TWST: Where do you focus your attention in the restaurant space these days?

Ms. Collier: Primarily I'm focusing on the casual dining companies and some of the faster-growing names in the space. I'm also working on the fast casual segment with Panera (PNRA). So that's where I spend most of my time.

TWST: How would you characterize the industry over the last six to 12 months?

Ms. Collier: The industry has performed a lot better in the last six to 12 months. After about four years of negative same-store sales for the casual dining companies, we started to see positive same-store sales emerge in July 2010. And that has continued now with the exception of December through January 2011. We have had five out of the last six months or so of positive comps in the space. So the group is performing better. Same-store sales for the industry are performing better, and stocks have definitely responded to that.

TWST: The sector has done well, according to Morningstar. Over 12 months, the sector has improved by 32.5%.

Ms. Collier: That's a great return. And again, I think if I were to identify the number one catalyst that drives the restaurant stocks, it is improving same-store sales. The same-store sales improvement over the last six or seven months is the primary catalyst for the stocks' outperformance.

TWST: People have been talking about big trends in the space, one of which is skyrocketing commodity costs over the last nine months or so. Is that having a big effect on the space?

Ms. Collier: So far, increasing commodity costs have not been a significant factor to date, as most companies have forward contracted many of their food costs for 2011. So in effect they are contracted with the exception of some items like produce and dairy, which have recently trended higher. However, as we head into late 2011 and 2012, these companies will be rolling off these commodity contracts, and that in effect will result in higher commodity costs at that point. To offset that, I think we're going to see more menu pricing to try to offset commodities.

TWST: The second trend seems to be many people in the financial media are talking about what seems to be an improving economy, modest gains and deployment of recent tax cuts. Do you feel like restaurants are benefiting from the macroeconomic environment at this point?

Ms. Collier: Absolutely. The restaurant industry is a leading indicator, and same-store sales for the industry started to turn negative around 12 to 18 months before we started to see the economy deteriorate. As we are coming out of this and the economy is getting better, the restaurants have led the way in terms of improving same-store sales trends. The economy is improving and in particular the business customer is coming back to a greater extent. The higher-income customer is also coming back. We still see challenges with some of the middle-income customer that may be still be unemployed.

TWST: You mentioned you focus on casual diners and some fast casual. How are the different segments doing when compared to each other?

Ms. Collier: Most recently the fast casual segment, which is mostly comprised of Chipotle (CMG) and Panera, seems to be doing the best. I think part of the reason behind that is both of those companies have what is perceived to be a high-quality product. There is also a convenience factor. It is pretty fast and the price value is attractive. So they have three components that are very attractive to consumers right now. The fast casual segment seems to be performing the best. And then I would say casual dining is number two. And then I'd say the worst-performing group right now would be quick service, with the exception of McDonald's (MCD). Companies like Sonic (SONC), Jack in the Box (JACK) and others are still struggling. So again, quick service seems to be not faring as well, with the exception of McDonald's.

TWST: What are the reasons for the quick-service lag?

Ms. Collier: I think the biggest reason behind that is the unemployment picture. The customer base for quick-service restaurants, they tend to attract a younger audience, and the unemployment rate for the younger demographic is greater than the general population. So that is part of it. I think quick-service restaurants also focus a lot on the breakfast daypart, and if you're unemployed you're less likely to go out for breakfast. I think those are the two primary reasons we're seeing the segment suffer a little more than other segments.

TWST: What's the latest on pricing power for the industry? There was a lot of talk about discounting a year ago. What's the latest in pricing power now?

Ms. Collier: When same-stores sales were negative for the casual dining companies, we saw a lot of discounting as everyone was trying to have the most-compelling value. But as the same-store sales have in fact rebounded, I feel like there is more pricing power. When I look at particular companies that have the pricing power, those companies are the ones that are outperforming on customer traffic. If customer traffic is up and the company has been prudent in terms of menu price over the last few years, I believe those companies have the most pricing flexibility going forward. I look at companies in my coverage list that I think have the most pricing power, and BJ's (BJRI), Cheesecake Factory (CAKE) and Darden's (DRI) Olive Garden brand come to mind.

