Published January 28th, 2017 by Bob Ciura
The restaurant industry was arguably the most eager to wave goodbye to 2016. Last year was a terrible one for casual dining.
The restaurant industry closed the year on a particularly weak note: December sales fell 4.3%, the industry’s worst performance in three years.
The good news is that declining share prices across the industry have presented investors with some cheap stocks. It may be time to go bargain hunting, as many stocks sport price-to-earnings ratios in the teens, with 3%-5% dividend yields.
However, not all restaurant stocks are a bargain—investors would be wise to stay away from Chipotle (CMG).
Chipotle’s sales and earnings declined last year at a double-digit pace, mostly due to the E. coli scare that left dozens of customers sick.
Despite this, Chipotle stock is still not cheap, because the company is barely profitable. And, it pays no dividend.
That’s why, for income investors, the following five restaurant stocks are much better buys than Chipotle.
Yum! Brands (YUM)
Price-to-Earnings Ratio: 19
Dividend Yield: 2.7%
First up is Yum! Brands, which competes directly with Chipotle in the Mexican fare category. Whereas Chipotle has no dividend, Yum is a Dividend Achiever.
Dividend Achievers are a group of 272 stocks with 10 or more years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
Yum is a global fast food giant. It owns and operates three core brands:
- KFC (48% of profits)
- Taco Bell (32% of profits)
- Pizza Hut (20% of profits)
These are all strong brands, and compete near the top of their respective categories. In 2015, Yum’s sales increased 5%. It experienced growth across its brands.
Total sales grew 8% at Taco Bell, 7% at KFC, and 2% at Pizza Hut.
Taco Bell is a direct competitor of Chipotle’s. There is arguably no chain benefiting more from Chipotle’s loss of customer traffic than Taco Bell.
Meanwhile, Yum’s adjusted earnings-per-share increased 4% in 2015. And, the results are equally impressive to start 2016.
Yum’s operating profit rose 15% over the first three quarters of 2016. Future earnings-per-share growth will be comprised of four main factors:
- Accelerate franchise structure
- General & Administrative cost reductions
- Lower capital expenditures
- Maintaining a low cost of capital
Yum has made significant progress in each of these initiatives.
Source: Analyst Meeting presentation, page 42
By 2019, Yum expects to generate earnings-per-share of $3.75, which would represent 18% growth from last year.
This should be enough growth to continue raising dividends, and also buying back stock. The company expects to return $6.5-$7.0 billion in dividends and repurchases from 2017-2019.
Yum underwent a major transformation in 2016. It spun off its China operations into a separate, independent company which now trades as Yum China Holdings (YUMC).
The rationale for the spin-off was sound: Yum wanted to separate its China business so that each company could focus on its unique growth strategies.
The China segment encountered a number of operational challenges over the past few years, such as food safety incidents. This caused a high degree of volatility in sales and profit performance in China.
Without the China business, Yum will be more stable, with less volatility. This will help keep costs of capital low, and has resulted in a higher valuation multiple than many competitors in Yum’s peer group.
Going forward, Yum’s plan is to maximize profitability in its U.S. segment, and grow its international footprint in new emerging markets like India.
Franchising is at the heart of Yum’s plans for its U.S. business. Franchising is a very attractive option for large fast-food operators, because it places most of the renovation, maintenance, and tax expenses onto the franchisee.
Source: Analyst Meeting presentation, page 44
By 2018, Yum expects to be 98% franchised.
The company is investing significantly in new restaurants overseas. Last quarter alone, Yum opened 475 new restaurants worldwide, 78% of which are in the emerging markets.
Yum is in solid financial condition. The company’s debt is spread out fairly evenly over the next 30 years.
Source: Investor Relations
Yum generates high restaurant-level profit margins, thanks to a streamlined cost structure.
Its hefty margins and modest debt levels allow the company to return cash to shareholders each year.
For example, Yum raised its dividend by 11% in 2016, and the company projects $1 billion of share repurchases for the year.
Price-to-Earnings Ratio: 12
Dividend Yield: 5.6%
Next up is DineEquity, which operates more than 3,700 Applebee’s and IHOP restaurants in 18 countries. These two concepts are leaders in their respective categories.
Source: 2016 Investor Overview, page 4
DineEquity’s current financial performance is mixed. The IHOP brand continues to perform well. Comparable-restaurant sales, which measures sales at locations open at least one year, increased 0.5% over the first nine months of 2016.
However, performance deteriorated for the Applebee’s brand. Its comparable sales declined 4.4% in the same period.
