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

Mr. Tarantino: As always, we think the metric that is most important to track for the industry is same-store traffic trends. So we're spending a lot of time gauging consumer demand trends, including the current trends and the factors that we believe will impact the future trends.

TWST: What are you seeing with same-store traffic trends, generally speaking?

Mr. Tarantino: We're seeing a gradual improvement, which started over the last 12 months or so. That's when trends in the industry started to become less negative coming out of the recession. We're seeing many chains turn over into positive territory on the same-store traffic metric as the economy appears to be stabilizing, or even improving in some respects. We think that trend can continue as we move through the balance of this year. I think some of the key factors that could influence the pace of improvement are employment growth and tax cuts, both of which could be positive for consumer confidence and spending patterns. The potential offset is rising oil prices. At this stage, we think the positives outweigh the negatives, and we think the demand trends can continue to get better from here.

TWST: Broadly speaking, these stocks had a great 2010 and were down a bit over the last three months or so. What do you see as some of the key drivers for share prices?

Mr. Tarantino: Our analysis says that valuation metrics - p/e ratios and enterprise value-to-EBITDA metrics - tend to correlate very strongly with same-store traffic trends. We think that the performance we've seen over the past couple of years has been tied to the traffic trends getting better and the earnings growth that has resulted from that improvement, as well as a favorable cost environment. Looking forward, we think restaurant stocks will need to be driven more by earnings growth and free cash flow generation than by further increases to the valuation metrics. We're seeing an environment where the demand trends are getting better, but also the cost picture is becoming much more inflationary. So we think companies are going to need to drive earnings growth with positive same-store traffic and a little bit of pricing, to offset inflationary pressures and drive potential unit growth to get the operating leverage. That's the recipe for growth going forward, in our opinion. We think shares of companies that can grow this way can perform well and maybe outperform the market, depending on how fast the earnings growth is.

TWST: You mentioned the rising cost of oil. A lot of people are also talking about skyrocketing commodity costs for coffee, sugar, corn, wheat and others. How is that impacting companies you cover at this point, and do you expect it to be more of a factor as contracts run out going forward?

Mr. Tarantino: Absolutely. I think 2009 and 2010 presented a fairly benign and deflationary cost environment, in most cases, for restaurant companies we cover. And as we move through 2011, especially the second half, we think inflation will become more meaningful. We believe companies that can take price increases and pass some of that inflation through to the consumer can manage through the situation well. But companies that may not have as much pricing power could struggle and see margins pressured from some of these cost increases.

TWST: What's the latest on pricing power in the industry? Is it still a difficult thing to come by?

Mr. Tarantino: I think there is some pricing power, because most companies took very little pricing over the last year or two. It really depends on the individual brands. Some brands are much better positioned than others to take price increases. For example, Chipotle (CMG) hasn't raised prices since the fourth quarter of 2008 - almost two-and-a-half years. In our opinion, the company has a very strong brand and value proposition, and thus plenty of room to take price increases if they need it. Other brands in much more competitive situations may be a little bit more challenged to take pricing. In general, companies seem to be taking a cautious approach with respect to pricing, which I think is prudent. While demand trends are getting a little better, it's certainly not a robust environment, so companies need to be careful. Still, we think some brands, especially those that already offer strong value propositions, will be well positioned to take those price increases when the inflationary pressures kick in.

TWST: Have you not seen a lot of price taking up to this point?

Mr. Tarantino: We've only seen very modest increases so far. In my opinion, there are two reasons for that. First, as I said, companies haven't needed to take meaningful price increases yet. Inflation is just creeping in, and companies have some favorable contracts that are helping to buy them some time on pricing decisions. Second, as I said, there is a somewhat cautious approach with respect to how much the consumer can really absorb at this stage. Still, my sense is that many companies are ready and willing to take some as we get into the second half of this year and move into 2012.

TWST: How are the various segments of the industry doing in comparison to each other?

Mr. Tarantino: The trend line is improving for all segments, but fast casual has done quite well on a relative basis. These are the chains such as Chipotle and Panera (PNRA), with conceptual positions and price points wedged between fast food and casual dining, but with very high-quality food offerings. That segment caters to a slightly higher income demographic, which has helped them over the past year, as that consumer seems to have recovered more quickly than the middle to lower-income segments. That said, we've also seen gradual improvements in QSR and casual dining. We're really seeing it broadly, but I would say the most robust trends on an absolute basis are coming out of the fast casual segment.

TWST: Are you bullish on Chipotle and Panera?

Mr. Tarantino: We do have outperform ratings on both of those stocks. That largely reflects our view that both can continue to take share, drive healthy same-store sales momentum, take enough pricing to offset inflationary pressures, build more high-return units, and as a result of all of those factors, grow earnings at a healthy pace. While the valuations for those stocks may not expand further, we think that Panera and Chipotle can retain their current valuation metrics, and that earnings growth can drive above-average returns in those stocks over the next 12 to 24 months.

TWST: What's your general take on valuations these days? Obviously we had a run-up over the last 12 months or so.

Mr. Tarantino: Valuations are consistent with what we would expect, given the demand environment. Our models show fairly strong correlations between valuation metrics and demand metrics, and if you look at where we are in the cycle, valuations are quite consistent with where the demand is. We think demand can gradually improve, and that valuations could expand a little, but mostly we think the stock performance is going to be more about earnings growth than valuation expansion from here.

TWST: Broadly speaking, what's your outlook? It sounds like you're pretty optimistic.

