This Restaurant Stock is Highly Undervalued

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A lot has been happening in the restaurant sector lately. McDonald's (NYSE: MCD) which has been a darling of defensive investors over the last 2 decades announced a 10% increase in its quarterly cash dividend to 77 cents a share. The announcement of the dividend raise has brought the company’s 2012 anticipated total cash return to stakeholders to more than $5.5 billion via share repurchases and dividends. As a result, the shares are moving up. On the other hand, Darden Restaurants (NYSE: DRI) stock has been gaining ground over the last month and leaped to a new high for the year after the company announced $0.85 per share of earnings (as compared to consensus estimates of $0.83) for the first quarter of its fiscal year. Darden owns about 2,000 restaurants and its best known restaurant brands are Olive Garden, Red Lobster and LongHorn Steakhouse. Darden's Olive Garden business which represents 43% of its total revenues has rebounded well and it looks as if the worst is behind the company.

Let's analyze the key metrics of McDonald's and Darden with respect to each other. The following chart summarizes the forward PE, dividend yield and estimated growth rate of Darden and McDonald's.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>McDonald's</p> </td> <td> <p>Darden Restaurants</p> </td> </tr> <tr> <td> <p>Forward PE</p> </td> <td> <p>15.72</p> </td> <td> <p>13.06</p> </td> </tr> <tr> <td> <p>Dividend Yield</p> </td> <td> <p>3.00%</p> </td> <td> <p>3.70%</p> </td> </tr> <tr> <td> <p>Next 5 Year EPS Growth</p> </td> <td> <p>9.40%</p> </td> <td> <p>11.88%</p> </td> </tr> </tbody> </table>

Source: Yahoo Finance

Darden is trading at a healthy (~17%) discount to McDonald's yet it offers a better dividend yield and growth rate over the next five years. Thus on the basis of these metrics, Darden looks highly undervalued with respect to McDonald's.  Even when compared to casual dining chains like Ruby Tuesday (NYSE: RT), Darden's discounted valuation looks unjustified. The following chart summarizes the forward PE, expected unit growth and estimated growth rate of Ruby Tuesday and Darden.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Ruby Tuesday</p> </td> <td> <p>Darden Restaurants</p> </td> </tr> <tr> <td> <p>Forward PE</p> </td> <td> <p>20.3</p> </td> <td> <p>13.06</p> </td> </tr> <tr> <td> <p>Expected Unit Growth</p> </td> <td> <p>5%+</p> </td> <td> <p>-2.80%</p> </td> </tr> <tr> <td> <p>Next 5 Year EPS Growth</p> </td> <td> <p>9.00%</p> </td> <td> <p>11.88%</p> </td> </tr> </tbody> </table>

Clearly, Darden offers better growth prospects yet its trading at a ~37% discount to Ruby Tuesday. Moreover, the expected unit growth for Darden (5%+) is far greater than Ruby Tuesday (negative unit growth; planning to close 25 to 27 stores) in 2012. Thus, Darden seems to have good upside potential. In addition, the company has good sales momentum and is making clever investments to drive traffic.

Encouraging SSS Trends in August

The improved SSS in the quarter was due to strength at all 3 major brands. Encouragingly, monthly sales at Olive Garden, Red Lobster, and Longhorn accelerated towards the end of the quarter and showed improvement from June into August. Thus, the sales momentum seems good and I anticipate a good start to the second quarter.

Moreover, management indicated that the testing for their new menus are resulting in traffic improvements. Darden plans to execute significant change at both Olive Garden and Red Lobster, starting with a major new menu for Red Lobster that will be supported with advertising and a new advertising campaign for Olive Garden in 2Q, menu changes at Olive Garden starting in 3Q that will include layering in new food platforms over several quarters, and accelerated remodels for Olive Garden in the second half.

Easing inflation and cost cuts funding investments in traffic

Darden is very clearly using a lack of inflation and impressive store-level cost management to fund investments in traffic without margin degradation. The most effective promotions are starting earlier and running longer, media buys (and not just at Longhorn) are increasing, lower pricing on a promo at Red Lobster, and the emails to registered customers continues to show an uptick in couponing.

Darden has diversification across its restaurant portfolio, which provides it with additional unit growth and SSS opportunities, strong unit economics (20% cash on cash returns), and a decent long-term store unit growth opportunity (potential to ultimately open 800-1,000 more units domestically). Going into Q2, the sales momentum looks favorable, and new menu testings and increased marketing will drive a good top-line growth. In addition, Darden's dividend yield is among the best in the industry. I think the company's valuation at a significant discount to its peers doesn't reflect the company's strong growth prospects. I find the risk/reward profile attractive and recommend buying this stock.

AnjaliPaliwal has no positions in the stocks mentioned above. The Motley Fool owns shares of Darden Restaurants and McDonald's. Motley Fool newsletter services recommend McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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