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3 Restaurants for Your Watchlist

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

Sometimes, you can find good investment ideas by looking at the myriad of restaurants in your neighborhood. They may not all rank with huge global restaurant chains such as McDonald’s; however, they may still be worth some of your research time. The three restaurant chains below reside in a turnaround situation that can profit the long-term shareholder.

From pancakes and steaks

Full service restaurant chain DineEquity (NYSE: DIN) and its franchisees operate Applebee’s and the International House of Pancakes, or IHOP.

The company stands just shy of completing a move toward a 100% franchised system, a process that began five years ago. Last year, the company sold 154 IHOPs and Applebee’s each to franchisees, sacrificing short-term revenue for long-term gains in profit margins with franchisees doing most of the heavy lifting in terms of overhead.

DineEquity’s revenue and free cash flow declined 21% and 62%, respectively, due to the significantly lower number of stores owned by the company. However, its net profit margins doubled from 7% in 2011 to 14% in 2012.

DineEquity made strides in improving its balance sheet. Cash to stockholder’s equity stands at 21%. Its long-term debt to equity ratio stands at a monstrous 389%; however, DineEquity paid its long-term debt down $200 million last year.

With the future depending so much on its franchisees, it established a purchasing cooperative where the company’s franchisees can participate in the purchasing power of the company’s more than 3,600 restaurants. This better enables it to profitably sell to restaurant patrons at a value price.

Look for DineEquity to finish its move to 100% franchisee ownership by selling its remaining company-owned stores. In addition, its efforts to pay down debt won’t hurt either. DineEquity still has plenty of room to grow outside of the United States. Right now, the count of Applebee’s and IHOPs stand at 149 and 44, respectively, in the international arena.

The drive-in chain

National drive-in chain Sonic (NASDAQ: SONC) sells hamburgers, hot dogs, and ice cream. This chain probably appeals to you on a nostalgic level. Pulling into one of those drive-ins certainly provides an experience difficult to find elsewhere.

In recent years, Sonic experienced difficulty with product quality and the lack of a uniform national marketing campaign. The company made moves to invest in its national marketing efforts and improve product quality. Moreover, like DineEquity, Sonic is moving more to a franchised system and paying down debt. In addition, Sonic wants to build smaller store formats to better attract franchisees and to expand into smaller markets that wouldn’t necessarily support a larger restaurant.

In 2012, Sonic’s revenue declined 41 basis points due to the re-franchising of 34 restaurants. Its free cash flow increased 17%. Long-term debt declined 3% last year, but still comprises 788% of stockholder’s equity.

The company still needs to pay down significant amounts of debt before achieving a decent margin of safety. Last year, operating income only exceeded interest expense three times. A good rule of thumb calls for at least five times interest expense.

Sonic’s investment in marketing, product quality, and a smaller store format may prove beneficial to the company and its shareholders.

Hamburger deluxe

Casual dining chain Red Robin Gourmet Burgers (NASDAQ: RRGB) defines itself on a pleasant dining experience. Interestingly, “Unbridled Acts” serves as part of the company’s culture where company employees can delight the customer with random acts of kindness.

Red Robin sports the strongest fundamentals of the three companies discussed here. The company’s revenue increased 7% last year. However, its free cash flow declined 34%, stemming from lower operating cash flow and higher capital expenditures.

It’s in good shape debt wise, with long-term debt to equity declining 9% and calculating to 44% of stockholder’s equity. Its operating income exceeds interest expense eight times as of the end of last year.

Unlike the other two companies mentioned here, Red Robin owns the majority of its stores. Current turnaround efforts include re-branding initiatives and the opening of new store formats.

Look for this company to continue its focus on the consumer and growing its brand. Red Robin possesses a good set of values that will only help the company and its shareholders over the long-term.

Conclusion

Overall, the turnaround efforts of these three companies should prove beneficial to shareholders. DineEquity’s move to a nearly 100% franchise model and its purchasing cooperative will enable this company to maximize profit margins over the long-term. Sonic’s re-franchising moves and smaller store formats will help its shareholders as well. Red Robin’s commitment to its customers and re-branding efforts also represent a good idea. Finally, their efforts to pay down debt will do nothing but improve profitability. These companies warrant a place on your Motley Fool Watch List (sign-in required).

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William Bias has no position in any stocks mentioned. The Motley Fool recommends Red Robin Gourmet Burgers. 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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