Published on June 20th, 2018 by Aristofanis Papadatos
Fast food stocks are popular in the investing community, as they have an easy-to-understand business model and most investors are well familiar with their restaurants. In this article, we will focus on the 6 largest fast food restaurant chains that are headquartered in the U.S. In order of market cap, these stocks are: McDonald’s (MCD), Yum Brands (YUM), Chipotle Mexican Grill (CMG), Domino’s Pizza (DPZ), Wendy’s (WEN) and Jack in the Box (JACK).
More information can be found in the Sure Analysis Research Database, which ranks stocks based upon the combination of their dividend yield, earnings-per-share growth potential and valuation changes to compute total returns.
In general, fast-food chains have greatly rewarded their shareholders over the long term thanks to a series of growth drivers; opening of new stores, same-store sales growth, margin expansion and share repurchases. However, competition has greatly heated in this business in recent years and hence there have been huge differences in the returns of the above stocks. Therefore, investors should be particularly careful in the choices they make in this group of stocks, particularly given that some of these stocks have already priced a great portion of their future growth.
The managements of all the above stocks are certainly shareholder-friendly. Nevertheless, only McDonald’s currently offers a dividend yield above 2.0%. Five of the stocks on this list pay dividends to shareholders, and all five can be found on our list of 674 dividend-paying consumer cyclical stocks.
The main reason behind the lackluster dividend yields of this group of stocks is the fact that they have shifted their focus on executing aggressive share repurchases in recent years. As a result, most of these stocks have passed under the radar of income-oriented investors in recent years. However, investors should not underestimate the benefit from a steep decrease in the share count, which results in rising earnings per share and stock prices.
In this article, we will compare the expected 5-year returns of the six largest fast food stocks by summing their earnings-per-share growth, their dividends and their expected price-to-earnings expansion or contraction.
Fast Food Stock #6: Chipotle Mexican Grill
Chipotle Mexican Grill operates fast-casual, Mexican food restaurants throughout the U.S. It currently has more than 2,400 restaurants.
The company has suffered from a series of health safety incidents in the last three years, which caused the stock to plunge 67%, from its all-time high of $758 in 2015 to $250 early this year. Those incidents led the company to replace its CEO with the CEO of Taco Bell. This change in the CEO position has so far proved a game changer for the company.
In Q1, Chipotle grew its same-store sales by 2.2% and its total sales by 7.4%. While the same-store sales growth resulted from a 4.9% hike in the menu prices and not from an improvement in traffic, the company exceeded the analysts’ estimates by 36% and thus it was rewarded with a 25% rally of its stock upon the announcement of its results.
Moreover, while its sales have recovered to their pre-crisis all-time high level, its operating margin is still less than half of its pre-crisis level, as it has plunged from 19.0% in 2015 to 6.7%. Therefore, there is still ample room for improvement.
The management expects to increase the store count by 6% this year and the same-store sales at a low single-digit rate. In addition, it is trying to reward its shareholders via share repurchases but the stock is trading at a sky-high price-to-earnings ratio of 53.7, which renders the share buybacks inefficient. Overall, in the next five years, it is reasonable to assume 5% annual growth in the store count, 2% same-store sales growth, a 5% annual margin expansion and a 1% annual buyback rate for a total 13.0% average annual earnings-per-share growth.
On the other hand, the stock is now trading at an excessive price-to-earnings ratio of 53.7. As it is reasonable to expect this ratio to come down to 26.0, which will correspond to a PEG ratio of 2.0, the stock is likely to incur a 13.5% annualized contraction of its valuation multiple. Consequently, as this contraction will fully offset the earnings-per-share growth rate, the stock is likely to offer a -0.5% average annual return over the next five years. In other words, the market is so enthusiastic about the recovery of the stock that it has already priced its expected 5-year growth into the stock.
Fast Food Stock #5: Wendy’s
Wendy’s is the third largest hamburger quick-service restaurant chain in the world, with more than 6,600 restaurants in 28 countries and the U.S.
The company boasts of having grown its same-stores sales for 21 consecutive quarters and having posted rising or flat traffic share for 10 consecutive quarters.
Source: Investor Presentation
Wendy’s is also growing its international same-store sales at a double-digit rate but these sales comprise only 4% of its total sales and hence the overall performance of the company is essentially determined by its North American segment.
Wendy’s is opening new stores at an approximate 2% annual rate. In addition, it is reimaging its stores in order to enhance the dining experience it offers and thus attract new customers, with a higher dining standard. The restaurant chain has remodeled 44% of its stores so far and expects to reimage about 10% of its stores per year in the next two years. Moreover, the company is expanding its delivery service to more stores. More than 25% of its stores currently offer delivery service.
All the above initiatives are expected to be growth drivers in the upcoming years. In addition, share repurchases are likely to be a significant component of the total return. Wendy’s has repurchased its shares aggressively in the last four years and has thus reduced its share count by 39% during this period. Given the aggressive buybacks and the above growth initiatives, it is reasonable to expect the stock to grow its earnings per share at a 10.0% average annual rate over the next five years.
