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

Mr. Staszak: In the restaurant space there is fast food, which we're all extremely familiar with, probably too familiar with, and that includes some good stocks like McDonald's (MCD), and good companies like McDonald's are performing well, and Yum! Brands (YUM), which is performing well because people whose budgets are pinched are trading down. This is a very important term in the restaurant industry from casual dining to the fast food service. There's Yum! and McDonald's, and they're doing pretty well.

Next, the big trend that I'm really excited about is fast casual, which combines the best aspects of fast food, fast counter service and high-quality foods. Chipotle (CMG) also offers us fast casual, and those companies have being doing very well even though the restaurant industry is a very mature, fiercely competitive industry. Chipotle has been doing very well, as has Panera (PNRA). I don't cover Panera, but Chipotle Mexican Grill has been doing very well and growing earnings rapidly. As mentioned earlier, I had a "buy" in Chipotle all last year, the shares were up 141%, and this company is just likely to do well. So the second segment is fast casual.

Then of course, the third segment in the restaurant industry is the casual dining industry, where more time is taken to prepare meals. It's better quality food and you sit down and you eat. That would include Chili's, which is owned by Brinker International (EAT) or Darden Restaurants (DRI), which owns Olive Garden, Red Lobster and LongHorn Steakhouse. I do like Darden. They grew again in fiscal year 2011. But getting back to fast casual, it combines the best aspects of fast food, fast counter service and good food at Chipotle that you're going to see do well. I'm still pretty bullish on it. They have a customizable menu, which is very simple, a few simple ingredients and the orders can be customized to suit customers' preferences and done quickly. And that makes it easy to train new employees, which they're going to have to do because they had to replace some employees. And it makes for ease of training and leads to very quick service, and it's high-quality food. They don't get any ingredients from farmers who inject their cattle with growth hormones or anything like that. So it's very high-quality food, sit-down but fast service. Hence the term fast casual, combining the best of both words, if you will. So I'm very bullish on Chipotle. It is very well-managed company, and we might say it's very expensive in terms of valuation. But it has a lot of room to grow, and so that's the fast casual segment.

In the fast food segment I like Yum! Brands because of its international growth component. Realistically it's going to be a little tough here in the domestic industry with KFC struggling to increase same-store sales. But Yum! Brands is growing rapidly in China, and they have a lot of room to grow in China. They just have 1.5 restaurants per million customers, and they usually handle more than that, 60 restaurants per million people here in the United States. So they're far from saturation in China, and they're just even growing very rapidly in China, and it even has an international growth component. I prefer those type of restaurants that have an international growth component like Yum! Brands. Anyway, I like Yum! for that reason. I like Domino's Pizza (DPZ) because they're growing in Mexico, the United Kingdom, France, Australia, India. And Domino's, well, admitted that they had disappointing products - they could improve their products, which they have, and that has led to some very, very impressive same-store sales gains at Domino's. Those are still my top picks, and that's how the restaurant industry is divided or subdivided, if you will. And that's basically where I'm in the restaurant industry.

TWST: Please tell us about the industry over the last 12 months. It seems like a lot of people had a really good 2010, and stocks have been moving laterally so far in 2011.

Mr. Staszak: They had good 2010 because the recession was good for deflating commodity prices, and so they had a good bottom-line yield with a recovering top line. You can have even just a modest recovery in the top line, or you can have just only slightly lower sales at some chains. You had cost cutting and lower commodity prices, and they were really able to grow earnings. So 2010 was a very good year for the restaurant industry overall, but now the sideways activity reflects concerns regarding higher commodity prices.

Are restaurants going to be able to raise prices enough or soon enough? That's the one thing I'm watching with Chipotle. When are they going to raise prices? Do they have to raise prices? And I guess we ought to look at certain commodities when we know coffee has gone up about 15%, and how much is Starbucks (SBUX) going to be able to raise prices or what they are going to do in response to that. Now the sideways activity reflects primarily concerns regarding higher commodity prices, because the outlook for 2011 is just across-the-board increases, with at least moderately higher revenue, top-line growth. But that could be overshadowed by lower-double-digit commodity prices, so forth and so on.

TWST: How much of an impact are commodity prices having now and what do you expect going forward?

Mr. Staszak: They are having an impact now. Their cost of goods sold really is higher, but the impact varies. Like I said, at Starbucks, how much are coffee prices pinching margins? The top line is healthy, but they're pinching margins. So restaurants have to look at labor and also other costs. Occupancy as there is the key term is restaurant-level margins, which includes food, labor and occupancy. Commodity prices are an important element in the restaurant labor margin, and of course it's having an impact on the restaurant level margin. So it can be a big part of a company's operating income.

TWST: What is the latest in pricing power for the industry? Is that bifurcated?

Mr. Staszak: Yes, that can be put as bifurcated. They have had to lower prices in such a fiercely competitive industry when the economy was weak, so they had to lower prices and do a great deal of promotion. But some companies have pricing power, and some are just looking to offer more value menus. So it is bifurcated. Some casual dining companies like Cheesecake Factory (CAKE) have pricing power, and others have had to do a lot of promotional pricing. So it is bifurcated or there is that dichotomy.

