look at the company, brands, capital investment and are making the necessary changes to put things back on track.
Commodity costs have been very challenging for the industry and for OSI in particular. Beef has been the biggest problem with prices up over 50% since ’02. While OSI can get more favorable contracts than the market given its size, they are still extremely sensitive to the beef market. A simple calculation assuming that beef accounts for 40% of Cost of Goods Sold shows about 20 cents of earnings per a 5% move in their beef contracts. This is a decent approximate when looking at earnings upside if prices retreat, but not fair when calculating how much earnings have been hurt since they have been using menu pricing to offset it. While ’06 does not look like it will be the year that beef will be very favorable, the 2H of the year could show solid declines and set ’07 of for a much better year.
The casual dining market has become much more competitive and this just magnifies the issues when you are struggling. The market is much more of a zero sum and Outback has been hurt due to the lack of creativity and initiatives. A new competitor, Texas Roadhouse, has also been having an adverse effect on their business. This concept is fairly similar in its quality food and service, but offers even better value. Comps have been strong and that are growing units rapidly. Despite the threat, I am confident that Outback will perform well if they fix the things they do have control of. The concept consistently receives some of the highest quality and satisfaction scores and the quality of their food is a step above their competition.
In addition to Outback's soft sales and the impact of rising commodity costs, OSI’s EPS has been held back due to the explosive growth in the emerging brands.

Valuation

Outback is not screamingly cheap at these levels, but it is very attractively priced given the turnaround potential at Outback and the growth potential at the emerging brands. Using an ’06 estimate of $2.55, OSI trades at 16.4x EPS, 7.5x EV/EBITDA, and 7.4x EV/EBITDAR capitalizing leases at 8x. This is about inline with group averages for companies whose fundamentals are a bit stronger, but lack the earnings leverage from a turnaround as well as the unit growth opportunities. Darden (DRI) is the current mature casual dining company with the strongest trends and it trades for 17.6x C’06 and 9x EV/EBITDA. OSI is also underleveraged compared to peers with net debt/cap under 15% vs. DRI at 36% and EAT at 32%. They could float $400 million in debt to finance a large buy back of about 13% of outstanding stock that would be very accretive. On a FCF basis, OSI looks very compelling. After accounting for all of their growth capex and 12% square footage growth next year, they should still generate about $66 million in FCF or a yield of 2.2%. If they shut off all future growth and you just applied a bare minimum maintenance capex of $10,000 per restaurant, they would generate $320 million in FCF or a 10% yield. A much more conservative adjustment of $100,000 per restaurant that would allow them to make more substantial periodic investments in their stores would still leave over $200 million in FCF or a 6.5% yield. OSI is currently one of the highest dividend payers in the industry with a yield of 1.2% from a $.52 payout.

The upside is significant if they can get back on track next year. If they can stabilize margins and grow earnings greater than 15%, the stock could be trading at 18x an ’07 estimate that easily tops $3.00 a share. This would give some credit for the potential of emerging brands, but would not adequately compensate for the ultimate earnings impact that could be seen in the next few years. If OSI sees a favorable drop in commodity costs and EPS recovers from these depressed levels, $3.00 in ’07 could be a very conservative estimate. SSS could be well above the LT plan for a few years if the new campaign is successful since they will have the benefit of extremely easy comparisons.


Catalyst/Opportunities

New Advertising - One of the best indicators for casual dining sales turnarounds has been a strong new advertising campaign. It is pretty intuitive, but sales tend to suffer when a message becomes stale. The competitive landscape has intensified and this means that brands need a strong message to get through to consumers in order to drive them to their restaurants. While a great concept, service, and operations are all incredibly important, so is the marketing message for the large casual dining brands. Outback’s has clearly become stale after many years of success. The humorous Australian themed commercials are not driving incremental customers anymore. Fortunately they have realized this and have hired a new agency to work on their campaign. The agency selected is the Kaplan Thaler Group whose most recognizable work is the Aflac campaign. The launch of Outback’s new advertising campaign is expected to be in Q1 next year. Chili’s and Red Lobster are the two most recent examples of stale brands that launched new ad campaign that invigorated sales. The effect is especially powerful when the new ads are very strong and lap ones that were especially weak as opposed to a strong new campaign replacing another strong one. (Hopefully this will be the case next year).

They also hired the man credited with much of the success of both Nike’s Just Do It campaign as well as the formation of Starbuck’s brand image. Scott Bedbury has been retained to study their brand in order to better sculpt their brand image and communicate it to their customers.

New menu – Another area that often becomes stale without constant updates is the menu. Outback has not had a new major product innovation in quite awhile. While this is a difficult thing to do, it not difficult to consistently add new items to the menu to provide a little excitement for the customer. Outback has been hurt recently as their competition flaunts new products through limited time offers. They are now committed to updating 15% of the menu semiannually going forward. They refuse to go down the LTO path or to rely on price points, but these updates should help provide some new news as part of the advertising campaign.