TWST: And that's driven, you think, by the fact that they've got rising comps?

Ms. Collier: Yes, specifically the comps are the main driver, and improving traffic. The companies that have positive traffic counts have an easier time raising menu price, while I believe that the companies with negative traffic counts will have a much more difficult time trying to raise price.

TWST: We've talked about how the stocks have been performing well in 2010. Where do you see valuations these days? Do you have any concerns that things have gotten expensive?

Ms. Collier: When I look at the valuation from my coverage list versus historical norms, it's pretty much in line with the five-year average multiples. I don't think the group has run too far. And I think for specific companies, the valuations are still very attractive. So I don't think the group has gotten ahead of itself. I think the valuations are pretty much in line with where they need to be, and as I mentioned, in line with the five-year average multiple.

TWST: What is your broad-brush outlook for the companies you cover?

Ms. Collier: I think we are gradually coming out of the economic downturn. We are coming off the bottom, and I think things will gradually get better. I don't expect same-store sales to accelerate to the 5% to 10% level for most companies, but I think the low- to mid-single-digit range is reasonable for most of the industry. So I think just a gradual improvement. I think as the same-store sales stabilize and continue to get better for the space, there will be more investor interest in the growth names, like BJ's, Chipotle, Panera, Buffalo Wild Wings (BWLD). Those names will probably continue to command the highest multiples. So I am going to be looking at more of the growth names as we move through the rest of this year.

TWST: Before we talk about individual stocks, what drives some stocks to be growth stocks and not others?

Ms. Collier: I look back 10, 15 years ago, you could have asked me how many growth names do I cover, and I would have said probably 10 out of 13 are growth names; today I'd say three out of 13. We're definitely in a more mature industry. A major trend that we're seeing recently has been the initiation of a dividend. A lot of the companies are now initiating dividends for the first time. So we're in a mature space, and there are not a lot of growth names out there. Part of that is a lot of the restaurant chains are pretty built out. Particularly in bar and grill with names such as Chili's (EAT) and Applebee's (DIN).

TWST: Do you follow what companies do overseas?

Ms. Collier: We're seeing that as a major trend. Companies that have historically not had as much exposure on the international side are starting to ramp up development. Companies such as Cheesecake Factory, P.F. Chang's (PFCB) and Brinker are all starting to really accelerate unit growth internationally. Now I would say up to this point this hasn't had a big impact on earnings because the international business is so small for most of these companies and really hasn't hit the P&L on a big way. But I think that over the next five years, we'll start to see a more meaningful impact from the international operations. But at this point it has been pretty minimal.

TWST: As you talk with investors, do you see a lot of interest in the space?

Ms. Collier: I'd say in the last six or seven months that we are seeing a lot more interest in the space. We are seeing a kind of light at the end of the tunnel as comps for casual dining have turned positive after roughly four years of negative sales. The companies that have good same-store sales and have decent traffic can raise prices to offset some of the higher commodity costs. So what we're hearing from investor's is, "What companies have the most pricing power? Who can offset these higher commodity costs?" We are spending a lot of time looking at those companies that we think can outperform on comps and traffic and certainly have pricing power.

TWST: Where are you pointing investors? What are some of your favorite stories at the moment?

Ms. Collier: One of our favorite names that I've had as a favorite for a long period of time is BJ's. It has basically everything I look for in recommending a restaurant stock. It has a great management team. It has lots of growth opportunities. They only have 100 stores in 13 states. I think they ultimately could have 400 to 500 units. So they're still early-stage growth with great management, very good store level returns, no debt on the balance sheet and a concept that is portable. So that would be my top pick if I look out over the next 12 to 18 months.

TWST: What are some of your other favorites?

