These Sit-Down Restaurants Offer Big Plates of Profits

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As the economy gradually recovers from the worst financial crisis in decades, it’s reasonable to invest in cyclical sectors of the economy that do particularly well in good economic times.

One such industry is the casual restaurant industry, whose fortunes are tied closely to the health of the consumer. And, since American consumers are feeling better about their finances and spending more in recent months, wise investors should pay close attention to the sit-down restaurants that are serving up hefty portions of profits and dividends.

Profiting from the return of the consumer

Many sit-down restaurants are undergoing a transition to the franchise model employed by many of their fast-food peers. One such company is DineEquity (NYSE: DIN), the $1.3 billion operator of Applebee’s and IHOP.

DineEquity is rapidly turning toward the franchise model, and higher expenses related to this have dragged down profits in recent quarters. However, this will surely be beneficial to shareholders down the road, as the franchise model is extremely lucrative for a restaurant company, and the benefits are already being felt.

For instance, consider that although the company’s first-quarter adjusted diluted EPS fell 16%, this was due primarily to the aforementioned refranchising-related expenses. Free cash flow, on the other hand, rose 34% during the quarter.

Similar restaurant chains are also seeing firming business conditions. Recently, industry leader Darden Restaurants (NYSE: DRI) recently reported a 12% drop in fourth-quarter diluted EPS, but 11% sales growth at the same time. Same-restaurant sales, which measures sales only at locations open at least a year, rose across the company’s chains, which include Olive Garden, Red Lobster, and Long Horn Steakhouse.

For the full year, Darden’s total sales from continuing operations were 7% higher and diluted EPS clocked in at $3.14 per share.

Close competitor Brinker International (NYSE: EAT) operates the Chili’s and Maggiano’s brands and holds a nearly $3 billion market cap.

In the company’s recently announced fiscal third quarter results, Brinker showed that it is a company in high-growth. GAAP diluted EPS soared 26% and franchise comparable restaurant sales increased 1.3% year over year.

Of course, there’s often a cost associated with higher growth, which in this case is a premium valuation. Brinker trades for more than 18 times trailing earnings, while Darden trades for 16 times EPS. DineEquity, meanwhile, is even more attractively valued, exchanging hands for only 11 times earnings.

Cranking up the shareholder rewards

Not only is DineEquity changing its underlying business model, but the company is also overhauling its capital allocation program. DineEquity recently instituted a generous dividend policy, in addition to a new $100 million share buyback program.

After suspending its dividend payments in 2008 in the middle of the Great Recession, the company now intends to pay $3 per share annually to shareholders, which amounts to an impressive 4.3% yield at recent prices.

For its part, Darden announced a dividend increase along with its fourth-quarter and full year results. The company raised its shareholder payout by 10% to $2.20 per share annualized. At recent levels, Darden now yields 4.3% as well.

Brinker, meanwhile, is a lower-yielding stock but has demonstrated greater dividend growth in recent years than its rivals. Brinker’s last dividend bump was a generous 25%, and it’s likely the company will grow it again in time for its next dividend payment.

In the end, while each of these restaurant stocks is highly profitable and pays a solid dividend, DineEquity appears to be the winner. Not only does the stock offer a dividend yield in excess of 4%, but the company is very cheap at current levels. A likely cause of this is the company’s recent profit woes, but that’s due largely to the current transition taking place to the franchise model.

Those expenses will abate in time, so for investors with a long-term view, future returns are compelling. Moreover, you’re being paid handsomely to wait until these changes materialize. As a result, DineEquity looks like a great stock to buy at recent prices.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool owns shares of Darden Restaurants. 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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