On the other hand, the excessive buybacks have taken their toll on the balance sheet, which has become remarkably leveraged. The debt-to-assets ratio has climbed from 58.5% in 2014 to 88.7% now and the interest expense has increased so much that it now “eats” half of the operating income. As a result, it significantly hurts the bottom line while it also increases the exposure of the company to any unforeseen downturn. Moreover, as interest rates are on the rise, the debt load will become even more burdensome for the company.
Wendy’s is currently trading at a markedly high price-to-earnings ratio of 32.1. Given its debt load, it is only reasonable to expect this ratio to fall in the next five years to approximately 20.0, which will correspond to a PEG ratio of 2.0. If this occurs, the stock will incur a 9.0% annualized contraction of its price-to-earnings ratio. Overall, the stock is likely to offer a 2.9% average annual return in the next five years thanks to 10.0% earnings-per-share growth and its 1.9% dividend, which will be partly offset by a 9.0% annualized contraction of its valuation.
Fast Food Stock #4: Jack in the Box
Jack in the Box is a fast-food chain that operates and franchises one of the largest hamburger chains in the U.S., with more than 2,200 restaurants in 21 states and Guam.
The company has exhibited poor business performance in the last two years and is thus taking a series of measures in order to become more efficient and less capital intensive. First of all, it sold its Qdoba Restaurant in March for $305 M. It has also reduced its general and administrative costs from 4.3% of its total sales to 2.5% and aims to reduce them further, below 2% of its total sales.
Source: Investor Presentation
Moreover, it is in the process of refranchising its stores and expects the percent of franchised stores to increase from 93% to 95% by the end of the year.
Jack in the Box has repurchased its shares aggressively in the last four years and has thus reduced its share count by 31% in this period. Thanks to the above mentioned initiatives toward a less capital-intensive business model, the management has expressed its intention to increase the leverage and continue to repurchase shares at a high rate in the upcoming years. It is remarkable that the management recently stated that it would spend $200 M on buybacks through the end of the year. This amount is sufficient to reduce the share count by 7.4% in just six months.
Thanks to the above initiatives and the share repurchases, Jack in the Box can reasonably be expected to grow its earnings per share by about 7.0% per year, which is in line with its 10-year average growth rate. On the other hand, the stock is trading at a price-to-earnings ratio of 22.5, which is higher than its 10-year average of 18.1. As the stock is likely to revert to its average valuation level within the next five years, it will incur a 4.3% annualized contraction of its price-to-earnings ratio. Therefore, given also its 1.9% dividend, the stock is likely to offer a 4.6% average annual return over the next five years.
It is worth noting that the company has seriously leveraged its balance sheet in order to execute its excessive buybacks in recent years. Its debt-to-assets ratio has jumped from 64% in 2013 to 149% now while its book value per share has plunged from $11.1 in 2013 to -$13.2 now. On the one hand, the debt level is manageable and hence the company will not have any problem servicing its debt. On the other hand, the management seems to have focused much more on financial engineering than on improving the business performance amid heating competition. This does not bode well for meaningful improvement in its business performance in the near future.
Fast Food Stock #3: Domino’s Pizza
Domino’s Pizza is the largest pizza company in the world based on global retail sales. It has almost 15,000 stores in 85 countries and currently generates 48% of its sales in the U.S. while 97% of its stores worldwide are owned by independent franchisees.
While its competitor, Pizza Hut, struggles to grow its same-store sales, Domino’s has an impressive growth record. It has grown its international same-stores sales for 21 consecutive years and its domestic same-store sales in 17 out of the last 21 years.
Source: Investor Presentation
Even better, it has ample room to continue to grow for many years. More precisely, the company has 8,402 stores in its top 15 markets and its management sees potential for 5,400 additional stores in these markets. Given this growth potential in just 15 out of the 85 countries in which the company is present, it is evident that the growth prospects of Domino’s are still exciting.
Its management expects to grow the annual revenues by 8%-12% per year in the next five years. Assuming a 1% annual margin expansion and a 2% annual buyback rate, we can reasonably expect the company to grow its EPS by about 13% per year over the next five years. On the other hand, the stock is now trading at a price-to-earnings ratio of 34.0, which is much higher than its 10-year average of 21.1. If the stock reverts to its average valuation level within the next five years, it will incur a 9.1% annualized contraction of its price-to-earnings ratio. Therefore, given the above and its 0.8% dividend, the stock is likely to offer a 4.7% average annual return over the next five years.
It is worth noting that Domino’s has greatly increased its leverage in recent years in order to boost its share repurchases. However, thanks to its reliable free cash flows, the company will not have any problem servicing its debt. On the other hand, there is a much more significant risk factor, namely the retirement of its CEO at the end of the month. While the new CEO may be equally competent, the change of the CEO is always a risk factor, particularly for a company that expands at a fast pace. Therefore, investors should closely monitor the performance of the company in the upcoming quarters.
