“The industry saw stronger sales in November and December as people got back to normal routines,” says Gregory Levin, the chief financial officer of California Pizza Kitchen (CPKI, news, msgs), a popular casual dining chain. “Those patterns seem to be holding up in 2002, and that has been pleasantly surprising.”

Indeed, most of the country’s eateries have been getting robust positive earnings-estimate revisions by analysts in the past few months, according to IBES International, a sign that upbeat trends are likely to continue.

3 key restaurant trends...
Here’s a look at what’s behind the healthy growth in the sector, and how investors may participate.

Going out to eat is now a way of life. The resilience of diners after Sept. 11 shows that we won’t give up the habit easily. A big reason is that many households now have two wage earners. This means more money, but less time for the family and cooking. Restaurants have spotted the dilemma, and they’re capitalizing on it. That’s obvious from those “when-you’re-here-you’re-family” commercials from Darden Restaurants (DRI, news, msgs) to promote its Olive Garden chain, which, by the way, posted record sales in the most recent quarter.

Supply and demand are back in balance. The sector binged in the mid-1990s, when investment bankers cooked up too many new “concept” restaurants and established players over-expanded to compete. “The number of new units in that period was unbelievable,” says David Qualls, the chief financial officer of Garden Fresh Restaurant (LTUS, news, msgs). “I mean, people can only eat so much.” But now that binge is history -- good news for those left standing. “The ones that survived get a bigger piece of the pie,” says Qualls.

Restaurants are making price increases stick. Investors like this because pricing power is so rare among companies right now. Menu prices were up 2.4% in April, the seventh month in a row that price hikes exceeded cost increases, says Paul Westra, who covers restaurant stocks for Robertson Stephens.

Still, upward revisions are just a mirage, in part. Right after Sept. 11, no one really knew how diners would react. So analysts cut their estimates too much. Now their numbers are going back up in part to make up for lost ground. But talk to restaurant operators and it’s clear there is still a lot of caution behind the estimates. “Obviously we are going in the right direction, but it is hard to predict how much business will come back this year,” says Alan Stillman, chief executive of the upscale Smith & Wollensky (SWRG, news, msgs) steak-restaurant chain. “People do not have to go out and have a steak dinner.”

However, Robert Derrington, a restaurant analyst with Morgan Keegan, notes that weekly data show this quarter is shaping up well so far. He thinks sales will continue to improve as the economy gets better, and business and tourist travel come back. “As we go through the quarter we will see more upward revisions, and for several quarters we will see upside surprises, especially for the restaurants that market the most effectively.”

3 tasty investment themes
So how to play this as an investor? Here are three themes.

The micro-cap fixer-uppers and expansion plays. One way to catch more upside in a group that’s done well is to look for smaller players that are quietly fixing problems or building on successful concepts. Positive earnings-estimate revisions can lead the way ahead of the crowd -- because micro-cap companies don’t have much analyst coverage.

Three possibilities are Rubio’s Restaurants (RUBO, news, msgs), a fresh grilled Mexican food chain in the West; Garden Fresh Restaurants, which operates buffet salad bars; and Smith & Wollensky.

After two years of no sales growth, Rubio’s recently decided to cut the fat and get back to basics. The company closed 11 restaurants, put a lid on expansion plans and came up with a plan to bring in more diners. That meant bigger portions, a new décor and new menu items. The company is also putting grills and see-through refrigerators out front to reinforce an emphasis on freshness, says Jay Burnham of Rocker Partners, which has a position in Rubio’s. The next step is more expansion, further down the road. “We slowed the growth to focus on repositioning, and then we will ramp growth back up once we get the concept where we want it,” says Ira Fils, Rubio’s chief financial officer.

Like Rubio’s, the San Diego, Calif.-based Garden Fresh cut back on expansion to focus on reversing a decline in profit margins. That meant cutting marketing and other expenses. The company is also moving out of outlets serving soup to get back to its strength: salad buffet bars offered under the Souplantation and Sweet Tomatoes brand names.

Shares in the upscale Smith & Wollensky have doubled from lows of $3 earlier this year as business bounced back. But long-term investors should see more upside as the tiny restaurant chain replicates its formula in cities across the country. “The attraction is that they have a highly recognized name and the ability to grow off a small base,” says Bruce Vogenitz, a portfolio manager at the Henlopen Fund (HENLX), which holds shares in the company. The company has 16 restaurants, seven of which operate under the Smith & Wollensky name. It plans to open roughly four per year over the next four years, says Stillman. They key to protecting the cachet of the upscale name is to limit the chain to one restaurant per city. “We are trying to become a non-chain chain,” says Stillman.

The hot-concept momentum plays. These are the ones that have found a recipe that’s a huge hit, and they’re running with it. But these restaurants have also captured the investing public’s imagination, so they have high valuations to show for it. Prime examples include PF Chang’s China Bistro (PFCB, news, msgs), Cheesecake Factory (CAKE, news, msgs) and Panera Bread (PNRA, news, msgs), all sporting forward price-earnings ratios in the 40 range.

Not surprisingly, this is the turf in the dining sector where that market odd couple -- momentum investors and short sellers -- meet to do battle. Rocker Partners, for example, is short some of these companies. “We generally think the valuations in these stocks are ridiculous,” says Burnham. “People get excited about high-growth concepts, but we think the growth can’t continue and justify current prices.”

Other investment firms are cautious as well. “PF Chang is a phenomenal operator, but we are worried about the high multiples so we have trimmed back,” says Himali Kothari, an analyst for the John Hancock Small Cap Growth fund (TAEMX). Even sell-side analysts are cautious. “Unfortunately, even good companies can stumble, so at these valuations they are not for the faint of heart,” says Morgan Keegan’s Derrington. In short, there could be more upside as these chains build on their successes, but you need to be careful -- or wait for a misstep to get a better price.

The mainstream casual dining stocks with powerful brand names. They’re not growing as fast as the “mo-mo” players above. But they’re building out popular restaurants in the hottest area in the sector -- casual dining. It’s growing twice as fast as any other restaurant category because it gives customers -- often baby boomers and their families -- just what they want: good, cheap eats ($10 to $20 per person), and decent service.

The chief examples are Applebee’s (APPB, news, msgs); Darden, which operates Olive Garden and Red Lobster; Brinker International (EAT, news, msgs), with its flagship Chili’s, and Ruby Tuesday. Each enjoys a large base of restaurants that generates enough cash to support expansion. The downside: These restaurants are trading at forward P/E’s above their growth rates. And many are experimenting with niche dining concepts that might not pan out.

Risks
If valuations stay solid, you might see too many initial public offerings for new chains, or follow-on offerings by popular chains, to fund more expansion. That could lead to another bout of over-supply, just like in the mid-1990s.

Next, keep in mind that it’s a highly competitive business, and the mighty can fall hard when they lose out. If you buy these stocks, you have to watch them closely. Finally, if the economy ever does show signs of bouncing back, investors may flee this group to chase tech stocks that promise higher growth. “I don’t believe that will happen even if tech does recover,” says Matthew Stroud, who handles investor relations for Darden. “I think people will want to be diversified given what has happened in the past couple of years.”

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