Which Is the Best Franchise Restaurant Stock to Buy Now?

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As a value investor, I often search for investment opportunities in beaten down industries. A stock might be beaten down by micro reasons, which relate to its own business operation. Or it may be due to macro reasons, such as the overall economic environment and industry situations. In the latter case, investors should choose the outstanding star in the beaten down industry.

The industry I want to look at today is franchise/quick restaurants. All the big boys in this industry have had glitches in their operating performance. McDonald’s (NYSE: MCD) third quarter EPS declined to $1.43 from $1.45 from the same period last year.  The company’s executive recently said Asia's slowdown was causing its operating performance to decline. Chipotle Mexican Grill (NYSE: CMG) had increased its third quarter profit on double-digit revenue growth. Its EPS was $2.27, 19.4% higher than its third quarter EPS last year. However, the company missed Wall Street’s estimates of $2.30 EPS for the quarter. YUM! Brands (NYSE: YUM) reported an impressive earnings result for the third quarter. But investors worried that China recent economic slowdown might affect the company’s operating performance as the Chinese market accounted for 45% of its profit. And Starbucks (NASDAQ: SBUX) announced Q4 EPS would be $0.44-$0.45, lower than the analysts’ estimate of $0.48. 

Indeed, the industry’s stocks have not performed very well in the last 3 months.

<img src="/media/images/user_14219/screen-shot-2012-10-20-at-111941-am_large.png" />

Among the four, YUM has been the best performer with nearly a 6.5% gain in 3 months. The worst performer is Chipotle, with the significant fall of 40%. One of the big reasons for its free fall is the fact that it is one of David Einhorn short ideas in Value Investing Congress. Einhorn said that Chipotle received a “nosebleed valuation” with 35x P/E, whereas the average sector multiple is only 22x. In addition, he did a survey of this restaurant's customers and found that they visit Taco Bell as frequently. YUM’s Taco Bell had more locations and cheaper menus than Chipotle.

So among the four, which is the best one to buy right now, when investors take into consideration operating performance and price?

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>CMG</strong></p> </td> <td> <p><strong>MCD</strong></p> </td> <td> <p><strong>YUM</strong></p> </td> <td> <p><strong>SBUX</strong></p> </td> </tr> <tr> <td> <p><strong>Operating margin (%)</strong></p> </td> <td> <p>17.15</p> </td> <td> <p>31.45</p> </td> <td> <p>15.89</p> </td> <td> <p>14.86</p> </td> </tr> <tr> <td> <p><strong>Net margin (%)</strong></p> </td> <td> <p>10.41</p> </td> <td> <p>20</p> </td> <td> <p>11.5</p> </td> <td> <p>10.67</p> </td> </tr> <tr> <td> <p><strong>ROE (%)</strong></p> </td> <td> <p>23.44</p> </td> <td> <p>39</p> </td> <td> <p>67.77</p> </td> <td> <p>26.55</p> </td> </tr> <tr> <td> <p><strong>D/E (%)</strong></p> </td> <td> <p>0</p> </td> <td> <p>84</p> </td> <td> <p>156</p> </td> <td> <p>13</p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>28.25</p> </td> <td> <p>16.67</p> </td> <td> <p>20.61</p> </td> <td> <p>25.38</p> </td> </tr> <tr> <td> <p><strong>PEG</strong></p> </td> <td> <p>1.49</p> </td> <td> <p>1.88</p> </td> <td> <p>1.66</p> </td> <td> <p>1.43</p> </td> </tr> </tbody> </table>

Chipotle has no debt, whereas YUM is the most leverage with D/E of 156%. Because of the highest leverage, YUM enjoys the highest return on equity, of nearly 68%. MCD has the highest operating margin and net margin, citing the fact that its operation is the best compared to the other three. For valuation, MCD seems to be the cheapest, but with the lowest growth, that is why its PEG ratio is the highest.

My Foolish bottom line

Personally, I would prefer MCD for its top-notch operating performance, reasonable leverage level, and low P/E. Even though its PEG could be the highest, it is projected for 5 years and it could be less accurate than P/E ratio. The next candidate would be YUM with the second lowest P/E ratio and the highest return on equity. In addition, it would give investors a good exposure to the Chinese growth consumer market. 

hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Chipotle Mexican Grill, Chipotle Mexican Grill, McDonald's, Starbucks, and Yum! Brands. 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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