Ms. Collier: One of my other favorites is Panera Bread, PNRA. I like their positioning again within the fast casual space, which is very attractive right now. So I think they will benefit from being in that category. They also have company-specific initiatives such as MyPanera, which is a loyalty program that they rolled out at the end of the fourth quarter. That is just now taking hold on a system-wide basis. So that's going to be a catalyst. They have increased focus on the catering business. They also have increasing marketing expenditures as we look out over the next couple of years. So I like the niche they're in. They have a lot of company-specific initiatives, and again they have a very clean balance sheet with a pretty significant repurchase program.

And then another name that I want to point out is a stock that we upgraded just a couple of days ago, the Cheesecake Factory, CAKE. The stock has pulled back a lot, pulled back from a recent high of $34. It's now $28 and change. Again, I like the management, I like the fact the brand is very differentiated. They do have the new international business that's starting to ramp up. And I think they have a good handle on their commodity costs for 2011, and I see some additional unit growth coming from them. Many investors have written off Cheesecake as a mature brand. But I think there is a lot more unit-growth opportunity for them than many investors are giving them credit for.

TWST: What about Chipotle? You mentioned them a few times when you were talking about growth ideas.

Ms. Collier: Chipotle is not a name that I currently cover. I have a high regard for it. Good management, attractive growth opportunities, but I don't currently cover that name.

TWST: You mentioned when I asked you about valuations that there are some other stocks you find attractive.

Ms. Collier: The three names that I have highlighted - BJ's, Panera, Cheesecake Factory - don't necessarily have the lowest multiples. I consider those three names as growth names, so they're going to have a higher multiple than some. However, I do have "buy" ratings on what I'd call more of the value names, like CEC Entertainment (CEC), California Pizza Kitchen (CPKI) and Darden, DRI. However, the three names that I highlighted as top picks are more of the growth names which command higher multiples.

TWST: Are you concerned about any areas of the industry or markets you cover?

Ms. Collier: The area within the restaurant space that seems to have the most difficulty is bar and grill, which would mostly include Applebee's, Chili's and T.G.I. Friday's. That is the area that I see as the most challenged. In terms of number of stores, it's very competitive. The food is very similar. So it's very hard to differentiate. They can be good stocks, but I think those companies are going to have difficulty in gaining market share. They are going to have difficulty in raising menu price. So I think while Brinker and DineEquity and Red Robin (RRGB) have cost-cutting initiatives and some reengineering of the balance sheet, they are going to have some trouble in gaining market share and raising menu price.

TWST: From the stocks you mentioned, it sounds like pricing power is a big part of the equation.

Ms. Collier: Absolutely. I think the first three names I mentioned - BJ's, Panera, Cheesecake - have a lot of pricing power. I would put Darden up there also. But you're absolutely right, the names I like the best going into this year are those names where I think they have the most pricing power that can offset some of the commodity cost pressure that could come more to the surface toward the end of this year.

TWST: What is it about Darden that gives them pricing power over their competitors?

Ms. Collier: I think the Olive Garden has pricing power. They've been pretty conservative over the years in their menu pricing. I think, hands down, they have probably the best price-value equation in the space. In other words, the customers perceive it to be very strong value with the all-you-can-eat salad and breadsticks. So I think they have pricing power. But I would say for Darden that unfortunately Red Lobster doesn't have as much pricing power. So I think it is kind of half and half. I think Olive Garden has good pricing power, and Red Lobster probably does not.

TWST: Would you like to add anything else about the industry or the stocks you cover?

Ms. Collier: I think that covers everything. That's about it.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 02/01/11.

Lynne Collier

Managing Director & Senior Research Analyst

Sterne Agee & Leach, Inc.

800 Shades Creek Pkwy.

Suite 700
Birmingham, AL 35209

(205) 949-3500

(800) 240-1438 -TOLL FREE

(205) 949-3607 - FAX

www.sterneagee.com