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Fast Casual in 2018, Part 1: More M&A on the Horizon?

- By John Engle

Fast-casual dining has exploded in recent years, with a raft of new restaurant chains seeing explosive growth. Unsurprisingly, the rapid rise has attracted a huge amount of investor attention.

The attention has not always been positive, however, especially for some of the original darlings of the sector. Chipotle Mexican Grill Inc. (CMG), for example, took a nasty fall in the wake of a health scare and compressing margins, sending the share price down nearly 60% from the high in late 2015.

Buffalo Wild Wings Inc. (BWLD), which we discussed in a previous article, is another high-flier that has taken a beating more recently. In the midst of its turnaround turmoil, the restaurant chain became the target of Roark Capital Group, a private equity firm that owns Arby's.

Buffalo Wild Wings became a takeover target thanks to a series of struggles and complications, including slipping sales, increasing costs and mounting questions about its future. The turnaround story is still in its early days, and the jury remains out on whether the buyout price was worth it.

Buffalo Wild Wings is not the only fast-casual chain with an intriguing potential buyout story. This article discusses four other companies in the sector that could make attractive targets in the relative near-term future.

Brinker International

Brinker International Inc. (EAT) is the owner and operator of Chili's restaurants and Maggiano's Little Italy Italian restaurants worldwide. With a market cap close to $1.7 billion, Brinker could be an attractive target for a larger restaurant brand either looking to expand or to include more upscale fast-dining like Maggiano's.

Financially, Brinker's performance has been tepid, and certainly nothing spectacular. From 2015 to 2017, gross profit was $2.2 billion, $2.4 billion and $2.4 billion respectively. Now, those profit numbers are actually impressively high for a smaller fast-causal brand. The lack of revenue growth is notable, however. Perhaps a takeover with strategic vision could pull Brinker into the future and deliver revenue growth year over year, which could make a parent brand a lot of cash money.

Dine Equity

DineEquity Inc. (DIN) is the owner and operator of IHOP Restaurants and Applebee's, both older restaurant chains that have rebranded as fast-casual dining brands. IHOP specializes in breakfast foods, while Applebee's is more of a dinner and bar setting. We see DineEquity as an excellent takeover target because of its relatively strong financials, very reasonable size and brand appeal.

DineEquity's financials are fairly bright despite a general downturn in the restaurant business. Net income has increased from approximately $35 million in 2015 to over $95 million in 2017, experiencing industry-wide issues but maintaining relatively strong performance. With a market capitalization of about $1 billion, DineEquity is a relatively reasonable size for a larger brand to consider buying. The company is not necessarily cash-strapped or vulnerable, but with the right premium, DineEquity could see itself taken over faster than one can say International House of Pancakes.

BJ's Restaurants

Lesser-known but attractive, BJ's Restaurant & Brewhouse, which is owned by BJ's Restaurants Inc. (BJRI), is a fast-casual, sit-down restaurant that is one of Buffalo Wild Wings and Applebee's top competitors in certain regions. It is an attractive takeover target because of its size (market cap: $780 million) and vulnerabilities.

In terms of size, BJ's would not be a heavy lift for many other brands to add to their portfolios. For around $1 billion, they could merge BJ's brand and 200 locations into their companies. BJ's brand is one of fast-casual dining, but it is most prominent for its microbrewery and beer options. Another fast-casual brand could benefit from the inclusion of such alcoholic offerings.

Further, BJ's has faced certain challenges that have exposed vulnerabilities. The stock price plummeted from $45 to $28 after missing revenue estimates and earnings per share expectations. It has since rebounded with stronger sales, but BJ's remains vulnerable to economic downturn, sales drops or other unforeseen circumstances.

We see BJ's as a relatively inexpensive, attractive buy for a larger brand.

Darden Restaurants

Darden Restaurants Inc. (DRI) is the most "out-of-the-box" of the companies on this list. Its market cap sits at $12 billion, much higher (in many cases almost 6 times higher) than the other brands listed. However, the company has faced very significant financial and strategic problems of late, and we believe that the right large brand could consider a takeover or merger that might help stop Darden's bleeding.

Darden is the owner and operator of Olive Garden and, until recently, Red Lobster. Other portfolio brands include Longhorn Steakhouse. Now, it is pretty massive, but the company is facing uniquely difficult financial and strategic challenges. A much bigger dining brand might see an opportunity.

After several years of sagging sales and mismanagement, Darden is in the process of successfully turning around the Olive Garden brand. However, the company is still experiencing effects from several years of mismanagement and financial downturn, which makes it vulnerable to such a takeover bid. It would have to come from someone willing to take on a big project, but anything is possible.

Disclosure: I/We own no shares in any of the companies mentioned in this article.

This article first appeared on GuruFocus.