Seeking Alpha
Long/short equity, value, growth at reasonable price, income
Profile| Send Message| ()  

Back to Part XXV - Drug Industry

By Mark Bern, CPA CFA

If you are new to the series and would like an explanation of how and why I select companies for my list please consider starting at the beginning; just follow this link to "The Dividend Investors' Guide to Successful Investing." In the initial article I provide a description of my selection process and explanations of all the metrics I use.

In this article I will go back to the original series format for an analysis of the Restaurant Industry. I will continue the review process again once I finish with this industry. Meanwhile, for those who might be wondering about my expectations (short, intermediate and long-term) for the future of the economy, please take a look at my recent article to answer the question of inflation or deflation.

The restaurant industry can be very volatile with price swings much larger than the overall market index, S&P 500. It can be great to own some of these stocks coming off a major bottom, but it can also be excruciating to own them in the early stages of a recession. The answer is clear: because one of the first things cut from family budgets when income falls or fear sets in is dining out. And the reverse is also true. When the economy appears to be on the mend and people begin to feel secure in their jobs dining out is a small luxury that folks tend to add back to their routines again.

Thus, it is not surprising that companies in this industry can boast some pretty amazing appreciation during times of economic recovery. Just look at some of the more impressive results from the lows of the Great Recession: Starbucks (SBUX) is up over 1000 percent in less than five years; Cracker Barrel (CBRL) is up over 900 percent; and Darden Restaurants (DRI) is up nearly 300 percent. Compare that to the S&P 500 appreciation over the same time frame of 169 percent and you see what I mean.

But there is also the downside risk that tends to unnerve me. From their highs in 2000 to lows after the Internet Bubble crash caused that recession those same three companies stocks fell by 33 percent 77 percent and 41 percent, respectively for SBUX, CBRL and DRI. That does not seem so bad compared to the subsequent rebounds of 399 percent, 448 percent and 418 percent (respectively, same order) leading up to the top before the Great Recession. But those same companies also fell 81 percent, 79 percent and 72 percent. Considering that an 80 percent decline requires a gain of 500 percent just to get back to even, suddenly you understand why I generally do not hold just any restaurant stocks near record highs when stocks have been in a bull trend for longer than the average bull market duration. It is just too risky for me!

Therefore, I recommend caution and selectivity to reduce our potential downside risk. I will also consider SBUX during the next recession because it is a good company that retains good upside potential from continued expansion internationally. But I will stay away at these levels. When the next recession hits (and there will always be a next recession to hit) I will do my best to write a focus article on SBUX when the share price becomes just too undervalued to resist.

The companies in this industry that are expanding internationally to take advantage of the rising middle class in emerging nations around the world are best positioned, in my opinion, to add relatively consistent growth in the future. Think about it: the mainly saturated U.S. operations have become a cash cow to finance expansion in markets that still have huge potential growth prospects. That is an excellent strategy and certainly beats tying future earnings growth to market share increases in North America where growth is likely to be less than spectacular. With hundreds of millions of people entering the consumer class and hundreds of millions more yet to do so, the potential is mind-boggling. Of course, everyone in those countries will not automatically change their tastes and start buying American cuisine (especially in India and other Asian countries). So, it is also important to identify those restaurant chains with the skills, experience and ability to adapt to local tastes while also introducing new items to menus that enhance the dining experience for local customers.

There are two ways to identify companies that are successfully expanding overseas by my estimates. First, I like to read through the 10K filings with the SEC to see how much revenue and profits are coming from outside the U.S. market. Then I like to analyze the growth of international operations relative to domestic. That gives me a good idea of how well each company is focused on the international side of growth. Next, I like to look at the trends of earnings per share, especially during recessionary periods, to determine whether the company has developed loyalties that can be sustained better during the worst of times. When earnings either continue to rise or fall only slightly during recessions, I interpret that to mean that the company is expanding successfully and provides greater protection against large drops in the stock price. It also is indicative of those companies for which the stock price will rebound quickly and not need to cut dividends. Those things are important to the stability of my portfolio and income stream.

So, let's take a look at how some of the standouts in the restaurant industry stack up against my metrics. Be advised that I have decided to add a couple of improvements to the metrics (always look to improve how you analyze companies). I will include a new category in the metrics: the current price/earnings (based upon my expected forward EPS) and compare that to the price/earnings I believe the company will be able to sustain long-term. The later ratio is more of a look at how I expect earnings per share to grow in the future and how I expect the market to value the company accordingly. It is not a historical perspective but does take into consideration premiums that have been accorded to the company for growth prospects and performance relative to peers. Quality begets a little better valuation. Quality is a subjective matter but, for me, includes (but not limited to) such things as how well management manages debts levels, cash flow, dividends, margins, expansion and acquisitions. It all boils down to how consistently management provides value to shareholders. The second change is to use the return on total assets ratio as opposed to the return on total capital. It is more a matter of semantics than substantive difference and I decided that the more commonly used ratio will be better understood. Finally, I also decided to use cash on hand and only the debt due within the next five years in my calculation of free cash flow. This is still far more stringent than the norm, but since I feel that our companies need to be prepared to weather the worst of storms I consider it to be prudent to retain a conservative posture here.

