We closed this position on December 14, 2012. A copy of the associated Position Update report is here.

Of the 36 restaurant stocks we cover, only 2 get our “very attractive” rating and only 2 get our “very dangerous” rating. Anyone who has worked in the restaurant business knows that it is very competitive. Margins are narrow, customers are demanding and hours are long. This business is especially tough when the economy is down and unemployment is high. People do not go out to eat as often when they are struggling to find a job. In this environment, I expect many restaurant companies will go bankrupt. Some of the most likely candidates for bankruptcy, in my opinion, are those stocks who have misleading earnings, which means that reported earnings are positive and rising while actual economic earnings are negative and declining. Companies cannot hide their cash flow problems for long, especially in this environment. The restaurant stocks with misleading earnings are: Denny’s (DENN), Brinker International (EAT) and BJ’s Restaurants (BJRI).

BJRI stock also happens to be very expensive. Specifically, the current stock price of $34.14 implies the company will grow its profits at 20% compounded annually for each of the next 15 years. I would say that is setting the bar high. I remind investors that for BJRI stock to go up further, investors will have to be willing to bet that the company’s future profits will be significantly higher than what is already baked into the current stock price. Consequently, tt is hard to believe there can be much future upside in this stock. On the other hand, downside risk looms large as both expectations can fall as can reported earnings, which, almost always, eventually reconcile with economic earnings.

As you might have guessed, BJRI’s misleading earnings and high valuation earn it our “very dangerous” rating and it is also one of January’s Most Dan­ger­ous stocks. We recommend investors sell or short BJ’S Restaurants (BJRI), my stock pick of the week.

Below is a quick summary of the red flags my research reveals:

  1. Mis­lead­ing earn­ings: BJRI reported a $3mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $2mm (a dif­fer­ence of $5mm or nearly 40% of reported net income) during the last fiscal year.
  2. Very dan­ger­ous val­u­a­tion: stock price of $34 implies BJRI must grow its NOPAT at over 20% com­pounded annu­ally for 15 years. A 15-year growth appre­ci­a­tion period with a 20%+ com­pound­ing growth rate sets expectations for future cash flow performance quite high. Historical growth rates are much lower.
  3. Free cash flow was -$83mm or -11% of the company’s enterprise value last year.
  4. Off-balance sheet debt of $265mm: 79% of net assets and 25% of market value.
  5. Outstanding stock option liability of $44mm or 5% of current market value.

See our report on BJRI for more details.

Over­all, the risk/reward of invest­ing in BJRI’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings and red flags while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

In a business where investors make money by buying stocks with low expectations relative to their future potential, BJRI fits the pro­file of a great stock to short or sell.

Note: Stock pick of the week is updated every Tuesday.

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