Is This Restaurant Still A Golden Long-Term Bet?

By Bill Edson - September 19, 2012 | Tickers: BKW, DPZ, MCD, YUM | 0 Comments

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Despite their price appreciation in 2012, service restaurants will soon be influenced by a confluence of macroeconomic factors which will curb their sales growth and profitability. Investors should avoid any long bets on McDonald's (NYSE: MCD), Yum! Brands (NYSE: YUM), Burger King (NYSE: BKW), Domino's (NYSE: DPZ), and Dunkin' Brands (DNKN), and should look elsewhere for cheaper stocks with better prospects.

Obesity is Their Business

Obesity is commonly held as disease and an American epidemic. Though there remain areas of controversy surrounding many of the perceived negative consequences of obesity, the medical consensus and public perception is that obesity is an “undeniable risk.” Obesity is treated as a scourge or disorder whose reduction would be in the public interest. With this mindset, there are many activist groups who wish to tax or ban particularly unhealthy foods.

New laws are being proposed, approved, and enforced which regulate what quick service restaurants can sell. For example, New York City's Board of Health passed a rule limiting sodas and other sugary drinks to 16 ounces at restaurants and several other kinds of establishments. This regulation is a challenge to the domestic locations of quick service restaurants.

World-Wide Demand Destruction: Nowhere for Global Corporations to Hide

Demand for quick service restaurants is likely to be curbed by the predicted global economic slowdown. Currently, some regions are driving growth but could collapse later. McDonald’s locations in China and Australia that have been open for over a year saw a 3.7% rise in sales in August. Sales are also increasing for McDonald’s in Africa and the Middle East, as the regions saw more than a 5% increase during the same month.

These regions are shaky at best. The anti-American riots the Middle East spurred by a blasphemous video which originated in the United States will likely hinder sales in the region. Any deflation in the Chinese real estate bubble will negatively impact Chinese restaurants as well as locations in countries like Australia which export construction commodities to China. Problems in China would fly in the face of McDonald’s plans to capitalize on recent success in Pacific Asia by opening up 250 more stores in China.

And the increase in sales for McDonald’s in those precarious regions was the good news. The bad news is that McDonald’s sales fell in the US, Japan, Germany, and Southern Europe.  In the U.S., McDonald's sales have slipped a total of 9.1% this year. Sales in Japan in the entire fast food market fell 2.5% in August.  McDonald’s performance in the UK, France, and Russia was good despite the discouraging prospect of the European economy, but McDonald’s overall performance in Europe is hurt by poor sales in Germany and Southern Europe.

Quick service restaurants may focus on lower prices (and lower profit margins) in 2013. Following the success of rival companies like YUM! Brand’s KFC focusing on value menus, McDonald’s game plan across the globe to bump up sales is to promote the economical choices offered under the golden arches. McDonald’s feels that value menu items are the way to capture more of the market as more economies around the world like that of the U.S. and Europe see hard times.

This change in strategy would be similar to what has happened in the European coffee market. The economic stressors of unemployment, higher taxes, and reductions in pay have also pressured Europeans to choose cheaper, lower-quality coffees. Gourmet Arabica coffee was much preferred in Europe up until Europe’s economic crisis. Now, Europeans are switching to Robusta, a more bitter but less costly alternative to Arabica beans. This trend, which has been the norm for over two years, has turned the global coffee market on its head as Europe has the greatest coffee consumption rate per person. Whereas in the past Arabica was the more coveted coffee, over the past year Arabica prices fell by 30% while those of Robusta rose by 18%. The price difference between these two types of coffee is the lowest since July 2009.

Increasing Commodity Prices

Finally, quick service food and drink is likely to see lower margins as food costs increase. This drought in the Midwest has dramatically raised the price of corn futures and other soft commodities. Damage to the crop from the hottest July since 1936 caused corn futures contracts to increase as much as 63%. This will increase the cost of goods sold for restaurants and detract from gross profit.

Valuation

Looking across valuation metrics none of these stocks are attractively priced:

The only intriguing multiple among these stocks is the historical price-to-earnings ratio of Burger King Worldwide. Unfortunately, this low valuation based on the trailing twelve months is not expected to be maintained going forward since its future price-to-earnings ratio is anticipated to be much higher. Moreover, a price-to-earnings ratio which is higher than a company’s price to sales ratio is questionable. The remaining historical price-to-earnings ratios are rich when compared to the average 14 price-to-earnings ratio of the S&P 500. The price-to-book ratios of these stocks are also rich. Among the price-to-sales ratios, only Domino’s Pizza looks attractive, but investors should steer clear of the stock based on its negative book value of owner’s equity.

Clearly, these stocks are not appropriately priced given the challenges they are facing based on agricultural shocks, weakening global demand, and domestic regulatory threats. Given a choice between these stocks and buying the S&P 500 index as a whole, investors should just buy the index.

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