In a market at all-time highs, finding stocks to buy can be a challenge. But at the moment restaurant stocks seem to provide an opportunity for value, which is somewhat of a surprise.
After all, the group tracks macroeconomic sentiment. All-time highs for broad market indices usually suggest the same for restaurant stocks.
This time around, that hasn’t been the case. In fact, most of the largest stocks in the industry are trading at a discount. Yum! Brands (NYSE:YUM), owner of Taco Bell, KFC, and Pizza Hut, tumbled after earnings and is down 15% from early September highs. Burger King owner Restaurant Brands International (NYSE:QSR) has fallen 18% over roughly the same period.
A huge run in Chipotle Mexican Grill (NYSE:CMG) has seen a reversal. From a near-term standpoint, Domino’s Pizza (NYSE:DPZ) has bucked the trend, rising off August lows, but DPZ still has declined about 10% over the last fourteen months.
Again, the sector-wide weakness is surprising. But there are pressures on restaurant stocks that could explain the pullback. Valuations in many large restaurant stocks became stretched. Competition is intense. So is discounting. Finding labor remains a challenge.
But those issues have been present for some time — and yet restaurant stocks only now are pulling back. And for investors who see the sell-off as overdone, three of the industry’s leaders look like attractive stocks to buy.
Over the past four years, McDonald’s (NYSE:MCD) has been one of the best large-cap stocks in the entire market.
Under now-former CEO Steve Easterbrook, who took over in 2015, the company has posted impressive growth. All day breakfast has been a driver for traffic and revenue. The company has “refranchised” company-owned restaurants, further limiting its exposure to rising wage and input costs. Simply put, this has become a better company, and as a result investors have rewarded MCD stock.
But a third-quarter earnings miss last month sent MCD stock down 5%. Recent results aside, there are concerns here. The refranchising opportunity largely has played out. Discounting across the industry remains intense, particularly in the U.S., which pressured margins in Q3. Some consumers still shun the company’s less-healthy products. Easterbrook’s firing over the weekend will likely weight on the stock as well. And even with a 12%-plus pullback from September highs, McDonald’s stock isn’t cheap.
That month I called out MCD stock as one of ten high-quality names with potentially questionable valuations. Even with the cheaper price, a 22.6x forward P/E multiple still is well above the company’s historical range.
That said, there’s a case to buy the dip here. Q3 earnings may have disappointed relative to expectations, but the results weren’t poor. Same-store sales still rose nearly 5% year-over-year. As a defensive stock, MCD stock provides safety against economic weakness, as consumers generally trade down to its offerings. The operational turnaround may be near an end, but there still should be some work left to do in improving profits and margins (with technology a key potential driver on that front).
Below $200, MCD stock still requires some faith. But there are worse investment decisions than owning one of the best restaurant operators in the world at a cheaper price.
There are a number of similarities between the case for MCD stock and that for Starbucks (NASDAQ:SBUX). Both companies are the leaders in their respective categories. Both stocks saw big breakouts after years of being dead money, with SBUX stock at one point doubling between mid-2018 and this year’s highs just shy of $100.
Meanwhile, SBUX stock and MCD stock each have pulled back in the last couple of months. And yet neither stock looks particularly cheap at the lower price. At $83, SBUX still trades at 27x fiscal 2021 (ending September) consensus earnings per share.
The trading in both stocks suggests that the pullback might not be an opportunity. Rather, the market simply has corrected valuations that were too high. Earlier this year I made a similar argument when Starbucks stock still traded around $70.
There’s also a case for focusing on quality over valuation. Starbucks continues to grow same-store sales. It has a massive opportunity in China, if it can fend off fast-growing domestic rival Luckin Coffee (NYSE:LK). Shareholder returns — both dividends and buybacks — should ramp going forward. Like McDonald’s, this is a quality business at a cheaper price, with the question being whether “cheaper” actually means “cheap.”
Darden Restaurants (DRI)
Thanks to a turnaround at its Olive Garden unit, Darden Restaurants (NYSE:DRI) actually has outperformed even the best restaurant stocks in recent years. In five years, DRI stock tripled.
Here, too, there has been an earnings-driven pullback. DRI stock fell 5% in September after a decent, if unspectacular, quarter. Like MCD, the 5% post-earnings loss is part of a roughly 12% decline from the highs.
That said, DRI stock is much cheaper than those of the leaders in other categories, at just 16.5x FY21 earnings estimates. But its placement in the casual dining space might explain that discount.
Higher check prices increase the group’s exposure to macroeconomic weakness. Fast casual competitors like Chipotle are taking share. And casual dining rivals like Brinker International (NYSE:EAT), operator of Chili’s, are discounting heavily, suggesting potential profit pressure going forward.
That said, DRI stock does look attractive on the dip. Valuation is reasonable. The company is the clear-cut leader in casual dining, with growth potential from secondary concepts like Capital Grille and Eddie V’s. A dividend yield over 3% provides income. For macro and restaurant bulls, DRI stock has a strong case.
As of this writing, Vince Martin has no positions in any securities mentioned.