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Back to Part XXVI - Restaurant 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 continue in the original series format to complete my analysis of the Restaurant Industry. I will go back to 2013 the review process again in the next article. 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.

To summarize what I covered in the prior article which began my review of the restaurant industry, I cannot emphasize enough that this can be a very volatile investing area. Economic recessions can hit some of these stocks much harder than the broader market averages. Income investors need to be very selective here.

Also, I believe that with the relative saturation of the U.S. market most of these companies will need to prove the ability to expand and grow internationally to sustain respectable growth rates and dividend increases.

Tim Hortons (THI), based in Canada, is next up on the list. The company has a total of over 4.300 restaurants in Canada (80.5%), the U.S. (18.75%) and other international locations (<1%) serving sandwiches, wraps, soups, baked goods, coffee, tea, smoothies and espresso. Over 99% of restaurants are operated by franchisees. The decision is still out as to whether THI can succeed internationally. By the numbers the company does very well. Formerly owned by Wendy's International (NASDAQ:WEN), the company was spun off in 2006.

The company was not public during the earlier recession, but during the Great Recession the stock faired quite well suffering a drop of only 46% compared to over 57% for the broader market index of the S&P 500. EPS fell eleven percent in 2008 but rebounded to new highs in 2009. The stock regained the earlier high ground by late 2010. Dividends have been paid in every years since the company went public and have increased in all but one year (2009).

Metric

THI

Industry Average

Grade

Dividend Yield

1.7%

2.2%

Fail

Debt-to-Capital Ratio

30.0%

41.0%

Pass

Payout Ratio

34.0%

35.0%

Pass

5-Yr Average Annual Dividend Increase

25.1%

N/A

Pass

Free Cash Flow/ share

$0.34

N/A

Pass

Net Profit Margin

13.6%

10.5%

Pass

5-Yr Average Annual Growth in EPS

27.2%

9.0%

Pass

Return on Total Assets

18.0%

16.0%

Pass

5-Yr Average Annual Growth in Revenue

19.3%

2.4%

Pass

S&P Credit Rating

NR

N/A

Fail

The forward P/E is 18.2 while my expected average future P/E is 19. This is another pass giving the stock nine passes and two fails. The problem in the credit rating is that I could not find a rating by either S&P or Moody's. However, I tend to believe that since the debt to capital ratio is well below the industry average and the company has adequate cash flow there is now imminent danger of the company filing for bankruptcy during the next economic downturn. But the low dividend yield does bother me, even with the exceptional average annual increases and industry average payout ratio. The problem here is that the company has not proven to be capable of expanding internationally in a sustained manner. While I like the metrics I believe I will pass on THI for now and wait to see how well received its concept is in international markets over the next few years. I would also like to see if the dividend increases can be sustained at these levels. This is more a qualitative judgment on my part. If you own THI you should hold the stock unless the fundamental reasons for which you bought the shares changes. More than 80% of the future annual average ROI will need to come from stock price appreciation. I prefer that ratio to be closer to 60% for income purposes.

Starbucks (NASDAQ:SBUX) is a nice growth story since the founder returned to right the ship. The company is appropriate for investors looking for growth with less concern for income. The future yield will likely be exceptional ten or more years from now for investors of today. My focus is more on current income. That said, the company has proven that it can expand internationally with great success and there is still significant potential for more of the same in the future.

My biggest problem with SBUX is how the stock fared during the Great Recession, falling 81%. The rebound took longer also. New highs were achieved in late 2011, nearly four years after the low of 2008. This is a stock I want to buy during the next recession. Shares are currently up more 1000% from the 2008 low. In times of record market highs and economic uncertainty, I believe I will wait a while longer to enter SBUX.

Metric

SBUX

Industry Average

Grade

Dividend Yield

1.3%

2.2%

Fail

Debt-to-Capital Ratio

9.0%

41.0%

Pass

Payout Ratio

38.0%

35.0%

Neutral

5-Yr Average Annual Dividend Increase

29.6%

N/A

Pass

Free Cash Flow/ share

$0.02

N/A

Pass

Net Profit Margin

11.3%

10.5%

Pass

5-Yr Average Annual Growth in EPS

42.8%

9.0%

Pass

Return on Total Assets

26.5%

16.0%

Pass

5-Yr Average Annual Growth in Revenue

25.7%

2.4%

Pass

S&P Credit Rating

A-

N/A

Pass

The forward P/E is currently at 30.6 and my expected future average P/E is 23. Unfortunately, this is a fail. SBUX does well by the metrics with eight passes two fails and one neutral rating. Total future ROI prospects are very good though. I estimate the five-year price will hit $120 providing an average annual ROI of about 8.8%.

I have included the metrics for Darden Restaurants (NYSE:DRI) because I would expect to be questioned if it were not included, especially because of the juicy yield. DRI, owner of The Red Lobster, The Olive Garden, Longhorn Steakhouse, Capital Grille, Yard House, Bahama Breeze, Seasons and Eddie V's restaurants, the company has a deadly combination of problems: high payout ratio, negative cash flow (by my stringent calculation), low net margins, slow EPS growth, and a high debt to capital ratio. This combination points to the likely potential of increased debt levels in the future by my reasoning. However, I do like eating at several of the company's venues and the nice dividend yield. Let's take a look at the metrics.

Metric

DRI

Industry Average

Grade

Dividend Yield

4.2%

2.2%

Pass

Debt-to-Capital Ratio

63.0%

41.0%

Fail

Payout Ratio

63.0%

35.0%

Fail

5-Yr Average Annual Dividend Increase

22.7%

N/A

Pass

Free Cash Flow/ share

($3.37)

N/A

Fail

Net Profit Margin

4.8%

10.5%

Fail

5-Yr Average Annual Growth in EPS

2.5%

9.0%

Fail

Return on Total Assets

10.1%

16.0%

Fail

5-Yr Average Annual Growth in Revenue

6.8%

2.4%

Pass

S&P Credit Rating

BBB-

N/A

Pass

The current forward P/E is about 16.3 while my expected average future P/E is 14. I like the food but the growth potential here is subpar, in my opinion. Only four passes and seven fails make this decision a no-brainer for me.

Cracker Barrel (NASDAQ:CBRL) and Bob Evans (NASDAQ:BOBE) did not make my list for multiple reasons. The biggest worry I find with each of these issues is a negative cash flow and lack of credit ratings. CBRL had a rating with Moody's until it was withdrawn by Moody's in 2011. That concerns me. Both have higher than average payout ratios and CBRL also has a relatively high debt to capital ratio. Both are trading at forward P/E levels much higher than my expected future average P/E. Finally, both have net margins that are less than half the industry average.

This concludes my review of the restaurant industry. 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!

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.

Source: Dividend Investors' Guide - Part XXVII - Let The Restaurant Industry Feed Your Portfolio (Cont'd)