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Darden Is a Leaner, Meaner Restaurant Stock Than Yum Brands

Inflation, reliance on China growth should worry YUM owners

According to the Department of Agriculture, 15% of Americans use food stamps. It’s such a large number that Yum Brands (NYSE:YUM) is lobbying for its restaurants to be permitted to accept food stamps. If you’re an investor in Yum Brands, this might seem like a huge opportunity because three states already have pilot programs under way. However, Yum Brands already is a major contributor to childhood and adult obesity. Accepting food stamps would only increase this.

This is just one reason why investors ought to ditch Yum Brands and buy Darden Restaurants (NYSE:DRI). Read on and I’ll explain some others:

China

China is a popular choice for many American companies looking for growth outside their own country’s borders. Yum Brands is opening stores there at an amazing rate, and business is strong. In the third quarter, YUM opened 138 units in China, and it expects to open 600 in 2011. At the end of Q3, it had 4,187 restaurants open in China with 83% under its KFC brand. Year to date, the China division’s same-store sales are up 17% on the top line and its operating profit YTD is up 20% on the bottom line.

It’s no wonder Yum Brands is pushing hard into China. Its U.S. segment saw operating profits and revenues decline 20% and 10%, respectively, in the first half of the year with little hope for near-term improvement. China must perform, because YUM’s stock isn’t cheap right now, trading at a forward P/E of 16 — almost identical to McDonald’s (NYSE:MCD) but with a smaller dividend. If China slows, the impact is much less severe for McDonald’s than for Yum Brands. Therefore, if you believe China’s growth is slowing or will do so, holding YUM stock carries too much risk compared to its potential return.

Inflation

China’s labor costs are rising substantially, as are its food costs. This will continue to put margin pressure on Yum Brands’ business there. During the past decade, while China has grown by double digits, its inflation rate has increased by just 2% annually. If growth continues, the inflation rate is expected to increase to between 3% and 5% annually.

Combine this with labor inflation of 20% for Yum Brands in the third quarter alone, and its low-prices initiative in China appears under pressure. It recently raised its prices by 2%; it will continue raising them until its costs catch up with inflation. That might not happen until the middle of 2012. By then, YUM’s booming revenue growth might be a fading memory if Chinese customers decide to eat at McDonald’s and elsewhere instead. If you’re fixated on quick-service restaurants, McDonald’s is a better play. However, for those investors willing to give full-service restaurants a look, Darden Restaurants is your best bet. Here’s why:

Specialty Retail

Darden’s three big brands — Olive Garden, Red Lobster and LongHorn Steakhouse — have 1,813 restaurants between them. In its first quarter ended Aug. 28, Red Lobster and LongHorn Steakhouse both had fantastic revenues growing same-store sales 10.7% and 4.8%, respectively. Olive Garden’s dropped 2.9%. It is the weak link in an otherwise strong lineup.

On Oct. 14, Darden announced it was paying $59 million for Eddie V’s Prime Seafood and the Wildfish Seafood Grille, two restaurant chains with 11 locations between them. It’s one more deal to beef up DRI’s specialty restaurant group that includes The Capital Grille, Bahama Breeze and Seasons 52. At the end of the first quarter, those three brands had 89 restaurants open, up from 77 at the end of the same quarter in 2010. Seasons 52, a once slow-growing brand, appears to be taking off. In the first quarter, the number of its restaurants open was 18, a 64% increase in one year.

Darden is building a strong bench that started with its acquisition of RARE Hospitality all the way back in 2007 for $1.4 billion. That deal added $1.1 billion in debt but brought with it LongHorn Steakhouse, the third leg of its mature brands segment, as well as The Capital Grille for its specialty restaurant segment. Its business is more diversified today than it was in 2007. One of the five specialty restaurants will step up and become the next Red Lobster or Olive Garden.

In the meantime, DRI also will focus on returning Olive Garden to positive same-store sales growth. Darden, like most restaurants, faces food cost increases that aren’t going away anytime soon. Fortunately, most of its restaurants are growing at a reasonable pace.

Bottom Line

Yum Brands’ enterprise value is 10.5 times EBITDA with a current dividend yield of 2.1% as of Oct. 24. Darden Restaurants, on the other hand, has an enterprise value of 7.6 times EBITDA with a dividend yield of 3.6%. An investment in Darden gives you a higher dividend payout, almost as much growth and not nearly the amount of risk.

As of this writing, Will Ashworth did not own a position in any of the aforementioned stocks.


Article printed from InvestorPlace Media, http://investorplace.com/2011/10/buy-darden-restaurants-dri-sell-yum-brands-restaurant-stock/.

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