TWST: Where are you focusing your attention in the restaurant space these days?

Mr. Ludington: The closest focus has been on casual dining. I think that has the best opportunity for improvement in the coming months and quarters. We keep an eye on the entire space absolutely, but if you are looking for the opportunities, especially after the recent pullback we had, I think casual dining presents some of the best opportunities.

TWST: What is it about the casual dining space that you like now?

Mr. Ludington: I believe that you are getting some people starting to trend back in the casual dining. There was a lot of pullback from that space over the last 18 months or so. Unemployment is still very high, and we would like to see some hiring pick up to feel more bullish on the space as a whole. However, we believe there are better opportunities in the casual dining segment, as consumers that are still employed have been saving money over the past 18 months and are likely to start to spend some if they can once again feel like they have some level of job security. At that point, I think you will see many of these consumers trend back into full-service restaurants.

TWST: How would you characterize the restaurant industry so far in 2010?

Mr. Ludington: I think 2010 has absolutely been volatile. But I think when you get past the monthly volatility and look at the picture as a whole, you are seeing improvements - absolutely some stabilization - and I think you are seeing some separation between the restaurants that will outperform this year versus ones that are still going to lag or fall behind.

TWST: When you say you are seeing improvement, what indicators are you looking at?

Mr. Ludington: Again, getting back some of the volatility, the trend has been upward in the Consumer Confidence Index. The trend has been upward in Knapp-Track same-store sales, which tracks the casual dining industry as a whole. The trend has also been positive for many names that have reported their numbers individually. Again, you do have some that have fallen behind with recent announcements, but the trend has been positive overall, I believe. If you look at Knapp-Track, I think you'll see some caution from investors around the fact that the traffic hasn't really improved. But what you are seeing is same-store sales improve where they were falling below traffic levels by as much as 110 basis points throughout quite a few months in 2009. We are seeing same-store sales falling 250 basis points or more above traffic levels here in May and June, which shows that consumers are still going out and spending some in spite of reduced discounting, and they are probably also trading up to higher-priced items, maybe getting the appetizer they weren't getting last year or maybe getting their first or second beverage they weren't getting last year.

TWST: What's been going on since the pullback, which I believe was in line with the market to a large degree?

Mr. Ludington: It's been in line with the market. Essentially, I think you've seen reactions to some cautious or negative macro data points. You get the weekly and monthly retail sales reports, consumer confidence data and other macro data points, and that gets translated to what's happening with the restaurants. I think there was some enthusiasm at the beginning of the year, when we started hearing some large same-store sales numbers that were trending much more positive. And then as April and May likely pulled back and you saw some negative housing data and other things, I think there is just a lot of conjecture that things must be negative in the restaurant space as well.

TWST: How are the various dining segments doing in comparison to each other? You mentioned casual dining earlier - what about the other segments?

Mr. Ludington: We are most heavily focused on casual dining, but we watch everything and have a little bit of everything on the list. It looks like the upscale segment has started to really show some improvement, which is likely due to the return of corporate cards, you know, businesses starting to travel a little bit more and also a lot of those companies lapping an entire year of having their private party and banquet rooms empty. So we've seen some benefit there. If you look at the QSR space as an aggregate, I think you are seeing an improving trend, but you are absolutely seeing some brands do much better than others. We are a little cautious on that segment right now, given its exposure to the breakfast day part. We might need to see some hiring pick back up to see an improvement to the breakfast day part and feel stronger about that segment.

TWST: I've seen reports that middle-income consumers may be opening up their purse strings. Have you seen indications of that elsewhere on the economic spectrum?

Mr. Ludington: I believe so. You know, something different with this recession versus other ones that made us more comfortable with casual dining, as one example, is that the higher-income consumers also pulled back on or even cut off spending this time, where they traditionally did not in past recessions. Given this fact, we may not need to see hiring pick back up right away to see improvement in casual dining. So I think you've begun to seen both higher-income and middle-income consumers open up the purse strings, for lack of a better term. Recently, we've seen some reports that segments of retail, such as jewelry and home repair supplies, have gotten stronger, which are traditionally leading indicators of improvements in the consumer space. And I think we've definitely gotten signs of consumers opening the purse strings at some of the stronger restaurant brands.

TWST: What's your outlook at this point?

Mr. Ludington: I think that you are going to see a separation from the stronger brands and the outperformers versus the laggards going forward. If you look in casual dining, I think the brands that have stuck to their brand identities and their core competencies throughout the recession will fare better, rather than the ones that went just for deep discounts to try to buy some traffic at that point in time. Menu innovation is also very important. I mean, one thing we are seeing across the casual dining space that was started by The Cheesecake Factory (CAKE) in 2009 is the proliferation of these small plates and snacks menus, where they are smaller than an appetizer, half the price roughly of most appetizers and something that serves as an incremental purchase rather than an item that takes place of your entree.