As a result, the company’s main objectives are to continue the positive momentum at IHOP, while drastically improving the results at Applebee’s.
DineEquity is executing a five-point growth plan.
Source: 2016 Investor Overview, page 5
The first step toward a return to sales growth in the U.S. is stabilizing its Applebee’s brand. The company launched a multi-faceted approach to restoring positive customer traffic. The measures employed include transitioning from frozen, microwaved food to hand-cut, grilled meals.
Source: 2016 Stockholder’s Meeting, page 13
Boosting quality standards could reinvigorate the brand in 2017.
Outside of firming its domestic operations, another major component of DineEquity’s future growth strategy is increasing its international exposure.
Just a tiny portion of its Applebee’s and IHOP locations are located outside the U.S., but this is about to change.
The company recently announced four new multi-unit development agreements in the Middle East, Asia Pacific and Latin America.
The IHOP brand expansion continues into the Asia-Pacific region by opening 10 locations in Thailand by 2021. It will also build 20 locations in India by 2025.
Applebee’s will extend its growth in the Middle East by opening six new restaurants in Bahrain and Oman by 2023. In addition, the concept will grow in Latin America, with an agreement to build five new restaurants in Panama.
DineEquity has aggressively expanded its international restaurant count in recent years. Since 2014, it has opened 80 new international restaurants.
Furthermore, in that same time the company nearly tripled its pipeline of future international openings, to over 200 restaurant commitments.
In all, DineEquity plans to double its international locations over the next five years.
Despite its weak sales, DineEquity still generates lots of free cash flow. The company expects 2016 free cash flow to total $113-$121 million.
At the midpoint of its guidance, the stock trades for approximately 10 times free cash flow.
This allows the company to continue sending cash back to shareholders. DineEquity is a very shareholder-friendly company.
It utilizes the vast majority of its free cash flow to reward shareholders with cash returns. For example, DineEquity returned approximately 96% of free cash flow in dividends and share repurchases in 2015.
The stock has a very high dividend yield of 5.6%, plus it increases its dividend regularly. The company raised its dividend by 5.4% in 2016.
Brinker International (EAT)
Price-to-Earnings Ratio: 13
Dividend Yield: 3%
Brinker International was founded in 1975. Today, it owns, operates, and franchises 1,652 Chili’s and Maggiano’s restaurants.
Source: 2016 Investor Day presentation, page 7
Chili’s makes up the vast majority of the company’s restaurant count, and for good reason. The concept is highly valuable, and enjoys strong customer satisfaction rates.
Source: 2016 Investor Day presentation, page 20
However, Chili’s has struggled throughout the current fiscal year. Last quarter, Brinker’s total revenue declined 2.2% year over year.
Chili’s was the major underperformer—comparable-restaurant sales declined 3.3%. The Maggiano’s brand performed better, but its comparable sales still declined 0.8%.
For the full fiscal year, management expects company-wide comparable sales to decline 1.5%-2.0%.
One initiative the company is deploying to reignite domestic growth is to focus on expanding the Maggiano’s brand in the U.S.
Source: 2016 Investor Day presentation, page 29
Maggiano’s success is thanks to the resilience of higher-end restaurant. Premium restaurant concepts are still seeing growth, which has insulated Maggiano’s from the declines on the lower end of the pricing spectrum.
Like DineEquity, Brinker is aggressively expanding its overseas restaurant count for growth. It is targeting China and Vietnam, among other countries.
Source: 2016 Investor Day presentation, page 23
International growth should help the company return to sales growth. Brinker’s international business is performing well, while the U.S. struggles. International comparable sales increased 2.6% for the core Chili’s banner last quarter.
Another strategy for the company is acquisitions. In 2015, the company acquired Pepper Dining, a Chili’s franchisee, for $106.5 million. Pepper owned 103 franchised Chili’s restaurants.
In the company’s view, these restaurants were not maximizing their potential. So, the company bought them back, and believes they can be meaningful growth drivers.
Brinker expects these 103 locations will be accretive to annual earnings-per-share in the high-single digit range moving forward.
And, Brinker enjoys a highly profitable business model. The company has effectively managed costs to keep margins intact. For example, general and administrative costs were cut by 5% through the first three quarters of the fiscal year.
Also, Brinker is going through a significant corporate restructuring. Its reorganization is expected to produce pre-tax savings of over $5 million in fiscal 2017 and approximately $12 million on an annualized basis.
Moreover, Brinker cut capital expenditures by $60 million in the past two fiscal quarters combined.
