Restaurants
COMMENT
Don't Take Dining Trends Casually
We believe casual dining shares may come under significant pressure near
term as: 1) investors realize fundamentals will not actually support an earlycycle
play and the early-cycle bid wanes, and 2) consensus estimates come
under pressure in 1Q and 2009 in the face of an accelerating deterioration in
conditions for the core casual dining customer.
Consensus still views casual diners as an early cycle play…: Once
investors saw a move off of the bottom, fear of missing rapidly appreciating
early cycle outperformance led to a rapid move from more defensive consumer
staples into more discretionary names, including casual diners. Casual dining
shares are now up 64% (eq. wtd.) from the lows on Nov. 20th and we have seen
numerous upgrades over the past several weeks.
…But casual diners should be invested in as a mature industry: As we
have said before, a new paradigm for restaurant investing is emerging,
particularly for casual diners. A slow recovery in consumer spending as
households repair massive balance sheet destruction, as well as structural
limitations on unit growth, mean that fundamentals will increasingly reflect a
mature industry.
As a result, we believe investors will increasingly focus on free cash flow and
value, not growth, which raises three points: 1) valuations will mimic more
mature sectors – this has already occurred, 2) the casual dining ownership
base should reflect the change in fundamentals— a potentially tough transition
remains ahead, and 3) the new downside case is zero (or negative) free cash
flow in a zero growth mode, which would effectively remove an investable
thesis. We find this scenario very unlikely near-term, but still well within the
realm of possibilities.
Expectations are still unrealistic: Casual dining’s core customers only
recently started feeling the impact of job losses and wage reductions, which
accelerated in Dec. for this higher income demographic. As a result, we believe
Dec. and Q1 will be very challenging. For the full year 2009, we anticipate
discretionary PCE declining (despite anticipated stimulus and lower energy
costs), and a noted change in core consumer “eating out” behavior to address
weaker personal income statements and increased savings to rebuild balance
sheets. We also do not expect lower commodity costs will particularly benefit
earnings; we still anticipate the basket up roughly 5%. We do not believe these
risks are reflected in the market, and see potential for another step-function
down in casual dining comps and earnings, beyond that of this past November.
Ratings Changes: Downgrade TXRH to Neutral. While we view TXRH’s
focus on capital conservation, long-term brand preservation, unique business
model, and strong value proposition to consumers favorably, we see macro
demand headwinds dominating earnings and the investment thesis near term.

Effects of worsening macro accelerating for casual
dining core customers
Higher-income job growth, wage growth, and the resulting purchasing power growth have
supported outsized square footage, unit, and comp growth across the broader retail
industry through the most recent consumer cycle. This has been particularly beneficial for
brands and retail space focused on higher income consumers, including much of the
casual dining industry (particularly restaurants associated with higher-end retail spaces,
such as CAKE or PFCB). Their targeted, core customers, have outgrown the economy
and their lower income peers (Exhibit 1 and Exhibit 2.)

It wasn’t until September that this higher-income consumer’s aggregate wages started to
be directly affected by the economic environment (Exhibit 3 and Exhibit 4), and, YTD
through October, higher-income consumers were still experiencing net growth in wages.
However, higher-income job losses accelerated in the most recent three months, and
given that companies have announced over ~200K additional layoffs (many coming from
professional/business services employees) in December, we only expect that higherincome
jobs losses will continue to accelerate. Outright reductions in wages have also
become increasingly prevalent with announcements from numerous industries, let alone
bonus driven industries like the financials sector. As layoffs and minimal leverage for
wage increases finally start to drive YoY contractions in higher-income consumers’
aggregate wages, we see the potential for another step-function down in casual
dining comps.