TWST: There has been a lot of talk about companies with exposure to China and labor costs becoming an issue there. What's your feeling on chains with significant exposure to China or other developing countries?

Mr. Ludington: I think that there is probably some risk to expectations on maybe margins for companies that have a large presence of company-owned and -operated units in China. You might need to be a little cautious about what that's going to do to the margins and earnings from their Chinese divisions in the coming years. However, I would assume, as we've seen here in the U.S., when labor rates go up, prices traditionally go up as well. So I think you will get some level of an offset to some of that. For the companies that are more franchised internationally, there should be much less risk as the revenues from China would primarily be from a royalty stream.

TWST: What is the broad picture of pricing power for the industry these days?

Mr. Ludington: It's still weak, I think. You are starting to see some companies feel, especially in the casual dining space, a little more comfortable taking some price here in 2010. But I think you need to see a lot of caution there, and that's one thing that has been built into our thesis since 2009, is the companies that were very aggressive with pricing in the 2005, 2006, 2007 time frame may be at a disadvantage to those that were more conservative. I think you want to seek out the ones that were much more cautious and have more pricing power going forward because I think that you do have a consumer that is much more focused on getting the best value for their dollar at this point. And while that doesn't necessarily mean the cheapest price, it does mean the best perceived quality for best perceived price.

TWST: What's your general feeling on firms that have been discounting? Are there risks down the road when a company doesn't discount properly?

Mr. Ludington: Absolutely. I think it's difficult to tell your customers that here in the recession, you are going to sell them these items for $20, but when the recession is over, they will need pay $30 for the same thing. I think that strategy is tough to roll off or recover from, and then you also run the risk of potentially bringing in consumers that are just the cheapest deal-seekers that maybe aren't compatible with your core customer while running the discount promotions. I believe the better way to go about that has been through limited-time offers or bundling of menu items, or even adding a little something extra onto the purchase. Bundling by adding a little something extra onto the order without taking a full mark-up. I think those strategies help. And then with the menu innovation, like the small plates and snacks we've seen with Cheesecake over the past year, and with some of these other companies that have adopted that strategy now, I think you see consumers feeling that they have an opportunity to get a real value from some of those incremental purchases.

TWST: As you talk with investors, are you finding a lot of interest in this space?

Mr. Ludington: There is absolutely interest, but it's very cautious. I think people are just trying to gauge how much pressure there can potentially be in the space and where the consumer stands right now. I believe we have some sentiment that some of these names have pulled back a little too far, but I think investors are also concerned about where 2011 estimates are falling out and probably want to see them come in a little bit.

TWST: They want to see them pull back a bit, you mean?

Mr. Ludington: Yes. You know, 2011 estimates pulled back a little bit because there is a lot of risk and uncertainty about how this recovery - or lack of recovery, depending on your viewpoint - is going to play out. That would provide some margin for error.

TWST: Where are you pointing investors now? Obviously you mentioned casual dining.

Mr. Ludington: I think my favorites really coming into 2010 and still around this earnings season are Cheesecake Factory and Ruby Tuesday (RT). I think that both of them are going to have strong quarters, stronger than a lot of people expect. I believe that shares have come back very significantly along with the space, but there hasn't been anything company specific to drive that level of a decline in share price and value. So I think you've got some great opportunities there. On other names, I'm definitely more focused right now around this earnings season on casual diners and on the ones that I think are taking share. I believe that BJ's Restaurants (BJRI) is attractive here, although they do have some expected legal fees and infrastructure spending this quarter that may hinder some of the flow through that investors would like to see from positive same-store sales. So I think it's very attractive with limited downside from this level, but strong upside may be a couple of quarters out still. I really feel that Darden (DRI) is attractive here as well. It's going to be a little bit before they report, but I think that the pullback in shares that occurred after their last announcement was a little over done.

TWST: What is it about The Cheesecake Factory that makes the company stand out for you as a favorite stock pick?

Mr. Ludington: I think that you have a strong, strong brand. I mean, arguably one of the strongest, if not the strongest, brand in casual dining that outperformed very strongly in 2009 and has continued that trend here into 2010. I think it's due to real quality operations and quality management. They did hire a new CFO at the beginning of 2009, Doug Benn. He is considered to be a very strong operator by many investors, and I think really proved that view throughout 2009. They are a little probably behind the ball in the restaurant space on implementing cost controls, so they had a little more opportunity to identify sustainable cost-savings through 2009 and coming into 2010. I also think you will continue to see stronger top-line improvement with them than a majority of the casual dining space along with more significant margin expansion.

