While top brands tend to dominate the publicly traded restaurant market, few are actually undervalued. Most trade at high multiples under the assumption of strong expansion yet competition remains intense with few barriers to entry. In my view, McDonald's (NYSE:MCD) and Yum Brands (NYSE:YUM) may be worth a small investment for stability and exposure, but I would hold out from investing in Dunkin' Brands (NASDAQ:DNKN). Below, I review the fundamentals of each company.
My main issue with the leading global burger restaurant chain is that growth forecasts do not offer a meaningful margin of safety. Analysts project 9.7% annual EPS growth over the next 5 years, which means 2016 EPS of around $7.94. At a 16x multiple, the company should have a future stock value of $127.04. Accordingly, there is 12%+ upside when you factor in dividend yields. Clearly, this is attractive for a stable brand. But, if you discount, the future stock projection back by 8%, the stock should be worth around $86.50 - nominally less than the current valuation. Accordingly, investors may want to balance the firm's great brand with generating higher risk-adjusted returns elsewhere.
The firm recently missed expectations in the second quarter. Challenges ahead, however and fortunately, mostly arise from macro trends and FX headwinds and not the weakening of a powerful brand. Consumer confidence has fallen while competition has increased. Pricing pressure is expected to at least continue into the near-term with global industry margins down 80 bps year-over-year - worse than expectations. European debt woes and spending from restaurant remodeling will add to the costs. To counter the challenges, McDonald's is preparing to increase media exposure and offer new products.
In terms of expansion, McDonald's has been below the average in unit growth. But the company still maintains superior cash flow and a leading 3%+ dividend yield, market share gains, and a sustainable brand. Greater attention over obesity in the United States will be offset by international growth. Accordingly, I recommend McDonald's for those looking for safety and exposure into restaurants.
This franchiser manages and operates Dunkin' Donuts and Baskin-Robbins. Despite recently going public, the firm's businesses have been around for more than half a century. I do not believe that the market has fully factored this into the stock price, as evidenced by the sky-high multiples of 59.1x and 20.8x on a past and forward-basis, respectively. Analysts even forecast 16.1% annual EPS growth over the next 5 years, but this appears to not justify the current valuation given the PEG ratio of 3.67.
Management has done well communicating the lack of risk in achieving 10-12% EBIT growth based on unit expansion. A greater advertising campaign in under-penetrated market coupled with new products and digital menu boards should help increase consumer demand. But consumers tend to be very unpredictable and the competition is intense. Management, however, has reduced uncertainty by expressing that it will increase debt for expansion and aim to buy back shares in 2H12. If $525M worth of debt is added in 2012, JPMorgan estimates that Dunkin' will repurchase approximately 40% of share sponsor holdings, which amount to 36.7M.
If you assume that the company will grow EPS by 16.1% annually over the next 5 years, 2016 EPS should come out to $2.27. A 15x multiple would imply a future stock value of $34.05 and a 10% discount rate would imply a present value of $21.14. At a $30.12 current stock price, I believe Dunkin' is overvalued and worthwhile mainly as a speculative growth investment. If future earnings power continues to be seen in 2016, the upside case may turn out to outweigh the downside case. But, at current multiples, I would opt for a stabler brand, like McDonald's.
Yum manages and operates several brands, including Pizza Hut, KFC, Taco Bell, and around 450 Chinese casual diners. This diversification and exposure to emerging markets render Yum a company worthy of a possible buy. It trades slightly high at a respective 20.9x and 17.8x past and forward earnings but growth forecasts are solid at 13.4% annually over the next 5 years. ROA, ROE, and ROI are all in the high double-digits and reflect a growing business.
During the second quarter, management released results that also proved to be much better than what some feared. Some are still anticipating headwinds in China, but I believe the story abroad has much more upside than downside potential. With rising incomes in China and an increasingly free market economy, consumer expenditures are likely to rise. Management has guided for mid single-digit same-store China sales in the 2H12. Confidence over margins, which held up better than the market feared, has kept shareholder value elevated. Going forward, the company should be mainly focused on increasing store count abroad to further saturate the market.
Lastly, I am optimistic about the company's path in re-franchising KFC and Pizza Hut stores this year while divesting underperforming Taco Bell stores. By switching the business to a lower cost and higher growth model, Yum will be able to keep multiples elevated. If poor returns from Taco Bell continue to overwhelm progress elsewhere, shareholders will likely switch toward safer peer McDonald's.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.