Food For Thought: Why I Like These 2 Restaurant Stocks

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 |  Includes: ARKR, FRS, MCD, XLY
by: Bram de Haas

My process of finding writing material usually starts with running screens on NY-listed stocks. The remaining candidates I go over manually. I don't pre-select certain sectors. I noticed restaurant stocks come up fairly often and over the past year I've reviewed several of them. Although the sector isn't undervalued as a whole there are certainly some golden nuggets to be found.

One of them - Frisch Restaurants Inc. (NYSEMKT:FRS) - has run up a great deal and isn't as interesting anymore as it originally was but the other 3 are still compelling investments.

Ark Restaurants Corp

I want to highlight this small company again because in recent years it faced numerous challenges and adversity - aside from those posed by the general economy. Now these are dealt with. Free cash flow will enjoy a significant uptick in the next two years.

My original story - a medium rare value stock with a nice dividend on the side - is still intact and the stock even declined a little from $21.45. Subsequently an Alpha-Rich article on Seeking Alpha discussed the stock as well.

The story got very little attention while I think it is somewhat protected on the downside, and has real opportunity to go up 50% over one or two years.

It's protected on the downside because of a bid by Landry's earlier this year at $22.

On the upside I think opportunities like the new low rent (locked in until 2029!) location Clyde's in New York and the location at the racetrack are undervalued.

McDonald's Corporation (NYSE:MCD)

The future is notorious for being unpredictable. But McDonald's fortified competitive advantage (economies of scale) combined with their ability to cater to changing needs of the consumer give me the confidence the company will come through over the long haul.

It is equipped to deal with almost any flood of challenges the future might give rise to; for sure it's on equal ground with its major competitors and perhaps on higher ground.

McDonald's is rarely a steal when looking at the classic valuation multiples like P/E value. The brand name and the growth rate add such obvious value that the raw P/E number is unlikely to go down to the level where the value investor usually becomes excited. But it is also because of that growth rate and brand name that McDonald's is attractively valued even at a P/E of 17+.

MCD PE Ratio (NYSE:<a href='http://seekingalpha.com/symbol/TTM' title='Tata Motors Limited'>TTM</a>) Chart
(Click to enlarge)

MCD PE Ratio (TTM) data by YCharts

The growth has slowed down temporarily but I think it will be able to pick up its historic pace. Emerging markets provide plenty of room to make up market share in the U.S. over the long term.

In my article 5 Reasons to buy into the McDonald's Story I go into its market leadership position, its ability to cater to changing needs, its stable franchise/real estate cash flow and it's defensible and sustainable competitive advantage.

Especially its massive economies of scale provide an incredible advantage over other restaurateurs. Matching them on price is sheer impossible unless competitors accept terrible margins. For small competitors both cost of capital and costs of goods sold are numbers they can only dream of.

Sector Comparisons and Conclusion

XLY Chart
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XLY data by YCharts

If we compare these two restaurant picks to the greater market they come out relatively attractive. There is no restaurant ETF available at the time but the Consumer Discretionary Select SPDR (NYSEARCA:XLY) is the closest thing I found. In recent history the two have underperformed but I don't see a credible fundamental reason for that situation to continue long term.

company P/E Sector Average P/E Dividend
Ark Restaurants Corp (NASDAQ:ARKR)
17 24.6 4.7%
McDonald's Corp 17 24.6 3.4%
Click to enlarge

The company's both pay respectable dividends as well and as a result of the recent underperformance trade at a discount to the industry average P/E that is quite sizeable. McDonald's is the more traditional of investment of the two but Ark has a few compelling assets among its hodgepodge of restaurants.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.