Even though sales are expected to decline for the full year, the company still expects earnings-per-share of $3.05-$3.15 for fiscal 2017. Free cash flow is estimated to reach $205-$215 million.
The company generates more than enough profit to reinvest in the business, and reward shareholders with capital returns.
Brinker routinely increases its dividend each year. In 2016, the company raised its dividend by 6%.
Darden Restaurants (DRI)
Price-to-Earnings Ratio: 19
Dividend Yield: 3%
Darden owns and operates more than 1,500 restaurants, with approximately 150,000 employees. It operates four major segments:
- Olive Garden (56% of sales)
- LongHorn Steakhouse (22% of sales)
- Fine Dining (7% of sales)
- Other Businesses (15% of sales)
The Fine Dining segment includes The Capital Grille and Eddie V’s restaurants in the U.S.
The Other Business segment includes Yard House, Seasons 52, and Bahama Breeze. It also includes results from Darden’s franchises and consumer-packaged goods.
You may have heard about a difficult operating environment for restaurants. Some analysts have called it the “restaurant recession”.
But Darden is showing no effects of the so-called restaurant recession. In fact, it is thriving, with growth across all of its major segments over the past year.
Source: Q2 Earnings Presentation, page 10
Company-wide operating profit rose 29% in the first two quarters of fiscal 2017.
The Olive Garden brand led Darden’s resurgence in 2017. Comparable-restaurant sales rose 2.3% over the first six months of the fiscal year.
Source: Q2 Earnings Presentation, page 4
Olive Garden in particular has enjoyed high comparable-sales growth rates over the past five quarters. The Olive Garden banner has helped the company buck the generally weak trend for restaurants overall.
As has Darden’s smaller chains, most of which posted strong growth in the most recent quarter.
Source: Q2 Earnings Presentation, page 13
For the full fiscal year, Darden expects 1.7%-2.7% sales growth. Comparable restaurant sales are expected to increase 1%-2%.
Sales growth will be due in part to new restaurant openings; Darden expects to open 24-28 new restaurants this year.
In addition, pricing increases are helping. Darden realized price increases of 1.6% and 1.7% at the Olive Garden and LongHorn Steakhouse, respectively, over the first half of the fiscal year.
Earnings-per-share growth is also being boosted by cost cuts. Darden expects to realize $30 million in cost savings this year.
Darden is a company in transition. The company sold off one of its major brands, Red Lobster, for $2.1 billion in 2014.
But the new Darden is nimbler and has returned to strong growth rates. Plus, it can use the proceeds of the sale to repurchase stock and pay down debt.
Cracker Barrel Old Country Store (CBRL)
Price-to-Earnings Ratio: 20
Dividend Yield: 2.9%
Last but not least is Cracker Barrel, a small company that holds a lot of potential.
It was established in 1969. Today, it operates 640 company-owned Cracker Barrel locations and two company-owned Holler & Dash Biscuit House restaurants in 43 U.S. states.
Cracker Barrel is much smaller than Yum! Brands and Darden—it has a market capitalization of just $3.8 billion.
But it has carved out a niche for itself in the casual dining industry, and has attracted a loyal customer base. Cracker Barrel serves home-style country food, with a regional focus.
In addition, Cracker Barrel specializes in seasonal menu offerings. The company routinely serves limited-time entrees, which it believes retain customers and drive incremental growth.
And, Cracker Barrel prides itself on being a popular destination for family gatherings and holidays.
Judging by the results, it’s hard to argue with the strategy.
Comparable-restaurant sales increased 2.2% in 2016. Cracker Barrel has consistently outperformed the casual dining industry in terms of sales growth, for an extended period.
Source: Annual Shareholder Meeting, page 20
In addition, adjusted earnings-per-share increased 11% for the year. Cost cuts have helped accelerate the company’s earnings growth in recent years.
Source: Annual Shareholder Meeting, page 21
One factor promoting margin expansion is lower raw materials costs. Cracker Barrel expects 2%-3% food cost deflation in 2017.
With its strong earnings growth, the company is free to return boat loads of cash to investors, primarily through dividends.
Source: Annual Shareholder Meeting, page 23
In 2016, the company not only raised its regular dividend by 4.5%, it also paid a special dividend of $3.25 per share.
Total declared dividends were $7.70 per share for 2016, good for a total dividend yield of nearly 5%.
Restaurant sales are expected to increase 1%-2% in 2017, thanks largely to the expected opening of seven or eight new Cracker Barrel restaurants.
With continued margin improvements, the company will likely generate enough earnings growth to raise the dividend once again.