Another menu change in test has been one that is more value focused. Outback’s sales have been the softest in the Midwest, Northeast, and TX. They began a menu test in 39 restaurants that incorporated smaller portions and smaller price points. It also rolled back pricing on various items without changing portion size. The intent is to provide more value in markets that the customer is clearly more value focused. They were happy enough with the test that it was rolled out to 250 more restaurants and they plan to roll it out even more broadly next year. They did see an initial hit to check that was not made up by an increase in traffic for several months. But this should be less of a concern with a wider rollout since local media will be used to highlight the improved values. The media should be able to increase traffic enough to offset the check decline.

They are also testing a brunch program in many markets to extent the day part. This adds about 5% to SSS and will be evaluating to see if it makes sense for a wider rollout.

Emerging concepts becoming more meaningful – It is hard to ignore the great potential of Outback’s emerging brands. Fleming’s is already a solid contributor and will continue to grow at a strong, but somewhat modest pace. Bonefish has the potential to become another power brand like Outback itself. From a demographic standpoint, it is extremely well positioned with its popularity with baby boomers. The earnings power is being muted by the rapid growth. If we just look at ’05 and ’04, OSI has invested about $200 million in these brands and should only earn about $11 million this year in net income. This number should ramp up dramatically as they achieve leverage.

Capital allocation – Outback is in a similar situation at Brinker last year where they are investing a significant amount of money in new concepts in attempt to find the next homerun. While the payoff would be huge if successful, Outback would probably be better served to focus on a few and get rid of the others. I think they have their hands full with Bonefish and Fleming’s and that they represent a significant enough of an opportunity to warrant an increased focus. If they do sell some or all of the other concepts, they would see an immediate benefit from the focused intention and more shareholder friendly use of capital. Growing an emerging concept is very expensive and dilutive to ROIC early on. Freeing up this capital to buyback more stock or raise the dividend would a better use in my opinion.

Commodity costs – Many have been forecasting a falling beef market for awhile now and it has yet to materialize. While it is still clearly not around the corner, this represents a significant opportunity when it does finally arrive. Management seems optimistic enough that prices will fall that they have chosen to wait before locking in their contract. Their ’06 guidance was predicated on flat beef prices on ’06 which still seems reasonable. Hopefully this will provide a catalyst later in the year, but it should not be the headwind it has been recently at the very least.

Risks

There are several risks to the story in the near term that could provide a better entry point or opportunity to add to a position.

Beef and other commodities – OSI has only locked in a little of their beef needs for next year. They discussed on their last conference call that they believe fundamentals do not warrant current prices and thus will wait until next year before locking in the rest of their needs. They reiterated this sentiment in mid-November for their analyst day with the new CFO. Their plan is to buy beef in several contracts that will average down their cost throughout next year. Since these comments, prices have continued to rise and there is risk that the color they provided for margins was too optimistic (expected flat for year). Most other commodities should be flat to better, but this could obviously change over the course of the year.

Expectations – Unfortunately my view is not that unique on this stock. While I have been negative on the stock for most of the last few years, there have been plenty of bulls laying out a similar thesis that I just did in this report. Obviously it has not materialized yet, but I think the catalysts are finally in place for the thesis to begin playing out. And while sentiment is not overwhelmingly negative as I would prefer, it isn’t very positive either. Short Interest is about 7.6% of float by a few % over the last few months and vs. last year. One of the three sell-side bulls recently threw in the towel and downgraded the stock (MS).

Outback brand is broken – It is clearly possible that the issues with the brand run deeper than poor advertising and a stale menu. New steak competitors may simply have a better “mousetrap” and Outback’s best days are well behind it. While the large, mature restaurant chains periodically get written off as broken, it is a very rare thing to actually play out. Chili’s and Red Lobster are the two most recent chains to be in a similar situation that have since seen a resurgence using very similar strategies that Outback will begin using next year. A separate, but almost equally negative scenario would be if Outback has gone way too far in its pricing and that it must be rolled back significantly. This would obviously be a big negative for margins and end any near term chance of a turnaround. This also seems unlikely given the regional weakness of the brand. The strong correlation between regional economic weakness and Outback’s sales weakness suggests that the problem is not just an internal one. CA and FL are both seeing strong results that would not indicate any major pricing issues.

Emerging concepts- Some or all of these concepts may fail to provide the future growth that is necessary to make the stock cheap at current prices.

Consumer spending/sentiment – Outback has generally been one of the most economic sensitive brands and this put the company at risk if the consumer slows further next year even if the current strategies are the right ones.

Casual dining maturity – Casual dining may be more mature than conventional wisdom. If this is the case, competition is just going to become more intense as it will be more of a market share battle. Growth plans will be reined in and SSS will suffer for all participants.

Construction costs – Due to real estate values and construction costs, the investment side of opening new restaurants is hurting returns. Whether than continues or not, I think ROIC will be worse going forward for this industry than it has been in the past.

Catalyst

Catalysts
- Improved Outback SSS early next year from new marketing, menu improvements, day parts
- A retreat in beef prices as well as other commodities
- Continued success at the emerging brands allowing them to become more meaningful contributors
- A continuation of the turnaround at Carrabba’s allowing that brand to approach the mega brand status
- Positive news on capital allocation through increased buyback or dividend.