This report was sent to subscribers on July 19, 2010.  Join our free mailing list to receive actionable SIR information 48 hours before it is posted for the public…

EXECUTIVE SUMMARY:

• Weakening consumer confidence bodes ill for discretionary spending.

• Restaurant stocks are trading with “growth stock multiples” with future growth likely to be stagnant.

• Investment in new store locations could backfire as consumer demand fails to keep up with growing supply of restaurants.

• Three popular restaurant names present opportunity as short sale targets (pending price action confirmation):

• Chipotle Mexican Grill (CMG)
• BJ’s Restaurants, Inc. (BJRI)
• P.F. Chang’s China Bistro, Inc. (PFCB)

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Consumer confidence has begun slipping over the last couple of months and that’s bad news for retailers.  Our first Strategic Intelligence Report offered opportunities in the luxury retail space as high-end boutiques began feeling the effect of tighter pocket strings.

But the weakness isn’t confined to high-priced luxury items by any means.  Today, we’re taking a look at Main Street restaurant chains that are showing classic signs of topping out as families across the US decide to gather ’round the kitchen table or pop in the microwave dinner to save those discretionary dollars.

Chipotle Mexican Grill (CMG)

• Commitment to organic food increases cost structure.

• Chipotle has become a mature company in a stagnant market.

• Rapid expansion plans don’t mesh well with cautious consumer environment.

• Investors are nervously selling ahead of the Q2 earnings announcement.

Chipotle has had an incredible run as one of the few true growth companies that survived the financial crisis of 2008.  Even during the darkest months when it appeared that consumers would stop spending and the entire financial system would collapse, the chain continued to grow earnings as their geographic footprint expanded.

The fresh Mexican fast-food concept began as a division of McDonalds (MCD) until the IPO in early 2006.  Over the years, the company has grown by not only offering quality food that is both unique and appealing to a wide assortment of the US population, but also building its brand on the concept of food with integrity – naturally raised, with a focus on responsible farming.  The concept is widely accepted by organic-conscious eaters, but has the potential to become a liability.

Serving the highest quality ingredients may make for a loyal following, but it also has the potential to jack up the cost structure which would be especially difficult when consumers are cutting back on spending.  Mainstream America may be willing to pay a bit more for an organic burrito when the paycheck is relatively stable, but when concerns of unemployment, retirement funding, and debt service are in play; cutting down on expenses will take priority over organically grown produce and meat.

From a valuation perspective, Chipotle is much more expensive than its fare…  The stock carries a true growth stock multiple as investors are willing to pay $26 for every dollar the company is expected to earn this year.  While a mid-20′s multiple may have made sense in a bull market when Chipotle had yet to take over the world, the pricing hardly makes sense in an unstable economic environment – not to mention the fact that CMG has very much become a mature company in a stagnant market.

On July 22, the company will release earnings and analysts are expecting $1.39 in EPS based on expected sales of $453 million.  The sales figure represents 16.5% year-over-year growth which seems a bit aggressive considering the recent consumer sentiment numbers.

During the first quarter, the company opened an additional 20 restaurants, bringing the total to 976 locations.  Management has the stated goal of opening 120 to 130 new stores in 2010 which means analysts are expecting an acceleration of store openings as we work towards the second half of the year.  Although CMG has plenty of capital to fund these openings, increasing the geographic footprint may look like less of a wise decision and it will be interesting to see if management revises this goal lower or pursues a strategy of capturing more market share by opening locations in a difficult market.

Investors in CMG appear more inclined to “shoot first, ask questions later” as the stock has begun selling off in front of the earnings announcement.  It takes a significant amount of growth to justify the current stock price, and even a strong earnings report could meet a cold reception as the shift towards more conservative investing is well underway.

BJ’s Restaurants Inc. (BJRI)

• A heavily weighted presence in California raises regulatory as well as consumer risks.

• Stock is trading at a lofty 34 times expected earnings despite low consumer confidence.

• Key support levels have been broken and negative technical pattern is emerging.

The challenging economic environment in California is no secret at this point, but one restaurant operation is betting big on a recovery.  While competitors were trying to “save their way through the crisis” BJ’s Restaurants Inc. (BJRI) has been aggressively opening new locations with the intent to capture market share in the quick service restaurant (QSR) industry.

The company owns and operates 94 locations with over half of its restaurants in California and a large portion of the remaining stores in western states.  Management has been using excess cash to open new stores and expects to increase its store count by roughly 10% this year.

California is likely to be a particularly difficult state to operate a major retail chain for two primary reasons.  First, the current state government is not particularly business friendly, and has a huge incentive to overly tax corporations with major operations in the state.  Second, with unemployment particularly high and property values even more depressed than the domestic average, California consumers are all-the-more likely to tighten the spending belt.

