Are These Restaurant Stocks Still Safe Picks?

 |  Includes: DRI, MCD, YUM
by: Winning Strategies

For the foodservice industry, forecasting what 2014 will look like remains a difficult exercise. While signs of this industry's growth environment remain encouraging, it is not yet bouncing back to prosperity as much as consumers and operators would like due to slow improvement in the economy. Further complicating matters are looming uncertainties about the employment situation, the U.S. government's debt ceiling and the effect the Affordable Care Act will have on restaurant operators.

Still, the economy remains the key issue. Based on AlixPartners' consumer survey, people are not dining out as much now as they did in early 2013, as dining rates dropped from an average of 5.8 meals/month in Q1 2013 to only 3.8 meals/month in Q3 2013. Consumers plan to dine out even less in the future, particularly at restaurants. However, Fast Food demand is rising with the increasing young population. Rising urbanization and a change in lifestyle trends and with increasing numbers of people working in office environments, consumers under time constraints are opting to eat outside, while price-conscious consumers are turning to fast-food options instead in cafés and restaurants.

Based on MarketLine, the fast food restaurants are increasing faster than the other restaurants on account of relative cost advantage and increasing young population. Consequently, fast food restaurants are expected to grow at CAGAR of 4% in 2014. On the other end, restaurants growth rate is coming down, from 2006 to 2010, its annual growth rate [CAGR] was at 3.7% which is expected to decrease further to 3% by the end of 2015. In this article, I pick three leading companies from the restaurant industry to see how well they appear to be heading out in front of these headwinds. These are McDonald's Corporation (NYSE:MCD), Darden Restaurants (NYSE:DRI) and YUM! Brands (NYSE:YUM). McDonald's and Yum Bands are primarily fast food restaurants while Darden is less. Let's dig into these companies to analyze either of these trends are impacting their financial situation, consequently, their returns for investors.

How McDonald's Is a Safe Investment

McDonald's Corporation franchises and operates McDonald's fast food restaurants in the food service industry, boasting 34,923 restaurants in 119 countries. Under its conventional franchise contract, franchisees provide a part of the capital required by investing in the signs, equipment, seating and décor for their restaurants. Revenues consist of sales by the company's own operated restaurants and fees from franchisees including rent, initial fees and royalties.

With this business model, its strategy to strengthen the alignment between the company and its franchisees and suppliers has been key to the success of McDonald's. Its business model permits McDonald's to deliver locally relevant restaurant experiences to customers. This further facilitates the company's ability to identify and implement innovative ideas to meet customers' changing needs and preferences, which the company has deemed a "Customer-Focused Plan to Win." This plan focuses on the five pillars of People, Products, Place, Price and Promotion. As per the plan, McDonald's is continually seeking to optimize its menu with convincing food and beverage offerings, modernizing and upgrading nearly all aspects of its restaurants from design to service, and broadening its accessibility.

In the overall testing environment, namely flat to declining informal eating out markets, the company has been able to generate 2% growth in the top line and its bottom line is high at 6%, representing strong cost management. In the face of the dynamics of the existing environment, with its heightened competitive activity and flat to declining informal eating out markets thinning the ability to raise menu prices, the company is further looking to decrease operating cost by 2%-3% in the coming days in order to enhance profitability. Nevertheless, the company has spent around $3 billion in growth opportunities to enhance its top line growth, including opening 1500 new restaurants.

Soft top line growth for McDonald's is impacting its cash generating potential to some extent. However, its current free cash flows are more than enough to cover its dividend payments. In the TTM, its dividend payments are only around $3 billion, while free cash flows are at $4.1 billion. Consequently, the company has recently increased its quarterly dividends by 4 cents to .81/share. With a payout ratio of 56%, its dividends look manageable. At the moment, its stock is trading at discount, at 17 times to earnings when the industry average is at 28 times to earnings.

