Buy McDonald's Despite Slip, Avoid Wendy's Despite Re-Imaging

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

The restaurant business is known for competition and generally tracking the broader economy. In fact, McDonald's is largely viewed as a bellwether of macro trends. To get the most out of restaurant stocks, I recommend looking carefully at corporate trends and whether the current price justifies an investment. Reasonable multiples can be gauged through making public equity comparisons and present value analyses. Below, I use these valuation methods in my assessment of McDonald's and Wendy's.

Why the McDonald's (NYSE: MCD) Sales Decline Was a Big Deal

Sometimes we lose sight of the scale of America's beloved burger joint. It's not just here; McDonald’s operates the largest chain of restaurants globally. McDonald’s is established in about 120 countries and attends to more than 55 million customers every day. The company has 34,000 restaurants and more than 1.7 million employees. But while McDonald’s had experienced a steady growth in revenues, it has lately been experiencing financial difficulties.

For 25 years the company has paid dividends, and the dividends have increased consecutively over these years. It was only in October 2012 that the company experienced a drop in its monthly sales, breaking a trend of sales increases that had dominated for nine years. A look at this company from the various geographical locations reveals that it had a 1% increase in revenues in the United States from 2009 to 2012. In the European market, revenues within the same period grew by 18%. In Asia, Africa and Middle East, revenues rose by 43%. Based on this previous performance, McDonald’s is expected to have an operating margin of 50% and a revenue growth of 5% year on year for the next nine years.

The company’s 2012 third quarter earnings were therefore much of a wet blanket to investors who felt that "good times were here to stay." Total earnings dropped by 3.3% to $1.46 billion. Revenue was $7.2 billion, as the company felt the effect of the strong dollar and lost some cents per share during conversion. Worse yet, the decline in revenues followed the appointment of the new CEO Don Thompson, which sets a negative tone in the new environment. The company is, however, optimistic that it will raise earnings by 10.2% in 2013. The company has to put its best foot forward, as it is facing competition from other restaurant chains, such as Wendy’s and Panera Bread. As a strategy for growth, the company purposes to double the number of restaurants in China. I believe this offers a tremendous gateway to value creation.

At a respective 17.4x and 16x past and forward earnings, the company trades at a discount to the US restaurant leader in China, Yum! Brands (NYSE: YUM). Yum may be well known in the United States for its Pizza Hut and Taco Bell brands, but it also has a popular chain of Chinese restaurants that actually have become a bit of a negative catalyst in recent months due to deceleration in the emerging market. In any event, Yum trades at a respective 19.2x and 18.1x past and forward earnings. It is forecasted for 11.1% annual EPS growth over the next five years, around 225 bps more than what is expected for McDonald's.

Wendy's (NASDAQ: WEN): Strong Performance Still Doesn't Justify Valuation

Wendy’s is a fast food chain restaurant with a global presence. The restaurants that Wendy’s runs are mostly franchised (about 77% of them). The company employs about 46,000 people globally.  In November 2012, Wendy’s reported their third quarter earnings. Consolidated revenue in this quarter amounted to $636.3 million, which was a 4.1% raise compared to the previous year’s consolidated revenue of $611.4 million. Same-store sales increased by 2.7% in North America. This was the sixth consecutive quarter that Wendy’s had reported an increase in same-store sales. Operating margins rose to 13.9%, compared to 13.7% in the same quarter of the previous year. The company also reported a loss of $26.7 million from continuing operations compared to $2.5 million in income from the previous year’s quarter.

Strong results have been complemented by a more generous capital allocation policy and a change in branding. The board approved a $100 million share repurchase program and doubled quarterly dividends. The company plans to spend $10 million in re-imaging their restaurants in 2013. The total number of restaurants to be re-imaged in 2013 is 200 while the new ones that will be built are 65. The question then is whether this success and momentum will be enough to bring back shareholders weary of profitability.

The stock trades at 25.5x forward earnings, or around book value. Analysts forecast 15.5% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $0.31. At a multiple of 20x, this translates to a future stock value of $6.20. Discounting backwards by 10% (generously, given the risk) yields a present value of $3.85. In other words, Wendy's is around 25% overvalued.


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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