Dining Out

Consumers are going to restaurants more than ever, though high gas prices may impact future growth, analysts say.

Glen M. Petraglia

Citigroup

212-816-2497

OUTLOOK: Overall, our outlook for the restaurant industry is generally favorable. We expect the restaurant industry in the U.S. to sustain growth ranging from 4 percent to 5 percent per year at least for the next ten years. Our base case growth of 4 percent should be driven by population growth and inflation between 1 percent and 3 percent per year respectively.

The wealth of the Baby Boomer generation and the growing clout of Generation "Y" could drive the upside. Another positive factor is the trend toward the increased prevalence of eating out.

In the past 20 years, 40 percent of household spending on food is allocated to eating out. This makes the restaurant sector more of a staple.

Of the large hamburger operators, McDonald's is best positioned due to the recent prevalence of chicken and salad on the menu. This has the potential to yield share gains for McDonald's in the coming years. Strong brand recognition, solid domestic market operations and the opportunity to expand internationally will enhance market share gains in the sector.

BUYS: McDonald's (MCD);* Wendy's International (WEN)**

Why McDonald's: McDonald's is one of only two buy-rated stocks. We look at McDonald's relative to the packaged food sector, since the company is a very mature restaurant with relatively slower unit growth than some younger concepts.

Over the next three years, we believe McDonald's will grow earnings at a faster rate than the packaged food sector while also experiencing increasing returns on invested capital (ROIC). This should drive the multiple higher over time. McDonald's current menu and plans to test more chicken offerings have the potential to sustain momentum in U.S. sales trends and lead to market share gains. This is especially true as consumers become increasingly health conscious.

We see McDonald's as having a compelling valuation vs. packaged stock foods due to its mature status — McDonald's is trading at a relative P/E of 0.85 times to packaged food stocks vs. a historical 0.95 times. We think the gap should narrow due to our expectations for higher EPS growth, improving ROIC and expanding margins.

Our analysis of fast food menus shows McDonald's menu is relatively healthier than the other "Big Three" hamburger operators. This gives McDonald's the opportunity to grow market share as consumer tastes evolve.

McDonald's is also reducing its restaurant ownership profile in Europe and other markets via franchising and a shift to a developmental licensee structure. Over time, this should also contribute to improved margins at company-owned restaurants as well as earnings and returns in Europe and elsewhere.

*Citigroup Global Markets has a significant financial interest in McDonald's Corp.

**Citigroup Global Markets or its affiliates hold a long position in a class of common equity securities of Wendy's International.

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Michael Gallo

CL King & Associates

212-421-9382

[email protected]

Outlook: One of the key issues that the industry has to contend with at this point is the high price of gasoline. This squeeze on disposable income brings pressure particularly at the low end of casual dining. When gas prices spike up, what we see in the industry is a trade down from casual dining to quick-service restaurants, or QSRs.

We have also seen trading down within quick-service restaurants, especially with a lot of the quick-service restaurants now beginning to refocus on the dollar menus. For instance, Burger King has begun advertising the dollar menu, and McDonald's has moved several of its chicken sandwiches over to the dollar menu. So we are seeing a renewed focus on value.

Outperforms: AFC Enterprises (AFCE); Benihana (BNHN, BNHNA); Denny's (DENN); Landry's Restaurants (LNY)

Top pick: Benihana

Why Benihana: First, the stock has a very attractive valuation. Secondly, we're seeing same-store sales growth and positive traffic that is significantly outperforming the industry.

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Robert Derrington

Morgan, Keegan & Co. Inc.

615-665-3656

[email protected]

Outlook: Generally speaking, there are a number of positive factors that benefit restaurant sales. One is the consumer's propensity to dine out.

Families are now dining out with greater and greater frequency. According to the National Restaurant Association, dining out as a percent of consumer meals has grown from the low 20 percent range to what is expected to be over 50 percent by 2010. That represents a tremendous change, and it is a trend that is not likely to change anytime soon.

Outperforms: Panera Bread (PNRA); Rare Hospitality (RARE); Texas Roadhouse (TXRH)

Top Pick: Panera Bread

Why Panera Bread: Panera Bread combines an attractive market position with an average check of around $7 per person. The food quality at Panera Bread is very high, and the restaurants are located in comfortable, convenient neighborhood settings. As a result, there are very positive consumer perceptions around the brand. The company has been opening new units at a better than 20 percent annual rate in recent years, owing to the strong consumer interest in the brand. Longer term, we expect Panera will project earnings per share growth at better than 25 percent.

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Michael D. Smith

Oppenheimer & Co.

816-932-8080

[email protected]

Outlook: There are a couple of things influencing this sector right now. On the demand side of the equation, we are seeing the impact of gasoline and utility prices. So you've got some trading down going on in the industry for those people who are impacted by gasoline prices. Some are trading out of casual dining to quick service, where dining is a little less expensive.

Another thing we're seeing on the demand side is that the more expensive the restaurant is, the better it's doing. It doesn't appear that the customers who frequent the higher-priced restaurants are as impacted by gas and utility costs, because those units are doing OK. On the other hand, places like Chili's or Applebee's have been affected because their customers are probably a little bit more squeezed by the price of gasoline.

Buys: Applebee's (APPB); BJ's Restaurants (BJRI); California Pizza Kitchen (CPKI ); Cheesecake Factory (CAKE); Panera Bread (PNRA)

Top Pick: Panera Bread

Why Panera Bread: Panera Bread has been a consistent performer for the past five or six years. The company grosses earnings of 25 percent or better. It is a reasonably expensive stock, but it probably deserves to be even more expensive relative to where it historically trades and where stocks of that ilk historically trade.

Currently Panera has about 900 restaurants and will eventually expand this to about 4,000 to 5,000.

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Bryan Elliot

Raymond James

404-442-5856

[email protected]

Outlook: There's clearly been a behavior change in recent months within the small subset of casual-dining consumers at the lower end of the income stream of casual diners.

The rising gas prices, rising interest rates and other economic factors have clearly caused those consumers to cut back on their rate of spending in casual- dining restaurants. That has resulted in a slowdown in same-store sales and a decline in traffic at many chains. Until we get a rebound in discretionary spending power, accelerated incomes or falling energy costs, spending among those consumers is likely to remain weak.

Strong Buys: California Pizza Kitchen (CPKI); Panera Bread (PNRA)

Top Pick: Panera Bread

Why Panera Bread: I believe that Panera Bread will achieve a 5 percent niche market share of the fast-food sector. (The fast-food sector currently commands nearly $200 billion per year in sales.) Five percent of that sector is $10 billion. I believe that Panera Bread, when it is fully penetrated and a steady TV advertiser with strong brand recognition will be a $10 billion retail sales business.

Dining Out

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