How YUM! Brands is a Safe Investment

YUM has almost 40,000 fast food restaurants in around 130 countries operating primarily under the Pizza Hut, KFC and Taco Bell brands. These top three brands (Pizza Hut, KFC and Taco Bell) are the worldwide leaders in the quick-service pizza, chicken and Mexican-style food categories. Of their nearly 40,000 restaurants, 75% are operated by franchisees and unconsolidated affiliates, 20% are operated by the company, and 5% are operated by licensees. Yum Brands is operating under four reporting segments: YUM! China, YUM! Restaurants International, YUM! United States and YUM! Restaurants India.

Because the China Division, YRI and Taco Bell-U.S. represent close to 85% of its operating profits, the company's business strategy is focused on these regions. YUM Brands is looking to build leading brands in China in every significant category. With a growing economy and a population of around 1.3 billion, Yum China is rapidly adding KFC and Pizza Hut casual dining restaurants, combined with the additional restaurant concepts of Pizza Hut Home Service and East Dawning. Its recent acquisition of 66% interest in Little Sheep Group Ltd represents one more step towards building leading brands in China in every significant category. The company is also looking to drive aggressive international expansion and to build strong brands everywhere, including France, India, Germany, Russia and Africa.

With a higher-than-expected tax rate and slower-than-expected sales recovery at KFC China, the company is now expecting high-single to low-double-digit percentage decline in EPS for the full-year. However, even in the challenging current environment, KFC is undeniably the category leader in China, and its Pizza Hut business in China continues to generate strong results, while Taco Bell has produced seven consecutive quarters of positive same-store sales growth.

Soft growth in its top and bottom line over the past two quarters has impacted YUM's cash flows. Nevertheless, its free cash flows are still providing complete cover to divided payments. In the TTM, its free cash flows are standing at $909 million and dividend payments are at $602 million. Thus, its dividends look safe, as free cash flows are covering dividends with a payout ratio of 56% and projected 20% EPS growth in 2014.

How Darden Is Not a Safe Investment

Darden Restaurants is the world's largest full-service restaurant company. The company owns and operates above 2,100 restaurants, and its brands include: Red Lobster, LongHorn, Olive Garden, Seasons 52, The Capital Grille, Bahama Breeze, Eddie V's and Yard House. Darden has been facing volatility in sales and expects sales volatility as the slow and bumpy recovery in the economy persists. Recent changes in its two largest brands, Olive Garden and Red Lobster, have amplified volatility in sales. However, the company is working to improve affordability and to refine the guest experiences with the objective to regain same-restaurant traffic momentum.

To do this, the company has acquired 46 Yard House restaurants and 103 net new restaurant openings. Darden also undertook a comprehensive assessment of its operating support spending and identified significant spending reduction opportunities both in workforce reductions and program spending cuts. The company is seeking to save $25 million using cost saving initiatives by the end of 2014. Still, it expects EPS for fiscal 2014 to decline between 3% and 5% over fiscal 2013.

The sharp decline in both top and bottom line is affecting the company's cash generating potential. Its operating and free cash flows are decreasing compared to previous years. In the TTM, it has generated operating cash flows of $913 million and a free cash flow of $203 million. It free cash flows are not providing cover to dividend payments, as they stand at $266 million. With its latest figures, the company's dividend payments are set to further increase while the company is forecasting 3% to 5% decrease in EPS, which will further roll down cash flows. Its low price cash flow ratio of 7.5 also demonstrates this trend. At the moment, its payout ratio of 78% is manageable. However, with a recent dividend increase and projected downfall in earnings, its payout ratio will further rise. All these financial metrics are making Darden's dividends questionable. Consequently, I do not recommend Darden to conservative investors even though it is trading at attractive valuations.

Final Notes

The restaurant industry continues to face problems generating top line growth due to the depressed economic environment. However, some companies in the industry are taking initiatives such as investing in growth opportunities and cost cutting to enhance top line growth and margins. With their strong and diversified business models, and with the increasingly young population, rising urbanization, changes in lifestyle trends, and consumer time constraints, the price-conscious fast food restaurants operated by McDonald's and YUM! Brands make them look to be safe stocks. However, the poor financial situation of Darden Restaurants at present is not very inviting for conservative investors.

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.