Avoid These 2 Restaurant Stocks, Invest In This Safe Pick

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

McDonald's has been commonly seen as a bellwether of the broader economy. It should not be surprising then that analysts beyond the restaurant industry panicked when comparable sales declined in October. However, now that the economy is clearly improving and railroads--another macro bellwether--is improving, is it time to invest in McDonald's and the other burger joints? Below, I review several fast food companies with a focus on risk/reward and areas of media interest.

A Balanced Look At McDonald's (NYSE: MCD)

I am sick of the days where companies, struggling to achieve solid growth, come out with a gimmicky advertising campaign--maybe a logo change or two, a store layout update, or a new "premium product"--to cajole investors. Maybe I'm too sinister, but I think the executives know better. Perhaps Exhibit 1 for marketing gimmicks goes to J.C. Penney, which has fallen 53.4% from the 52-week low after investors came to the conclusion that the "new" J.C. Penney wasn't any better than the old one--in fact, it was worse. So, the investment community should take a grain of salt the next time a restaurant or retail executives comes out with a plan to "rebuild the brand".

In regard to restaurants, consumers are unlikely to jump out at any one new burger, for example--if it is obvious that they would, the company would have released it already. I am therefore stunned by all the media attention that is being given to the reintroduction of the "McRib sandwich". Two weeks ago, a Motley Fool contributor released an article title "Can the McRib Save McDonalds?". Analysts were meanwhile hailing the timing of a reintroduction, and they pointed to futures as proof. With all due respect, McDonald's is a $90 billion company, and to expect upside to depend on a reintroduced product is, in my view, naive at best. There are a lot of moving pieces.

So, how does McDonald's fare as a whole? The company has caused some investors to panic of late, largely due to the recent same-store sales decline in November--the first monthly drop in 9 years. Investors were somewhat relived when November same-store sales came out at 2.4% globally, or 200 bps above consensus. However, the main area of concern lies in China. Yum Brands (NYSE: YUM), the fast-food leader in China, expects slower growth in the nation. On the other hand, i like the company's accelerating growth in India, which currently has 148 stores in the western and southern regions as of late December 2012.

But McDonald's is still a great brand with nearly four decades worth of increasing payouts. It currently offers a 3.5% dividend yield and trades at a respective 16.8x and 15.5x past and forward earnings. Analysts forecast 9.1% annual EPS growth over the next 5 years, which is solid for a stock that is 60% less volatile than the broader market. Yum, however, has a slightly steeper growth curve ahead with a forecasted rate of 13.9%. Assuming expectations are met, Yum's 2016 EPS will come out to $5.44. At a multiple of 17x, this translates to a future stock value of $92.48. Discounting backwards by 10% yields a present value of $57.42--around 10% below the current market assessment. Accordingly, I recommend avoiding the higher-growth Yum investment for a safer holding in McDonald's despite the marketing gimmicks.

Why You Should Avoid Wendy's (NASDAQ: WEN)

Wendy's is another burger joint that has taken to marketing gimmicks. It will update its logo in March in a continued effort to brand itself as a "five-star restaurant at a three-star price".  Wendy's does, after all, need to seriously update its image on the market. Though it trades at 6% book value, earnings is just starting to break-even, and analysts are not buying the turnaround story. 11 of 14 reporting analysts are shrugging off the company with a "hold."

Throughout the third quarter, many were optimistic about the company's new products and updated marketing campaign. As it turned out, 3Q12 revenue of $636.3 million missed expectations by around $4 million, and investors subsequently sold off 1.4% of the burger restaurant chain's value. With only a 2.4% return on invested capital--around 10% of the industry average--Wendy's is destroying value. 

Promotional activity has increased amongst restaurant chains, so Wendy's will have a tough time winning over customers from competitors. It will also have a tough time winning customers from McDonald's, since its turnaround comes at a growth rate that is forecasted for only 16% annualized over the next 6 years. Investors who are seeking high growth will go for Yum, and those that want safety will go for Wendy's. In short, Wendy's risk/reward is not compelling at this time.


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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