There are few places where I feel more claustrophobic and manic depressive than Chuck E. Cheese.  While I have jumped out of airplanes, piloted an open cockpit bi-plane, dived from cliffs into water, and navigated class 5 rapids, I feel a small panic attack when walking into CEC.

It’s not that I’m uncomfortable with kids either.  I have six of my own and love time spent with each one of them.  But there’s something about the flashing lights, the sound of the music, the arcade games, and about a zillion screaming kids that just puts me over the top.  Oh, and did you know they serve beer in many locations?  No, I’m not kidding.  Although it’s disturbing, I may have to grab one next time I take the kids just to take the edge off a bit…

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But enough about my disorders, let’s take a look at the business.  CEC Entertainment, Inc. (CEC) operates 491 restaurants owned by the company and also receives royalties from 47 franchised stores.  For the first quarter in 2008, revenue came in at $248.1 million or 1.2% above the first quarter last year.  Despite flat sales, the company was able to increase earnings per share by 19%, realizing EPS of $1.48.  The first quarter is typically the company’s strongest period accounting for as much as half of the full year’s earnings.

Analysts are expecting 2009 earnings to come in at $2.69 for 2009 which would account for a 14% increase over 2008.  While it is difficult to project what the economy will look like in the next 2 years, professionals are estimating another 4% of earnings growth in 2010.  However, given the state of the US consumer, it may be difficult for the company to meet these expectations.  While my kids (and kids around the country) will certainly still beg their parents to take them to Chuck E. Cheese for another shot at the skee ball machine, parents will likely opt for the neighborhood park more and more as budgets are tightened.

Like many retail stocks that were trading at rock bottom prices as investors panicked this spring, CEC has rallied sharply off the lows.  The stock is currently 146% above the $12.96 low from March.  It’s easy to see why this price was a significantly low value for the profitable company even with the economic fears we faced.  However, the current price of $32 appears a bit optimistic given the employment trends and the broad shifts taking place in consumer sentiment.

The United States has always been a nation of spenders with consumer purchases making up the vast majority of our Gross Domestic Product.  In the past there has been only a loose association between personal income, and the associated personal spending.  Statistics have shown an actual negative savings rate meaning the average consumer is spending more than he is bringing home in earnings.  This has been a dangerous trend, and although it appeared that the US was extremely prosperous, the figures were exaggerated because of our use (or abuse) of debt to finance spending.

The trend is shifting now, and this is most likely a large macro trend that will take years to complete.  We are not anywhere close to becoming a “nation of savers,” but as we head in that direction, the amount of spending will significantly decline in order for households to sock away savings and build up their balance sheets.  In the long-run this will make for a much more healthy and stable economy.  But in the short-term this likely means that we will face much more pain as it takes time to build these financial reserves.

Retail stocks will likely give up a good portion of the gains from the last few months as it becomes clear that this trend is emerging.  It may not be unreasonable to see even healthy companies who receive revenues in the form of discretionary spending trade at single digit  multiples.  Depending on the situation, this could result in 10%, 20% or even 50% losses in what could be considered healthy retail companies.

If CEC were to trade at a multiple of 8 times this year’s expected earnings of $2.69 the stock would decline to roughly $21.52 which would represent a 33% loss.  While there are plenty of growth opportunities to follow in this market, I would not chase too many retail names at this time.  CEC may offer a great short opportunity for traders who understand the risks associated with this investment approach.  We have already seen declines begin in stocks such as Netflix, Inc. (NFLX), Buffalo Wild Wings (BWLD), and Chipotle Mexican Grill, Inc. (CMG) and I anticipate this trend continuing.  CEC offers a chance to hedge other growth stocks or simply profit from a decline over the next several months.

FD: Author does not have a position in CEC
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