Restaurant Stocks - Not on the Value Menu

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

Several of the more fashionable restaurant stocks have been phenomenal investments during the recent cyclical bull market.  Investors in these stocks have been aided by the powerful trifecta of positive same store sales, increasing operating margins, and strong new store growth.  However, at least two of these tailwinds have a finite life and this does not take into account any operational missteps regarding same-store sales growth.  Below are four risks that make owning restaurant stocks at today’s lofty valuation a dangerous proposition.

Risk 1:  Operating Margin Expansion is in the Final Innings

The massive expansion in operating margins is evidenced in the chart below. 

<img src="/media/images/user_36/operating-margin_large.png" />

These don’t have to collapse for consensus bullish estimates to fall short.  Panera Bread (NASDAQ: PNRA) has moved operating margins from 8.7% to 13.3% in just five years.  This has helped fuel five consecutive years of at least 20% earnings-per-share growth.  The outlook according to their 2013 guidance is FLAT TO UP 50 BASIS POINTS.  Simply put, operating margin expansion will slow considerably in upcoming years. 

Chipotle Mexican Grill (NYSE: CMG) leads most restaurant peers with 16% margins whereas many others, both growing and mature, reside in the 8-16% range.  While Chipotle’s margins improved during 2012, they contracted in the fourth quarter due to rising food costs.  It remains difficult to see how the company will be able to generate the operating leverage that fueled substantial EPS growth and a 58% annual return over the last four years. 


Risk 2:  Same-Store Sale Growth Will Moderate

This chart shows quarterly same-store sales since the first quarter of 2009.  

<img src="/media/images/user_36/sss_large.png" />

Several things are apparent in this chart.  First, the +10% SSS growth that Chipotle Mexican Grill enjoyed clearly couldn’t persist.  It was amazing that they were able to do it for seven consecutive quarters.  That sent the stock soaring to $440 per share.  Investors should have realized that lapping these superb growth numbers made continual double-digit growth impossible.  This is exactly what happened and the stock now resides more than 25% below its 2012 high. 

Second, Starbucks (NASDAQ: SBUX) is in a similar spot having put in nine consecutive quarters of at least 7% same-store sales growth before dipping ever so slightly in the last several quarters.  The company has demonstrated a wonderful operational turnaround with brand extensions and expanded menu offerings.  Can they keep this up? 

Lastly, The Cheesecake Factory (NASDAQ: CAKE) again lags several peers on operational performance.  A premium valuation doesn’t appear to be supported given subpar margins and modest, albeit positive, same-store sales growth.

Risk 3:  New Store Growth- Law of Diminishing Returns

The graph below shows quarterly new store growth annualized.  The Cheesecake Factory was left off given little to no new store growth in the last several years. 

<img src="/media/images/user_36/new-store_large.png" />

This has been the third leg to Chipotle’s superb earnings-per-share growth story.  But can it persist?  They are forecasting new store growth of around 12% in fiscal 2013 which would be lower than recent results.  Their store count now stands at 1410, the same spot that Panera Bread sat during 2010.  Panera Bread now has just over 1600 stores.  Will Chipotle’s new store count mirror that of Panera Bread after they reached 1400 stores?  If so, then new store count will start to drift from 18% to 12% to 6% relatively quickly.

Starbucks’ store count is taking on resurgence despite more than 18,000 locations.  The company’s Asian growth story is taking hold with 11% same-store sales growth in the most recent quarter.  The acquisition of Teavana also supports sustainable expansion opportunities.   Starbucks appears to have the best growth story having gained traction overseas along with opportunistic acquisitions.  Chipotle appears to be inevitably slipping down the mountain peak.  At some point they may have a good international story, but this will come years down the road and potentially after a notable compression in valuation multiples.

Risk 4:  Stock Valuations Ignore Above Risks

The chart below depicts the trailing twelve month price-to-earnings ratio for several restaurant stocks. 

<img src="" />

CMG PE Ratio TTM data by YCharts

All of these stocks seems rich from a valuation standpoint.  The Cheesecake Factory is the cheapest of the bunch, but 18x trailing earnings seem high given limited growth opportunities and zero economic moat.  It seems appropriate that Chipotle has a higher multiple than Panera Bread, but both bake in a lot of rosy forecasts in years 2013 through 2015.  Starbucks has the best fundamental story at this point, but 30x earnings makes shares a risky proposition.  All of the stocks offer investors little margin of error should any of the above risks materialize. 

The Foolish Bottom Line

Restaurant stocks are too risky at this junction for long-term investors.  They have benefitted from a perfect storm during the last four years, but these tailwinds will begin subsiding in the next several quarters.  And this doesn’t take into account the fickle consumer that can change their preferences seemingly overnight.  Fundamental headwinds and rich valuations imply investors avoid this industry in 2013.  

market8 has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, Panera Bread, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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