First up is McDonald's (MCD). It is amazing how many different food and drink items Mickey D's offers. Check out this link to see the full menu of offerings just in the U.S. Then there are the many international menu items of MCD, like the Chicken Maharaja Mac served in India, the Samurai Pork Burger served in Thailand, the McRice Burger served in the Philippines, the McD Chicken Porridge served in Malaysia, the Bacon and Potato pie served in Japan, the McCurry Pan served in India, the McTurco served in Turkey, Brie Nuggets served in Russia, or the McLobster Roll served in Canada. The company also serves beer in many of its European locations. The point of all this is that MCD does the research on local tastes and does a great job offering food items to please the local pallets. MCD even serves different items within different locales within a country. Have you ever found a MCD that offered everything on the U.S. menu? So, obviously, MCD passes the test for being able to expand internationally and offer items that sell well in every location. And the company is focused on international expansion. Here is a link from Time.com to a quick history of MCD expansion. It is a little outdated, but still provides the sense of how the company has expanded successfully over time. And finally, here is a link from Slate.com that explains pretty well, I believe, how MCD is winning in foreign markets. MCD still has significant growth potential in many markets around the world.

Next, I want us to look at how MCD stock did during the last two recessions. In the recession that began in 2000, MCD stock was down by 68 percent (S&P 500 was down 50.5 percent) but recovered to make new highs within less than a year off the lows. Then, in the Great Recession that began in 2008 MCD stock fell only 32 percent compared to more than 57 percent for the S&P 500. The shares were hitting new highs again by early 2010. As for EPS, the company posted higher results in every year straight through the Great Recession and only dipped temporarily by 9.6 percent during the previous recession.

Metric

MCD

Industry Average

Grade

Dividend Yield

3.3%

2.2%

Pass

Debt-to-Capital Ratio

47.0%

41.0%

Neutral

Payout Ratio

56.0%

35.0%

Fail

5-Yr Average Annual Dividend Increase

14.1%

N/A

Pass

Free Cash Flow/ share

($.045)

N/A

Fail

Net Profit Margin

19.9%

10.5%

Pass

5-Yr Average Annual Growth in EPS

9.1%

9.0%

Pass

Return on Total Assets

20.5%

16.0%

Pass

5-Yr Average Annual Growth in Revenue

6.5%

2.4%

Pass

S&P Credit Rating

A

N/A

Pass

The forward P/E ratio is about 15.8 currently and the average expected P/E I project for MCD is 16, so the company passes this test as well. So, this equity ends up with eight passes, one neutral and two fails. But one of the fails comes in the one of the areas that I do not like to have fails: free cash flow. When the next recession comes I expect MCD to manage its cash flow by keeping increases to the dividend slightly lower and by extending its capital outlays plan. Those moves will slow growth temporarily but should enable MCD to maintain its relatively high credit rating and immunize itself better should the capital market freeze up as it did during the Great Recession. Many companies will not have as much freedom. The stock appears to be fairly valued at current levels. However, with the markets making new historical highs I am taking a cautious stance in terms of making new investments. Personally, I prefer to wait for a correction or possibly the next recession since the current economic expansion, as anemic as it seems in many ways, is beginning to get a little long in the tooth by historical standards. My five-year price projection for MCD is only $126, with dividends increasing an average of eight percent per year, to yield an average annual ROI of nine percent.

Next up is Yum Brands (YUM), the owner of Pizza Hut, KFC and Taco Bell. Interestingly, YUM generates about 40 percent of profits from China. Avian flu scares have hurt sales at the KFC outlets in China due to health concerns. Similar occurrences have happened before with business rebounding in relative short order. Same store revenue declines are narrowing in China and are up in most other regions with strong results coming from expansion in Russia and South Africa. The company has proven it can translate success in diverse geographic areas around the world.

Here is a link to an interesting article by Seeking Alpha contributing author, TradeInvestor, which compares YUM to MCD for dividend growth prospects. How did YUM do in the recessions? The stock was down 65 percent in the recession that began in 2000 and down 44 percent during the Great Recession. The stock rebounded nicely by 584 percent and 206 percent from the lows in subsequent years, respectively. EPS dipped by 11 percent in 2001 but rebounded to new highs in 2002 and never fell during the Great Recession. Dividends have increased in every year since initiated in 2006.

Metric

YUM

Industry Average

Grade

Dividend Yield

2.0%

2.2%

Neutral

Debt-to-Capital Ratio

57.0%

41.0%

Fail

Payout Ratio

45.0%

35.0%

Fail

5-Yr Average Annual Dividend Increase

10.2%

N/A

Pass

Free Cash Flow/ share

$0.14

N/A

Pass

Net Profit Margin

10.4%

10.5%

Pass

5-Yr Average Annual Growth in EPS

10.2%

9.0%

Pass

Return on Total Assets

28.0%

16.0%

Pass

5-Yr Average Annual Growth in Revenue

4.6%

2.4%

Pass

S&P Credit Rating

BBB

N/A

Pass

I calculate that the forward P/E is about 19 while the average future P/E should be 17. This is another fail, but only by a relatively narrow margin. It means that the stock is not currently a bargain and investors should probably wait for a better entry opportunity. The final tally is seven passes, one neutral and three fails. The debt to capital ratio is high relative to the industry average but management has been improving in this area by paying down debt from 2008 through 2010 and then maintaining the amount of debt relatively stable while continuing to grow the company. Thus, the ratio looks to improve more in coming years. The two other things that jump out at me from this analysis is that the stock currently offers less appreciation potential from these levels and the dividend yield is lower than I would like. YUM is a good company but I would like to see additional improvement in the debt and would prefer a better yield. Dividend increases have been strong, but a continuation of that trend will require much stronger bottom line results. I believe that the future increases will average closer to 7.5 percent and that the total average annual ROI potential is only about five percent. My five-year price target is only $85.

Since this article is beginning to get a bit long I will conclude the industry review in the next article. Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

Source: Dividend Investors' Guide - Part XXVI - Let The Restaurant Industry Feed Your Portfolio