Shares in focus: Should you tuck in to Restaurant Group?

Strong growth makes these shares tempting, but wait until the price is right, says Phil Oakley.

Shares in The Restaurant Group (TRG) have been a very good investment over the last decade – they’re up seven-fold. The owner of casual eating restaurant chains including Frankie & Benny’s, Chiquito, Garfunkel’s and a number of pub restaurants has clearly got something going for it.

It has managed to thrive, in spite of the tough consumer backdrop of recent years. As a result, its shares are now richly valued by the stock market.

The company has certainly benefited from some helpful trends. Busier family lives and an ageing population have seen the number of people eating out enjoy steady growth. But investors haven’t always been able to make money from these trends – in fact, the opposite has often been true.

During the 1990s and 2000s, pub companies invested heavily in new sites to exploit these trends. But they racked up a lot of debt in doing so, which proved painful when the economy went into a steep recession and business collapsed.

Restaurant Group didn’t go down this ‘growth-at-any-cost’ path, and so has done very well. But given its stunning share price, we have to ask: is this as good as it gets, or are the shares still worth buying for the long run? Let’s take a look.

The outlook

TRG’s success has been based on a sound business model that has set it apart from its rivals. Instead of ploughing money into expensive town centre locations, where there’s lots of competition, TRG has opened up restaurants in out of town retail parks, airports
and rural locations.

The retail park sites have worked well, especially when the restaurants have been near to cinemas, which bring in lots of customers. More importantly though, competition is less fierce, because it is hard for rivals to get a foothold on the same site. This has helped boost TRG’s sales and profits.

And unlike the pub companies, TRG has not been buying lots of expensive freehold sites and racking up debt. It rents buildings instead, which means it doesn’t need to put as much money up front into each new restaurant.

This has helped it make very decent returns on investment (return on capital was an impressive 27% in 2013) and generate lots of surplus cash flow to pay growing dividends and reinvest in the business. The virtuous circle of growing cash flow and reinvestment has sent profits soaring over the last decade.

This business model is not without risks. Future rents payable to its landlords are a form of hidden, off-balance-sheet debt. These stood at £684m at the end of last year, while the annual rent bill was £65m. This adds an extra layer of fixed costs that makes the profits of the business more sensitive to changes in sales (this is known as operational gearing).

This can be very helpful when sales are growing, as they are now (because profits will grow faster than sales), but it can be painful if business takes a turn for the worse. That said, TRG does not seem to be overextending itself – current profits cover the rent bill comfortably.

So what of the future? The management team believes it can keep growing by finding more good-quality sites over the next five years. These will continue to be dominated by the Frankie & Benny’s chain, which specialises in American and Italian food.

On top of that, TRG is looking to open more high-quality food-led pubs, Chiquito Mexican restaurants and to expand its new Coast to Coast brand. It will not sacrifice profits by competing on price, but will focus on value and service – a strategy that has worked well so far.

If the economy is indeed improving, and interest rates stay low and wages start to grow faster than inflation, then shareholders could continue to see rapid growth in profits. Yet even if times stay tough, TRG has proved in the past five years that it can still do well. Its restaurants offer an affordable treat that won’t blow most household budgets.

Why I’m not buying right now

In short, TRG is a very good business. But three things would put me off buying the shares just now.

Firstly, at over 20 times projected earnings, the shares are quite pricey. City analysts expect earnings to grow at 10%-12%, but this looks to be already priced into the shares.

Secondly, the chief executive, finance director and chairman all sold a reasonable chunk of their shareholdings during the last year. While they all retain a significant stake in the business, heavy director share sales often coincide with peak share prices.

Finally, Andrew Page, the chief executive who has overseen a fantastic period of success at the company, is retiring.

He’s been at TRG for 14 years and has done a very good job. He is staying on as a part-time consultant – but there have just been too many chief executives recently who have got out at the top, and I’d see this as a sign to be wary.

Ultimately, good investing is all about buying good companies at the right price. TRG certainly fits the first criteria, but paying up for the shares now leaves little room for hiccups.

You are unlikely to find the shares in the bargain basement anytime soon, given the quality of the business – but I’d be looking to pay no more than 520p-550p for them (17 to 18 times forward earnings) at the moment.

Verdict: put on your watch list

Restaurant Group (LSE: RTN)

Restaurant Group share price chartShare price: 624p
Net assets (Dec 2013): £216m
Net debt (Dec 2013): £41.9m
P/e (prospective): 20.5 times
Yield (prospective): 2.4%
Interest cover: 30.7 times
ROCE: 27%
Dividend cover: 2.0 times

Restaurant Group dividends per share chartWhat the analysts say

Buy: 11
Hold: 5
Sell: 1
Target price: 729p

Directors’ shareholdings

A Page (CEO): 315,187
S Critoph (CFO): 275,220
A Jackson (Chair): 250,191