TWST: The other one was Ruby Tuesday?

Mr. Ludington: I think it's been a tough road for Ruby Tuesday over the last few years. I believe they made the absolutely right decision at the absolute toughest time to make it, and that was to reposition themselves up and out of the bar-and-grill segment in casual dining. It was difficult for them to compete with the much larger players, Chili's (EAT), Applebee's (DIN), Friday's and the like. So they have definitely improved their menu' they've remodeled the entire system. It is a better-quality experience and a better-quality menu now, and I think going forward you are going to see consumers continue to respond favorably to these changes and continue to really discover the new brand versus what they remember Ruby Tuesday had been in recent years. They are also coming off of what could really be considered trough earnings, trough margins and trough top-line performance over the past two to three years, when they were in the middle of this whole transition while the casual dining space and the economy were falling apart.

TWST: You mentioned Darden may be undervalued.

Mr. Ludington: I believe so. Darden came out and they had a miss in their fiscal fourth quarter on the same-store sales line and on earnings, and they came out with very positive guidance. So I think you are seeing a lot of investors say, "Prove it," at this point. I think it's very likely that they do hit their guidance of positive same-store sales, solid earnings growth and margin expansion this year. They have a lot of cost-savings initiatives in place that will be sustainable cost-savings. We've seen the turnaround effort at LongHorn show great improvement with same-store sales turning positive and improved profitability in recent quarters, and I think Darden likely will see Olive Garden and Red Lobster turn positive as well, as the consumer, in our view, gets a little more confident in the coming months.

TWST: Anybody that you are high on outside of the casual dining sector?

Mr. Ludington: We have a "buy" rating on Sonic (SONC). They have severely underperformed in the last couple of years and have had a lot of issues, but I think that they have made a strategy shift where they are focusing on their brand identity and the differentiation versus trying to compete with the bigger players, similar to Ruby Tuesday's situation previously. It's hard for them to compete with the bigger players, the McDonald's (MCD), Wendy's (WEN) and Burger King's (BKC) on their own turf, where you are just trying to advertise the best meal deal or your dollar menu. Now they are focusing on the differentiation of skating carhops, the differentiated product offerings and the differentiated experience, where you pull into the stall and someone comes out and actually serves you. They are also focusing on improving product quality, where I think there is some concern that product quality was maybe lagging in some areas with Sonic previously.

TWST: What's your take on McDonald's?

Mr. Ludington: I don't cover McDonald's, but it is a strong company, I mean, arguably the strongest management team in the restaurant industry, and a very strong brand. I'm confident in that one, much like a Darden. If there is a misstep with that one, a pullback to Darden or McDonald's, I would always say consider putting some money in those because I think longer term and probably near term, they are going to be much stronger performers than a majority of their competitors.

TWST: Are there any segments or even individual stocks that concern you, looking ahead?

Mr. Ludington: I remain cautious around Buffalo Wild Wings (BWLD). I think that while there is maybe not measurable or sustainable downside from here in the mid-$30s or so, I do believe there is opportunity for them to have two or three quarters of negative same-store sales. And you will likely see some margin deleverage from that, and I think that will hold shares back. We are also cautious around Brinker, rolling off the deep discounts they did in 2009 at Chili's and the impact that might have.

TWST: Are you expecting to see some M&A activity over the next 12-18 months?

Mr. Ludington: I think so. I mean, we've seen some go on already. CKE Restaurants should close that deal in the next week or so. You had a lot of private companies, Papa Murphy's, Wingstop, Captain D's, Rubio's, many others complete deals in recent months. You are also seeing some companies, such as Logan's Roadhouse, and Bravo and Brio, file for IPOs. So I think that we are on the verge of seeing some more of that activity going forward. There has absolutely been some speculation very recently with Red Robin (RRGB) about some sort of M&A or at least - at the very least - a couple of activist shareholders getting involved. Plenty of speculation also remains around many other names in the restaurant space, about both M&A opportunities or potential public offerings.

TWST: Is there anything else we should touch on?

Mr. Ludington: I think we covered most of it. I mean, it seems that fear wins out over favor right now. When you see positive sentiment in the space, you are starting to see some separation of the stronger performers from the laggards. They seem to run further on the way up, but on the pullback, they all seem to come in equally. I think you just need to look at those pullbacks as opportunities for the strong brands to maybe take a larger position or an initial position. I do think that we will see improvement in the restaurant space this year, but different from what we may have seen in past recoveries. I feel that you will almost definitely see some leaders and some laggards in this recovery.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 07/22/10.

BRAD LUDINGTON

Senior Analyst

KeyBanc Capital Markets, Inc.

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