Why You Should NOT Buy These 3 Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As an exception to my generally bullish outlook on most industries, I take a reserved stance on restaurant chains, especially those that have already established a mature presence. From intense competition to input inflation, the headwinds are outweighing the catalysts. In my view, Darden Restaurants (NYSE: DRI), Yum! Brands (NYSE: YUM) and Wendy's (NASDAQ: WEN) are all no more worthy than a "hold."
To look at the best case scenario, let's look first at the company that I am most optimistic about: Darden. The restaurant business trades at a respective 15.1x and 12.4x past and forward earnings - lower than the industry and market at large. A strong 3.7% dividend yield and beta of 0.85 further provide low downside. On the other hand, liquidity is quite weak with a quick ratio of 0.2.
Even still, the performance index of the National Restaurant Association has dropped 1.1% m/m to the lowest level in nine months. Darden recently acquired Yard House USA in a $585 million all-cash deal. While this company helps to widen the brand and reduce risk, it does not offer substantial revenue or cost synergies. If anything, it indicates weak momentum at either Olive Garden or Red Lobster. 4Q12 same-store sales for these businesses were disappointing and negative. Detecting this, the stock market fell 1% after hours following the announcement.
With just 39 restaurants, Yard House also does not have the scale that can improve visibility. It was, however, expensive enough to acquire that Darden had to slash the share repurchase program decline by as much as 80% out of the $250 million planned for 2013.
If you want to go for diversification, Yum Brands may be the safest bet. It not only owns household brands like Pizza Hut and Taco Bells but is also meaningfully penetrated into China. The firm is also preparing to increase growth in India and will not face very threatening competition there, since Hinduism restricts menus to largely vegetarian options. McDonald's, for example, has faced protests despite trying to appeal to community interests. Ultimately, Yum offers more vegetarian-oriented meals and thus is not exposed to such pressure.
Now that the stock has fallen by the double-digits from its highs as a result of China, investors may be tempted into buying a small speculative stake. However, growth is not enough to justify the current valuation. In fact, the PEG ratio currently stands at 1.6x. With the bar set at 13.3% and the stock trading at 17.8x forward earnings, there is more downside than upside pressure. Accordingly, I recommend holding out.
Perhaps the most overvalued of the three stocks is Wendy's. It trades at 24.1x forward earnings and is rated closer to a "sell" than a "buy" on the Street. Despite the fact that EPS has fallen by 15.5% annually over the past five years, analysts forecast 14.6% annual EPS growth over the next five years. ROA, ROE, and ROI are virtually nonexistent, so the bulls are mostly playing a turnaround story.
Unfortunately, the turnaround story would have to be quite historical for the company to outperform. Free cash flow has recovered from 2007-2008 losses, but it was still only $111 million for the TTM ending 2Q12 versus $109 million in 2Q11. At a $1.79 billion valuation, this momentum is not strong enough to drive meaningful returns. In addition, the firm is not doing well re-investing, since growth has been so weak. The low 1.8% dividend yield is not enough to encourage investors to back an uncertain future. As the economy heats back up, investors will flock to those that are currently succeeding and have succeeded in the recent past. Wendy's is too much of a "wait-and-see" investment to encourage entry in this uncertain macro environment.
TakeoverAnalyst has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.