Rainforest Cafe Bear's Den
Jim Surowiecki (TMF Cinder)

Designers in the toy business are told, "Never fall in love with a product." Investors, of course, need to take the very same advice when it comes to stocks. Hard as it is not to believe that a company that has rewarded you so handsomely up to this point will continue to shine in the future, successful investing depends on a hard-nosed separation of sentiment from analysis.

Nowhere is this truer than in the case of so-called story stocks. Companies that come with an easily explainable idea attached -- "See, it's a restaurant, but it's like you're eating in the rain forest!" -- can win the hearts of investors for a long time on the strength of the idea alone. The tough part comes when the strength of the idea and the strength of the company's future prospects no longer match. And that is where Rainforest Cafe currently finds itself.

Now, there's no question that Rainforest Cafe has been ably managed. The company has expanded wisely since the first restaurant opened in the Mall of America in 1994, refusing to overreach itself in pursuit of short-term gains. Rainforest Cafe cut an excellent deal with Disney <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DIS)") else Response.Write("(NYSE: DIS)") end if %> that put a Cafe into Disney World, and the returns from this location have been stunning, with the company taking in $33 million in its first year and set to do better than that in its second. Save for a slight dip in the first quarter of FY97, Rainforest cafe has kept net profit margins around 12%, and its operating margins, while more erratic, have been solid as well. Perhaps most importantly, the company has no long-term debt and has cash on hand totaling more than $120 million.

Looking at those numbers, the stock market's reaction last month, when the company pre-announced that it would miss fourth-quarter earnings estimates by a couple of pennies at most, looks like an over-reaction. The market chopped off 40% of the company's market cap in one blow. With a trailing P/E of 28 (at $13 per share) at a time when earnings are scheduled to grow 40%-50% next year, might Rainforest Cafe not be undervalued?

The simplest answer is: No. The market obviously punished Rainforest Cafe because, after more than a year of estimate-beating performance, the company failed to live up to expectations -- and for a growth stock that's the kiss of death. But there were substantive reasons for concern as well, most notably the fact that at the three restaurants that have been open longer than 18 months, same-store sales dropped 11%. For the Woodfield Mall location, this was the third straight quarterly drop, while the Gurnee Mills location had seen business slide 15% in the previous quarter. In other words, once the novelty of these restaurants wears off, consumers have started to turn elsewhere with their eating dollars. Now, as all fans of Rainforest Cafe are anxious to point out, this is typical of all restaurants. Once the honeymoon period ends and you don't have long lines of people anxious to see the new place in town, business slows.

The problem is that Rainforest Cafe has never marketed itself as -- nor has it been treated by investors as -- just one of many different restaurants. The whole premise behind its previously astronomical valuation was that it was going to be able to sustain massive growth rates into the foreseeable future. But if business at the restaurants already built is declining (not even growing slowly), then the only way to maintain a rapid growth rate is to build more restaurants. That, certainly, is what Rainforest Cafe plans to do, tripling its international locations and building aggressively at home. But that, in turn, raises the specter of the overreaching that Rainforest Cafe has so far avoided.

The deeper problem here, of course, is with the whole concept of themed eateries. Clearly, the sit-down restaurant business is about as hard a one to succeed in as you can imagine. Competitors are plentiful, and there's always a new one around the block. In fact, if there's been a sit-down restaurant company that has enjoyed growth rates in profits of more than 20% annually over a five-year period, I'd love to see it. Instead, all the evidence suggests that the phenomenon of slowing same-store sales is a universal one, and that counteracting this erosion of the core business by building new restaurants is only a temporary solution, since it cannot solve the central problem, which is that restaurants cannot expand existing markets via technological innovation. The only way to do so, then, is via branding, which is obviously what Rainforest Cafe has tried to do. But the evidence that an overdone, hype-ridden experience is what most people want regularly when they go out to eat is hardly strong. Certainly, the drop in same-store sales suggests otherwise.

In order to buy Rainforest cafe at this price, you have to believe that five years from now people will be happily eating at Rainforest Cafes around the country. Looking at the record of other themed eateries -- i.e., Cheesecake Factory <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CAKE)") else Response.Write("(Nasdaq: CAKE)") end if %> and Planet Hollywood -- I have a hard time seeing it. The appeal of these restaurants is their novelty. But novelty wears off, and it wears off quickly. If Rainforest Cafe really is going to grow earnings at 40% for the next five years, then back up the truck and buy as many shares as you can. But what we saw in this last quarter may very well have been the first sign of an inevitable slowdown, and in that case staying away is the only reasonable choice.

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