Restaurants Stocks to Avoid Buying

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

If you are looking for undervalued restaurant stocks, I encourage avoiding the premium brands and instead going for the ones that can either be taken over or are on a strong growth trajectory. The industry suffers from strong competition which puts pressure on margins and expansion opportunities. It therefore makes sense to look at inexpensive restaurant chains as possible consolidation plays that could see opportunities in margins or growth if integrated to a larger competitor.

McDonald's (NYSE: MCD): Defensive but not Undervalued

After experiencing the first sales decline since 2003, many investors are looking at McDonald's as if its days of virtually constant appreciation over the last decade are over. Yet, at a respective 16.4x and 15x past and forward earnings (versus a historical 5-year average PE multiple of 17.3x), the stock appears quite cheap for such a premium brand. It offers a dividend yield of 3.6% and 60% less volatility than the broader market--factors that go a long way in actually making it for the defensive investor.

Over the past five years, McDonald's has grown EPS by 18.1% annually; analysts expect a rate that is more than 900 bps less over the next half decade. Despite the bearishness of this estimate, it is still large enough to drive meaningful value creation if multiples hold steady. My one concern, however, is that the company doesn't generate nearly enough free cash flow to justify its valuation. It has hovered around $4 billion over the last few years, which implies declining yield--a yield that now stands at less than 5%.

Management is still taking the appropriate steps to build value. It has rolled out new items on its dollar menu and actually grown market share in Europe despite macro headwinds. The use of greater media campaigns and value offerings have helped drive traffic, especially in the UK and Russia. All things considered, I recommend a "hold" on the stock. It is neither undervalued nor a weak stock. It is fairly defensive and positioned for growth.

Avoid Dunkin' Brands (NASDAQ: DNKN), Buy Jack in the Box (NASDAQ: JACK)

If you want to go for a more risky stock, Dunkin' may pique your interests. At 20.5x forward earnings and a sub-par 1.9% dividend yield (but still a 63.3% payout ratio), I find the risk/reward uncompelling.  It is still up 35.8% from its 52-week low and $4.50 short of its $35 price target. And the company has beaten analyst expectations by an average of 7.3%.

In the recent quarter, management delivered on its impressive momentum as the top-line grew 5% and adjusted net income grew 34%. This is also a reversal from 2009 when several Dunkin' franchises were financially struggling. A few years and organizational changes later, the picture has turned to solid performance in domestic stores and emerging stores. But with all of this growth, the company has come nowhere close to justifying its current valuation. Free cash flow has actually fallen from $213.5 million for 1Q11 (ttm) to $85.9 million in 3Q12 (ttm). Even if you take $213.5 million as the normalized free cash flow generation, it is still at no more than a 6.5% yield against the current market cap.

As an alternative, I encourage an investment in Jack in the Box. The company has not meaningfully expanded in the west and thus has meaningful growth opportunities ahead. It is also reasonably priced at 17.1x past earnings. It just needs the capital and balance sheet strength to help catalyze these returns. Same-store sales have already gone up 3.4% in 3Q12 and performance is tracking above last year's fourth quarter.

But what attracts me most to Jack in the Box is its potential as a takeover target. With a market cap of $2.2 billion, a larger competitor, such as Yum!, could acquire the business, and it would be a drop in the bucket. Yum is a holding company, and buying out Jack in the Box would give it more exposure in the west and provide growth financing for subsidiary expansion.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend McDonald's. 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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