Investors Gobble Up Casual-Dining Stocks, But Rally May Sputter

Investors are chowing down on beaten up casual-dining companies, but some analysts wonder whether the run-up will prove to be another false start for the sector.

Casual-dining shares have been rallying on signs that sales declines are slowing after a brutal December where consumers significantly pulled back on spending, analysts say. The two largest casual-dining chain operators, Brinker International Inc. (EAT) and Darden Restaurants Inc. (DRI), are also setting a positive tone with expectations for better-than-expected margins even as same-store sales continue to be down.

Also, restaurants are seeing reversals on a couple of headwinds that ate into profits last year: costs for ingredients are falling while lower gasoline prices are putting more money in consumer's pockets.

Such trends are leading to some bullishness in a sector that has been pounded for several years, as consumers cut back on eating out during the recession or traded down to fast-food outlets.

"There is hard evidence that things are less bad," Howard Penney, restaurant analyst at The Research Edge LLC, said. "As we work through the balance of this year, things can get better."

Sales declines in recent years also have left restaurant chains facing their easiest annual sales comparisons in more than a decade, said RBC Capital Markets analyst Larry Miller. Investors are betting that the environment can't possibly get worse than it did at the end of last year, he said.

While "less bad" had been the new "good" for restaurants, some analysts still see several challenges that will continue to pressure sales throughout the year.

Unemployment fears still linger, and traffic at casual-dining chains is being driven by promotions and discounts that some executives say are at historical levels and deleterious to margins.

With fewer diners out there, casual-dining chains are locked in a battle for market share and expected to benefit as a wave of independent locations close their doors. But that is expected to take some time to play out.

A Morgan Stanley analyst recently said that 1,200 sit-down chain restaurants need to close to match up with diner demand, and that the balance could be restored next year at the earliest.

Steve West, restaurant analyst at Stifel Nicolaus & Co., said that casual-dining stocks have held similar rallies in the first quarters of the last three years before receding. He said the sector has staged several "head fakes" over that time as investors hoped to take news of stimulus packages or dips in commodities.

"I see negative traffic and that doesn't say 'stable' to me," said West, who remains bullish on fast-food companies. "Until unemployment stabilizes, I don't think you're going to see the consumer stabilize."

Among the stocks that have staged rallies in recent months are Ruby Tuesday Inc. (RT) and Applebee's and IHOP operator DineEquity Inc. (DIN). Both have been weighed down by liquidity concerns but are up 98% and 73%, respectively, over the last month. Cheesecake Factory Inc. (CAKE) shares have risen more than 54% over the same time.

Brinker's shares have jumped 34% over the last month, while shares of Darden, which Tuesday raised its fiscal 2009 guidance after beating fiscal third-quarter earnings estimates, rose $5.76, or 19.3%, in recent trading to $35.68.

-By Paul Ziobro, Dow Jones Newswires; 201-938-2046; [e-mail]