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Stock Strategist

Restaurant Stocks Still Look Ripe for Buyouts

Despite the recent turmoil, we still see takeover plays in restaurant stocks.

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With fears of a subprime contagion, credit spreads have risen sharply in the junk bond market. This means private equity firms no longer have easy access to this cheap money, which helped fuel much of the leveraged buyout boom. Still, we do not believe that mergers and acquisitions will come to a screeching halt. The junk bond market is not the only form of financing available to private equity firms, which still have plenty of cash to deploy. After taking a back seat to financial buyers, corporations could also play a larger role in buyouts, especially since they have record levels of cash.

We think several undervalued restaurant companies with strong brands, steady cash flow, and solid balance sheets (and in some cases, valuable real estate) would make attractive takeover candidates. Sale and leaseback financing on real estate can still help fund the purchase of some restaurant companies. Furthermore, a creative form of financing that involves the securitization of income from franchisees has remained cheap, despite tightening elsewhere in the credit markets. Therefore, we believe acquisitions of some restaurant companies could still be leveraged with debt.

The industry has been no stranger to mergers and acquisitions. Earlier this year, a consortium of private equity firms bought out OSI Restaurant Partners (the parent company of Outback Steakhouse, Carrabba's, and other chains). IHOP (IHP) has also entered into a definitive agreement to acquire  Applebee's (APPB). Nelson Peltz's Triarc Companies (TRY), owner of the Arby's chain, is presently pursuing  Wendy's (WEN), while  Darden (DRI) is trolling for acquisitions in the casual dining sector.

We do not, however, value a stock or consider buying shares in a company just on the chance of a buyout, which may never materialize. Therefore, we've restricted our recommended takeover plays to companies that are significantly undervalued as going concerns. A buyout could still serve as a catalyst for unlocking the value in their shares. Likewise, the boards and management teams of these companies could employ some of the same tactics as leveraged buyout firms, which would allow shareholders to more fully participate in the upside.

Our Top Restaurant Takeover Plays
One potential buyout target is  CKE Restaurants (CKR). As of the market close on August 7, this firm's stock was trading at a 26% discount to our fair value estimate and an enterprise value/trailing-12-months earnings before interest, taxes, depreciation, and amortization multiple of just 7.6 times. Thanks to the strength of its Carl's Jr. brand and a turnaround at its Hardee's chain, the company has significantly improved its cash flow and balance sheet. In addition, CKE owns the buildings on about half of its restaurants and owns the land on a little more than a quarter of its locations. Therefore, a prospective buyer could use sale-and-lease back transactions to help fund an acquisition of this company.

We also like  Brinker (EAT), the parent company of the popular Chili's chain. The company trades at a 27% discount to our fair value estimate and an enterprise value/trailing-12-months EBITDA of just 6.9 times, whereas IHOP offered 9.6 times EBITDA for Applebee's. We think a buyer of Brinker could generate cash by franchising company-operated restaurants and  selling off its other brands, including Macaroni Grill, On the Border, and Maggiano's.

We believe  Sonic (SONC), which currently trades at a 23% discount to our fair value estimate, is another takeover play. We like this chain of drive-ins, with its carhop service and unique menu offerings such as extra-long cheese coneys, tater tots, and cherry limeades. This fast-growing, highly franchised company consistently delivers strong cash flows and boasts a solid balance sheet.

 Panera's (PNRA) stock also looks very cheap now, with a share price 39% below our fair value estimate. The fast-casual leader generates more than $2 million in average sales per restaurant, on par with  McDonald's (MCD). The company is also debt free and delivers strong cash flow. We think Panera has plenty of room for expansion, much of which could be financed by franchisees.

Stay Aware of These Risks
We also note that CKE, Sonic, and Panera all have staggered boards, poison pills, and other defenses that could discourage potential suitors. These type of arrangements, however, did not stop Wendy's and Applebee's from being put into play after pressure from activist investors. Encouragingly, Brinker let its poison pill expire in February of last year. There is also a risk that these companies could be snatched up for a low-ball price, similar to the recently announced Applebee's deal.

If the trouble in the junk bond market does spread further to traditional corporate bonds and to the securitized financings that are now popular in the restaurant industry, then merger and acquisition activity in the industry could slow significantly. Also, a widespread credit crunch could damp consumer spending at restaurants. Given these risks, we'd only buy these stocks at a significant discount to our fair value estimate, and we'd be prepared to hold on to them for the long run.

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John Owens does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.