Mr. Tarantino: I would characterize our outlook as cautiously optimistic. Right now, we have outperform ratings on the majority of our stocks in our coverage and no stocks rated underperform. We are biased positively on the group, because we think the companies we cover can drive earnings growth above a normal market return.

TWST: Are you paying a lot of attention to what various companies are doing internationally?

Mr. Tarantino: Yes, we cover McDonald's (MCD), Yum! Brands (YUM) and Starbucks (SBUX), which each have significant presence overseas. We're also starting to see companies such as Buffalo Wild Wings (BWLD), Chipotle, Cheesecake Factory (CAKE), P.F Chang's (PFCB), Texas Roadhouse (TXRH) and California Pizza Kitchen (CPK) developing international strategies. They are doing it mainly by partnering with local operators who tend to execute the brand and know the local markets. That is an emerging trend, and we expect that to be an area of increasing importance for those companies in upcoming years.

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

Mr. Tarantino: Investor interest has been somewhat mixed recently. I think the rise in oil prices has tempered the enthusiasm about investing in consumer discretionary names. But I also would say that when the stocks pull back, we tend to get some interest. Overall, it's been a little bit more mixed than what we saw last year, but still some interest.

TWST: How concerned are you about oil prices?

Mr. Tarantino: It's becoming more of a concern. I think at a little over $100 a barrel, it's still quite manageable, unless oil prices start to derail the economic recovery. From a consumer spending perspective, the positives or potential positives - employment growth and a more stable credit and housing market environment - can more than offset the impact from higher oil prices, in our opinion. But at some point, if gas prices continue to rise, that could threaten the economic recovery and stop job creation. That would be an issue for restaurants as well as many other parts of the economy.

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

Mr. Tarantino: Chipotle is one of your favorites. We think that it's a rare type of growth situation that commands a premium valuation, much the same way some of the other great, large-cap growth stories have achieved premium valuations in the past. We are very confident in the near- and long-term outlook for the brand. I think Chipotle is a company that can deliver 15%-plus-type revenue growth for many years to come, and if you look at the consumer discretionary components of the S&P 500 Index, there are only a handful of companies that can grow revenue that way. We think that the current valuation metrics can hold, and Chipotle can drive a lot of earnings growth, fueling above-average returns for the stock as a result.

Another stock we like is Peet's Coffee & Tea (PEET). It's a smaller-cap name with a defensive business mix and a nice growth profile. They are growing their high-margin packaged goods segment faster than their relatively lower-margin retail segment, and that leads to healthy earnings expansion and very strong increases in returns on capital. We also like names such Panera and Darden (DRI), and Texas Roadhouse and Buffalo Wild Wings, because I think those companies can perform well in the current environment. Lastly, McDonald's: It's a defensive play, but also an extremely well-run company that has put up excellent results quarter after quarter. We think that can continue, and that's a company that can grow earnings slightly above average.

TWST: What's the thesis on Darden?

Mr. Tarantino: Darden is really two-fold. It's a play on the improving consumer demand picture. We think that they have brands that can capitalize on that very well. We also think that they have an operating structure that can help the company manage through an inflationary environment well. We view Darden as best-in-class operator that can grow earnings consistently in that 10%- to 15%-type range, on a three- to five-year basis. With that type of growth outlook, we think it deserves a higher valuation than it's getting today.

TWST: And what about Texas Roadhouse?

Mr. Tarantino: We like Texas Roadhouse because it has the best same-store traffic fundamentals in the casual dining industry. They offer an exceptionally strong value proposition, and we think they're well positioned to capitalize on an improving employment picture. We think the job growth is likely to occur among their core customer base, which tends to be lower- to middle-income consumers.

TWST: You talk about same-store sales as the key metric. Is there a theme behind companies that are doing well in that area or is it really stock by stock?

Mr. Tarantino: I think as always there are company-specific drivers that create differences. But I would say, generally speaking, the companies with the best same-store traffic profile tend to be either catering to a slightly higher-than-average income customer demographic, or those that are just offering exceptional value for their target customer. While the demand environment is getting better, it is not robust. Thus, I think that companies offering the best value are driving the best traffic flow into their restaurants. Two great examples of that are Chipotle and Texas Roadhouse. Those are among the best from a traffic perspective, and we think that it's because they offer a very high-quality food experience at compelling price points. We think that that's a good recipe that can continue to work even as the demand environment gets better.

TWST: You have no underperform ratings, but you also said that you're "cautiously optimistic." What are you concerned about as you look out over the rest of the year?

Mr. Tarantino: The biggest concerns right now are related to anything that would derail the improving demand environment, which includes energy prices. Certainly, the inflationary environment that's about to happen could dampen the earnings growth for chains without much pricing power. Those are the two big macro concerns. I don't have any major fundamental concerns about the stocks that we cover because we think the trends generally are getting better. It's really hard to be underperform on shares of well-run companies in an improving demand environment, where I think valuations can hold and the majority of companies can grow earnings at a fairly healthy pace. Our neutral-rated stocks tend to be ones where we have issues related to valuation or potentially less enthusiasm about the earnings-growth outlook.

TWST: Is there anything else we should talk about?

Mr. Tarantino: No, I think that's it.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 03/02/11.

David Tarantino

Senior Analyst & Associate Director of Research

Robert W. Baird & Co.

777 E. Wisconsin Ave.

Milwaukee, WI 53202

(800) 792-2473 - TOLL FREE

www.rwbaird.com