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VIDEOBurger King Buyout Creates Opportunity for Bearish Positions
The casual dining sector has spiked but growth will likely be unsustainable. Dine Equity is one of many to look at.
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The most enticing item on my bear menu is in the casual-restaurant sector, specifically within the casual dining space. While the industry is still struggling from a weak economy and trying to sop up the oversaturation that occurred in the private-equity/real-estate bubble of the past decade, several stocks are reclaiming rich valuations that look unsustainable.
The recent news that Burger King (BKC) will be acquired by private equity firm 3G for some $3.3 billion, a 24% premium to pre-deal prices, has sparked a rally across the sector. Darden (DRI), which runs Red Lobster and Olive Garden among others, Brinker (EAT), which operates Chili’s, Dine Equity (DIN) of IHOP and Applebee's fame, and California Pizza Kitchen (CPKI) all spiked some 5% in the past three days. This presents an opportunity to establish bearish positions as I think business across the casual-dining sector will remain sluggish.
Getting Stale
Consolidation in the form of mergers is unlikely to occur as the scale is too big and the niches too distinct; could Yum Brands (YUM) buy California Pizza Kitchen to cover the high and low end of the pizza market? Maybe, but the McDonald’s (MCD) foray into acquiring Boston Chicken tells a cautionary tale of trying to swallow a competitor, especially one outside of your wheelhouse. History has shown that big-cap companies tend to overpay to buy growth. Snapple (DPS) and Gatorade (PEP) also passed through several hands at a decreasing valuation.
The buyout bidding wars that defined the last wave of private equity are unlikely to be repeated. The attraction of acquiring retail companies, to gain access to cash flow and the real-estate portion of company’s assets (think Edward S. Lampert’s Sears (SHLD) Kmart combination), has surely passed. If you're not picking up an asset at a deep discount, such as Kmart out bankruptcy, the notion that one can extract increased profits through operational efficiencies seems unlikely. These companies already have scale in terms of buying power and geographical coverage. The growth story, especially through acquisitions, no longer has the real-estate tailwind at its back.
Keep Your Hands Off These Flapjacks
At this point many of these names can be played from the short side. I’m focusing on Dine Equity, which operates and licenses International House of Pancakes (IHOP) and Applebee’s restaurants. While the company has done a tremendous job reducing the debt it took on to acquire the latter and shoring up its balance sheet -- and remember, two years ago competitor Bennigan's had to fold up its fern leaves and declare bankruptcy -- Dine Equity still faces challenges of slow growth and slim margins.
The recent pop to $40 a share looks like a good entry point for establishing a bearish position. In the short term I expect upside to be limited so I’m looking at selling $40 calls with an October expiration. Longer-term bearish can be implemented by purchasing $35 puts with a January or even March 2011 expiration. I'd have a downside target of $27 over the next six months.
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