1 Strong Restaurant Stock to Buy, 1 Speculative Peer to Consider

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McDonald's has been said to be a bellwether of the broader macro-economy. In my view, this is likely to become even more true as the company expands abroad. Other firms, like Wendy's, are just returning to profitability and may offer exceptional upside on a stronger-than-expected economy. Before making an investment in a restaurant chain, I encourage looking at geographical expansion opportunities, marketing efforts, and financial trends. Below, I focus on McDonald's and Wendy's with these variables in mind.

Why You Should Buy McDonald's (NYSE: MCD)

McDonald’s is the leading fast food chain restaurant in the world. It has a presence in 119 countries and serves an estimated 68 million customers everyday in its more than 34,000 restaurants. Originally the company was known to sell hamburgers, French fries, milk shakes and other snacks, but the company has adapted to include coffee options and salad options. McDonald’s has also been dedicated to returning free cash flow to its shareholders, as evidenced by the dividend growth of 29.5% in the last five years. It has also had an 18% growth in earnings per share.

There is, however, fear that future investors will not enjoy the same payout due to market saturation. But analysts believe that McDonald’s will actually sustain an 8.8% earnings growth rate. With that said, there is something to be said about investors taking its consistency for granted. McDonald's growth has been so good that, when the burger chain experienced a same-store sales decline in October (the first one in a period of nine years), one analyst likened it to a "giant falling to one knee." But in November same store sales actually shot up by 2%.

Furthermore, McDonald’s is seeing a great potential in China with third quarter earnings increasing by 3.6%. The previous year’s increase was 11.3%. There are now more than 800 McDonald’s restaurants in mainland China, which has a GDP growth rate in the high single-digits to low double-digits. In the US, which has a population of 300 million, there are 13,000 restaurants. Considering that the population of china is 1.3 billion, there is obviously great potential for growth. The current sales from China account for 1% of total sales from upcoming markets. Yet the market continues to look at the downside, especially since management said it was decelerating growth in this emerging market after some speculated that it would actually close down stores.

Part of the negativity has to do with reports that western foods are losing ground in China. Yum Brands (NYSE: YUM), which leads in China’s fast food, is also expecting a decline is sales. Despite this, Yum continues to trade at a high premium of 19.7x and 18.5x past and forward earnings, respectively. Strangely, McDonald's, which is known for its wide economic moat, only trades at 17.3x past earnings despite having the same, if not better, growth opportunities (ie. China). By contrast, Yum will have to achieve a significantly sharper growth curve to even justify its current valuation. Assuming the company grows EPS by a rate of 13.4%, the 2016 stock price will be $84.50 at a 16x multiple. Discounting backwards by 10% yields a present value of $52.50, which actually suggests ~25% downside. For this reason, I recommend avoiding and possibly buying shares of McDonald's to profit off of multiples equilibrating.

Wendy's (NASDAQ: WEN): Pros & Cons

Wendy is also a fast food chain of restaurants that is very keen in providing ‘healthy food’ to the American market with a great emphasis on products with lower calories. It has constantly marketed itself as provider of cheaper and higher quality (or healthier) burgers. The company announced its third quarter earnings, indicating that it had cash worth $453.6 million. The company is also planning to buy back shares worth $200 million, which sets a floor on the downside.

In the most recent quarter, Wendy’s opened 25 new restaurants but also closed 29 others for now 6,543 restaurants globally. This makes me particularly weary about management's confidence over future streams of free cash flow. Instead, management has focused on improving its marketing messaging. The introduction of a $10 million incentive program will see the re-imaging of Wendy’s restaurants in 2013. From updating its logo to providing new staff uniforms, the company is, in my view, worrisomely focusing on gimmicks.

Wendy’s management believes that the company has the potential to register an EBITDA of $350-$360 million in 2013 versus $310 million in the trailing twelve months. In the third quarter of 2012, Wendy’s same store sales registered 2.7% growth. The growth is attributed to the introduction of new products and marketing efforts. In addition, Wendy’s is increasing margins by merging stores. The merge reduces expenses while increasing same-store earnings, and Wendy’s reports that it has witnessed a 25% sales increase as a result. But the company is largely a speculative bet right now with the bottom-line just starting to enter the profitable territory. Return on invested capital currently stands at only 2.4%. 11 of 14 reporting analysts are on the fence with a "hold."


TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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