Fast Food Stock #2: McDonald’s
McDonald’s is the largest publicly traded restaurant company in the world, with more than 37,000 stores in more than 100 countries. It is the only dividend aristocrat in this article. It has raised its dividend for 41 consecutive years, which makes McDonald’s one of 53 Dividend Aristocrats.
McDonald’s exhibited poor business performance under its previous CEO but its current CEO has managed to lead the company back to its growth trajectory thanks to a series of initiatives, such as the all-day breakfast and the expansion of the menu with healthier options. In addition, McDonald’s has reimaged its restaurants in order to attract new customers, who have a higher standard of dining experience.
Moreover, the company has been refranchising its stores in order to become more efficient and less capital-intensive. This strategic move has enabled the company to markedly increase its leverage without any problem and thus reward its shareholders via aggressive share repurchases. In the last four years, McDonald’s has reduced its share count by 17%. The refranchising process has resulted in lower revenues but higher operating margin, which has more than offset the decrease in the revenues.
McDonald’s is likely to continue to grow its earnings per share in the upcoming years. Same-store sales growth and meaningful share repurchases are expected to be the main growth drivers. The company is likely to grow its earnings per share from $7.70 this year to about $10.10 in 2023. This implies a 5.6% annual earnings-per-share growth rate. On the other hand, the stock is trading at a price-to-earnings ratio of 21.6, which is higher than its 10-year average of 20.0. If the stock reverts to its average valuation level, it will incur a 1.5% annualized contraction of its valuation. Given the above and its 2.4% dividend, McDonald’s is likely to offer a 6.5% average annual return over the next five years.
Fast Food Stock #1: Yum Brands
Yum Brands owns the KFC, Pizza Hut and Taco Bell fast food chains. It has 45,323 restaurants, 60% of which are located abroad. KFC generates about half of the total revenue and operating income of the company.
Yum Brands has pursued a strategy similar to McDonald’s in the last two years. It spun off its Chinese business two years ago and has refranchised its stores at an aggressive pace since then. As a result, the percent of franchised restaurants has increased from 77% before the spin-off to 97% now. This move has rendered the company much leaner and has thus enabled it to markedly increase its leverage to reward its shareholders. The company’s aggressive share repurchases have reduced its share count by 24% in just two years.
The announcement of the above business plan led Moody’s to downgrade the bonds of Yum Brands to junk three years ago. However, the net debt of $9.8 B is just 7 times the annual earnings. Therefore, the company will not have any problem servicing its debt. Even if an unforeseen headwind shows up, the company can suspend its buybacks and reduce its debt level at a fast pace. Therefore, investors should not be concerned over the leveraged balance sheet.
Before the spin-off of its Chinese segment, which accelerated its earnings-per-share growth, Yum Brands grew its earnings per share at a 7.6% average annual rate. Given the aggressive buybacks and the absence of any signs of fatigue, the company can be reasonably expected to grow its earnings per share at an 8.0% average annual rate over the next five years.
The stock is also offering a 1.7% dividend yield. On the other hand, it is trading at a price-to-earnings ratio of 24.2, which is higher than its 10-year average of 21.8. If the stock reverts to its average valuation level, it will incur a 2.1% annualized contraction of its valuation. Therefore, Yum Brands is likely to offer a 7.6% average annual return over the next five years.
Yum Brands and McDonald’s are the two fast food stocks with the highest expected 5-year returns. These two stocks have many things in common. They have implemented very similar strategic plans in recent years and, thanks to these strategies, they have become much leaner and more efficient. These strategies have also enabled them to increase their leverage without any problem and thus reward their shareholders via aggressive share repurchases. These two stocks have rallied approximately 40% in the last two years and have reached rich valuation levels.
Nevertheless, as the two companies have further room to grow, they are likely to continue to reward their shareholders in the upcoming years. Income-oriented investors may be better served by choosing McDonald’s thanks to its superior dividend yield and its exceptional dividend growth record.
Domino’s and Chipotle are growing their earnings per share at the fastest pace in this group of stocks but they are currently trading at nosebleed valuation levels. Thus the two stocks have already discounted a great part of their future growth and hence any unforeseen headwind will cause them to plunge. If investors want to initiate exposure on one of these two high-growth stocks, they should probably prefer Domino’s thanks to its exceptional growth record and its enviable consistency. Chipotle has a much more volatile record and is currently in turnaround mode.
Thanks to its strong momentum, it is likely to maintain its uptrend in the short term. However, due to its extreme valuation, it is the stock with the lowest 5-year expected return in this group. On the other hand, Chipotle is currently reaping the benefit from its competent new CEO whereas Domino’s is facing increased uncertainty due to the imminent retirement of its exceptional CEO.
Finally, Jack in the Box and Wendy’s have the most volatile performance records, remarkably rich valuation levels and they have dramatically increased their leverage lately, particularly Wendy’s. Consequently, they are likely to offer poor returns with an increased level of risk in the upcoming years.