TWST: In general, where do you see valuations?

Mr. Staszak: They have come down a bit, but eventually they will recover as the economy continues to recover. I see them moving back up a bit as the companies that see their top line grow and are able to do that. It has to have top-line growth through higher prices and recover those higher costs, but I see their valuations increasing. I still see Chipotle, which has a very high valuation, moving up a bit, and those companies commanding premium valuations that have international growth and good top-line growth have pricing power and are able to manage through a difficult operating environment. They can still move higher as you noted, then sideways are cutting down a bit, so they can go back up if circumstances are favorable.

TWST: What's your outlook for the industry?

Mr. Staszak: My outlook is very positive, as you probably can infer for fast casual like Chipotle, very favorable. The only wild card is, will they raise prices fast enough? They've been little reluctant to do so. They didn't raise prices last quarter. Will they raise prices fast enough to preserve margins? But I'm very bullish on them. Their managing labor and occupancy costs are very efficient at Chipotle. They are managing occupancy costs through a new Type A store design that is less expensive to build, seven hundred thousand rather than a million, and is less expensive to operate because they're a bit smaller and at Tier II locations - like say, in the suburbs rather than in an expensive urban location. These less expensive operations keep occupancy costs down, and there are still things like that to manage costs carefully. So I'm very bullish on CMG.

Fuel prices are high and people are feeling pinched because of rising prices, but I'm still kind of bullish on quick-service restaurants. I think they should do okay, but it's kind of weak demand here because of joblessness and the weak housing. So I'm really looking at quick-service restaurants that are growing internationally, like Yum! So casual diners, they should see their top line grow because of the recovering economy, just as they face those higher commodity prices. I am less bullish on them, though the better ones will do well, like Darden Restaurants. Therefore my outlook for the industry overall in terms of preference: fast casual, followed by quick-service restaurants for fast food and then casual dining, which is going to be pinched because of their more expensive menus. You spend like $25 for Chili's or something. Cracker Barrel's (CBRL) average check is like $9. So casual diners are ranked last, though their top line will recover along with the economy and benefit from the extension of the Bush-era tax cuts and the lowering of the payroll tax, and so forth. That's how I see it.

TWST: What do you look for when examining companies' potential expansion in international markets?

Mr. Staszak: I look at how penetrated the market is. And like I said about Yum!, it has very few restaurants per million people built in China and things like that. Looking at what the market share is of say Domino's Pizza in Mexico, because Domino's Pizza in Mexico is - and Pizza Hut - just really are a big part of the market there. So I see Domino's as being a leading firm internationally. I look at market share and how much market penetration there is, whether it's anywhere near saturation, which it is not.

TWST: Are investors showing interest in this space?

Mr. Staszak: They do have interest in this space, particularly Chipotle. A lot of my institutional clients like Chipotle. I guess I'm hopeful because I see it's a great opportunity. There is some international growth underway, and CMG offers natural food.

TWST: Are they concerned about commodity costs and even oil at this point?

Mr. Staszak: They are concerned about oil, because oil cuts discretionary income and makes people less likely to go out to eat. If gas first goes up to four or five dollars a gallon, then they will cut back on their other spending, so that's a concern.

TWST: Where are you pointing investors now? Are Chipotle, Yum! Brands and Domino's Pizza your favorites?

Mr. Staszak: Yes they are, because I'm pointing to those investors who seek international growth. I'm pointing them to Yum! Brands. As you know, Chipotle Mexican Grill is very high and that's basically where I'm pointing them to and steering them clear of Wendy's (WEN), which is having problems and divesting Arby's and that sort of thing. There's another component, how well they execute their growth plan and of course their menus, and so I steer them clear of Wendy's. But I'm positive on companies with international growth like Domino's and YUM! Brands and so forth. They're going to grow internationally. So the domestic restaurant industry is going to be tough. We just discussed commodity prices are going to be a big question, and of course gas prices can really impact results overall, meaning the domestic industry.

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

Mr. Staszak: We are in a tough industry environment. McDonald's is likely to do well. I actually look at their commodity price basket to see how well they are going to continue to grow. But McDonald's I like. They post strong performance in this difficult economy with higher fuel prices and joblessness and weak housing markets, and so customers seeking inexpensive meals.

TWST: Is there anything else we should cover?

Mr. Staszak: The big themes are international growth and the fast casual industry. That's where I see good investment opportunities.

TWST: Have you been bullish on the space for a while?

Mr. Staszak: Yes, I have. Last year I was bullish and saw stocks like Domino's rise 84%. I will keep my eye on commodity prices this year just to see whether I should still be bullish. Yes, I've been bullish, and I'm still kind of bullish because the economy is recovering, top lines are recovering. People are little more willing to spend.

TWST: Thank you. (MJW)

Note: Opinions and recommendations are as of 03/07/11.

John Staszak, CFA

Analyst

Argus Research Company

61 Broadway

Suite 1700

New York, NY 10006

(212) 425-7500

www.argusresearch.com