Long-term, management expects BJ’s expansion to feature more than 300 stores domestically.  Investors appear to buy the story as the stock is trading at roughly 34 times 2010 expected earnings.  That’s a heck of a growth multiple to put on a stock in this environment! BJ’s may have been a happy-hour place for investors up to this point, but the kegs are feeling pretty light…

BJ’s is scheduled to report earnings the same day as Chipotle – July 22.  The average Wall Street analyst is calling for EPS of $0.20 on revenue of $127 million, and the 2010 forecasts are for earnings of $0.68 per share and revenue just over the half-billion dollar mark.

If the “professional investor” estimate proves correct, BJRI’s earnings for 2010 will grow by 25%, not too shabby in this environment.  However, that estimate is already well handicapped in the robust stock price.  Analysts have been slowly raising their estimates for this company and investors appear very complacent.  It wouldn’t take much to create a negative surprise, while at the same time I can’t really figure out how management could say anything good that investors aren’t already expecting.

Early in July, BJRI broke through a key area of support near $21.50 but then rallied sharply.  Bullish traders would have you believe that the reversal higher was a display of strength.  However, the price ramp directly corresponded with what now appears to be a short-covering rally in the entire market.  Retail names were particularly strong over a two week period simply because they had some of the worst fundamentals and therefore the most short exposure.

A break back below the 50 EMA would set off all kind of alarm bells and potentially lead to a sustained downdraft.  If management revises guidance lower – or just fails to deliver an inspirational earnings call, analysts could easily reduce their 2010 estimates by 10% leading to consensus earnings of 62 cents this year.

The natural reaction of investors would be to place a lower multiple on the stock due to the declining growth prospects.  Over time, its not difficult to imagine a multiple of 15 on those earnings of 62 cents per share.  Unfortunately, that would represent more than a 60% decline in the stock - certainly worth a trade once the price action confirms a new leg lower!

P.F. Chang’s China Bistro, Inc. (PFCB)

• Revenue trends have been scattered and unpredictable.

• The premium stock price is vulnerable to both lower expectations and multiple contraction.

• Management signalling maturity through its conservative use of cash reserves.

It’s not a particularly good time to be leveraged in a consumer-dependent business.  Compound that with a lack of growth and a high Price/Earnings multiple and you have a recipe for some serious investor indigestion…

Revenue trends for PF Chang’s China Bistro (PFCB) have been anything but predictable.  In 2008, the company was actually posting double digit sales gains (on a year-over-year basis) before seeing sales begin to decline in 2009.  Ironically, this was the period when most restaurant chains were beginning to see improvement in growth trajectories.

The fourth quarter featured 11% growth in sales and a 68% increase in earnings – compared to the easy target from December of 2008 – only to be followed by a very disappointing first quarter report.  It’s little wonder that professional analysts and retail investors alike are unsure what to expect when the company reports earnings on July 28.

The market’s distaste for uncertainty has become an overused cliche, but the concept rings true.  As management loses credibility with investors, it becomes harder to justify a premium stock price.  And while investors may have given management the benefit of the doubt when the economy was experiencing a recovery, opinions are likely to be more cynical now that the recovery is being called into question.

Bullish investors point to a few primary data points:

• Management is expecting to open 7 new locations in 2010
• Outstanding credit line borrowing of $40 million to be repaid
• A $40 million buyback plan has been announced
• Management initiated a new quarterly dividend

But while these issues appear bullish at surface level, the underlying fundamentals remain challenging…

Opening new restaurants with weak consumer sentiment is risky at best.  Each store opening requires a significant capital investment, and with potential for reduced discretionary spending it seems naive to expect PFCB to generate a healthy return on this investment.

The fact that management is using capital to pay back borrowings, initiate a buyback plan, and distribute to investors through dividends may also point to the lack of growth opportunities.  The use of capital to reduce balance sheet risk may be wise, but it hardly justifies the growth stock multiple.  With investors paying $20 for every dollar the company earns, there’s very little room for disappointment or lack of growth.

While the earnings announcement is still over a week away, investors are keying off consumer confidence numbers and appear to be liquidating the stock ahead of the fundamental data.  The $40 level provided support in the spring after the disappointing Q1 earnings announcement.  But that level was broken in late June as the broad market experienced heavy selling.  Most recently, the short covering rally has provided a decent entry point corresponding with the disappointing economic reports.

Ultimately, PFCB could lose more than 25% of its value as multiple compression combines with lowered earnings expectations.  Bulls will likely make an argument based on the new dividend and the potential for yield, but at this point the dividend yield is still less than 1% and won’t be enough to provide much support for the stock.  If management reduces its guidance for $2.00 in earnings this year, the situation could get ugly very quickly.  So monitor the key inflection points and keep stops reasonably loose as the stock begins to trade off in earnest.