Mid-tier, full-service restaurants are in trouble. One of the first discretionary spending areas that households cut back on when economic conditions deteriorate is going out to eat. Upscale casual dining establishment operators should be avoided, particularly while consumer sentiment worsens.

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Pricier Restaurants Will Get Eaten Alive
Lower guest counts and less spending will most likely hit mid-range restaurants like The Cheesecake Factory Incorporated (Nasdaq:CAKE) and P.F. Chang's China Bistro (Nasdaq:PFCB) especially hard. A recent consumer survey conducted by RBC Capital Markets says that a third of Americans will tighten their belts when it comes to dining out over the next 90 days. If this scenario does play out, margins will come under pressure as restaurants are forced to offer more deals or lower pricing to maintain volumes.

There's evidence that level of impact will be segmented. Fast food restaurants are vastly outperforming higher priced restaurants. Since the beginning of September, McDonald's and Wendy's are down just 4.3% and 1.2%, respectively. That is vastly less than the 4% drop seen by Cracker Barrel Old Country Store, Inc. (Nasdaq:CBRL), or the 8.3% decline for Chili's operator Brinker International, Inc. (NYSE:EAT). However, that doesn't mean fast food restaurants won't be hurt by consumers spending less at restaurants. McDonald's, who has been ringing up some of the best sales growth in the entire food and beverage industry, saw August revenues come in well below expectations. (Don't put your money on the table before getting a taste for analyzing this sector. For more, see How To Analyze Restaurant Stocks.)

Few Appetizing Options
Several mid-range restaurant operator stocks are in particular jeopardy. DineEquity, Inc. (NYSE:DIN), the parent company of Applebee's, could be about to retest its 52-week low. So could Darden Restaurants, Inc. (NYSE:DRI), the parent of Red Lobster and Olive Garden. Darden does have the benefit of a solid yield (4.0%), as does P.F. Chang's (3.6%) and Brinker (3.2%). The combo platter of technical weakness and worsening sentiment may be too much to digest, even for investors in search of high yield.

Meanwhile, only O'Charley's Inc. (Nasdaq:CHUX) has been able to separate from the pack. O'Charley's is a good example of how a more attractively priced restaurant within the casual dining segment will outperform higher cost competitors. O'Charley's may be in the midst of a strong turnaround story. The Nashville, Tennessee-based chain had suffered a loss for six straight quarters before posting a profit in the first quarter of 2011. Even though O'Charley's did swing back to a loss during the second quarter, revenue was up 1% to $193.3 million and same-store sales climbed 2.9%. Still, O'Charley's offers no yield and there is little reason to believe the stock will be able to continue resisting market drag.

The Bottom Line
Restaurants with good brands, management and cash flow are favorable long-term investments when the economy is strengthening. When the climate changes, the impact is rapid. Weakening consumer sentiment hits restaurant operators fast. The negative impact will be slightly muted for low-cost restaurants as diners transition down the food chain. Yet the entire group is currently vulnerable.

Some mid-range restaurant stocks have fallen so quickly over the past few weeks that they may already be a bargain. But deteriorating sentiment is increasingly rendering valuation temporarily moot. Additionally, most dining establishments have already wrung out most of their potential cost savings that would prevent earnings compression. Investors need to be careful in the bar and grill space right now. (For related reading, see Sinking Your Teeth Into Restaurant Stocks.)

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Tickers in this Article: PFCB, CAKE, DIN, CBRL, DRI, EAT, CHUX

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