BlackRock Says Avoid Restaurants

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

In a recent weekly market commentary, Russ Koesterich, chief investment strategist at BlackRock, is calling for continued stock gains, but warns that consumer stocks look overpriced. He singles out restaurants as an area of concern.

"A combination of slow growth, low inflation, and relatively low interest rates should allow for stocks to move higher over the next 12 months," says Koesterich. However, he notes that consumers continue to struggle with weak income growth, which is a notable restraint on spending.

For example, income growth over the past 50 years has averaged about 3%, but was just 1.7% over the past three years. With that as a backdrop, it's easy to understand why he isn't expecting much from companies that offer discretionary products, like food away from home.

Hot Concepts

If you want to find an expensive restaurant stock, you don't need to look much further than the current hot trend--fast casual. Although Noodles & Company (NASDAQ: NDLS) doubling on its debut has made headlines, the euphoria overshadows Chipotle Mexican Grill's (NYSE: CMG) price to earnings ratio of over 40.

Although these concept restaurants are very popular with customers today, consumers are notoriously fickle. And so, too, are investors. For example, in the first four months or so of 2012, Chipotle shares ran up to over $425 a share. By the end of the year, though, the stock had fallen nearly $200, touching a low around $240.

The drop was precipitated by the company's sales stagnating at around $700 million in each of the second, third, and fourth quarters of 2012. However, if that's enough to knock over 40% from the stock's market cap, it was probably overpriced at $425.

Revenues headed higher again in the first and second quarters of 2013. The shares have responded by heading right back up to $400 a share. Revenues, though, haven't improved enough to support an over 60% price advance. Investors should tread carefully with Chipotle.

The New Kid

Noodles & Co. is another one to watch carefully. It has benefited from being one of just a few publicly traded fast casual restaurant. While the shares have come down some from their post-IPO heights, Noodles is still a hot concept in a hot sector. It has very little publicly available information for investors to go on and even less trading history.

The restaurant makes noodle dishes from Pad Thai to mac and cheese. It has around 350 stores in 26 states, so there's room for growth. In fact, pro-forma numbers show that it has been growing earnings and sales nicely over the last three years. Tthe bottom line, for example, jumped from just nine cents to over $0.20 cents a share in that time period.

That said, none of this occurred while the company was public. There are added costs and headaches that public companies face that could make life a bit more complicated and expensive for management. Opening more stores will probably more than make up for that, but investors shouldn't fall in love with a concept stock sporting a PE of over 200 using pro-forma numbers.

Feeling it

On the other hand, investors might want to consider Darden Restaurants (NYSE: DRI). The company's shares have a PE of around 16 and yield about 4.5%. The shares are up from about $45 at the start of the year, but have basically been trading sideways for the last couple of years as its Olive Garden nameplate has struggled to keep sales up.

That's one of two big concepts for the company and is an important performance driver. As long as Olive Garden and/or Red Lobster post weak results, Darden will struggle. Management, however, is aware of the problem and taking action.

For example, it has been more aggressive on the promotional front and has been willing to sacrifice near-term margins to maintain market share. That margin compression rightly has investors worried. However, the company also has a collection of growing brands, including Longhorn Steakhouse and the Capital Grille. So it is using its big brands to fund expansion via smaller, faster-growing concepts.

Although Darden is hardly a value stock, income investors looking for a restaurant play would do well to take a look. Note, too, that the dividend was just increased 10%.

Caution is Needed

Chipotle and Noodles are hot concepts, but investors need to be wary of a turn in investor attitudes and corporate performance. That said, both could continue to head higher over the near term if sales hold up. Darden, on the other hand, has already disappointed Wall Street. Income investors who believe it can get sales heading consistently higher at its core brands will be paid well to wait for a performance turnaround.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and 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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