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Restaurant Stocks: What's Cooking for Investors?

Valuations look full, as chains such as McDonald's realize turnaround efforts. But good deals are still on the menu.

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The restaurant sector had an interesting 2015.  Chipotle Mexican Grill (CMG) made headlines for all the wrong reasons when a few of its locations served food that made customers sick, leading to its shares getting battered.  McDonald's (MCD) picked a new CEO, who promptly got the fast-food behemoth into turnaround mode by rolling out an all-day breakfast menu option.  Yum Brands (YUM) announced plans to spin off its Chinese operations, moving the parent of KFC, Taco Bell, and Pizza Hut to a franchise-centric business model.

Investors brushed off the bad news with the good, focusing on potential versus past pitfalls. Indeed, valuations across the sector look full or outright rich. McDonald's shares rose almost 30% last year and now trade near Morningstar's fair value estimate. Shake Shack (SHAK), one of the year's hottest IPOs, saw its shares nearly double before cooling off last summer. Nevertheless, the shares still trade at roughly 100 times forward earnings.

To get a fresh perspective on the restaurant sector, we recently interviewed RJ Hottovy, who is a senior equity analyst with Morningstar and an expert on consumer stocks. His answers, below, have been edited for length and clarity.

Let's start with McDonald's, a stock probably owned by most of our readers. The company experienced a strong run in the 2000s, but more recently it has succumbed to increased competition and some self-inflicted wounds. What are your thoughts on the company?
Hottovy: The company is certainly in a better position than it was a year ago. It's doing a lot to remedy some of the self-inflicted wounds and position itself better to compete with rivals. That said, even though the company has struggled in recent years, we haven't wavered from the fact that it is a wide moat company. It's got a very expansive franchisee network. It's got a brand name that's widely recognized in just about every corner of the world. It's also got meaningful cost advantages.

As it starts to make a more pronounced turnaround, I think it is going to be an interesting stock to watch.

The company has a new CEO. What is he doing to get the company back on track?
Hottovy: The most interesting things that Steve Easterbrook has done since taking over are changing the organizational views about accountability and being more customer-centric. Those things give us conviction that a turnaround is possible.

Easterbrook reorganized the company into four segments based on the maturity and the competitive position of their markets, which has also led to rapid improvements in the level of communication and cohesion among executives, franchisees, and suppliers.

This has been most apparent in what the company's calling its international lead markets, which are Australia, Canada, France, Germany, and the United Kingdom. Innovations there are establishing a blueprint for more sustainable growth across the entire system.

For example, in France they've rolled out what they call the full restaurant model, which combines a number of different ordering technologies, whether it be kiosks or touchscreens, or just even at the counter. They've got a number of ways to customize burgers, chicken sandwiches, and salads. Then, there is also the in-restaurant experience, whether it be Wi-Fi, pickup at the counter, or table delivery. The full restaurant model has done really well in that market. It's a success that could be brought to the United States.

In the United States, what's important is that the company has decided that it's not a one-size-fits-all market. What works in Chicago may be different from the Northeast or the West Coast.

Then, there is the recent launch of the all-day breakfast platform. It's not necessarily the all-day breakfast platform doing well that's got me excited. It's the fact that they were able to roll that out from a test market to nationwide in just over six months. That's something that we hadn't seen under the previous management team, where it was a much more drawn-out process. Sometimes, we'd see products either delayed or outright canceled. That quick time frame gives me confidence that this can be a much more nimble company.

McDonald's has been advertising a lot on the all-day breakfast initiative. Do the early returns look positive?
Hottovy: First and foremost, it's created some positive buzz for this company. We hadn't seen that in some time. There's been a lot of negativity surrounding McDonald's for a while. For the first time in years, it feels like the company saw what its consumers were demanding and capitalized on it.

It's something that didn't require a whole lot of changes to the system. Certainly, they needed more products for the all-day breakfast rollout. But the people working in McDonald's know how to make these sandwiches. And it's not the full breakfast menu that's available. It's a pared-down version that's very easy for its workforce to put together.

To my point about the company recognizing the United States is not a one-size-fits-all market--there are regional differences within the all-day breakfast. So, while it's a nationwide launch, they allow for a level of customization, which I think is important to better address what consumers are looking for.

What about overseas?
Hottovy: That's probably the bulk of our free cash flow assumptions going forward. There's a lot of white space for the company to capitalize on. If I had to rank where I'd expect to see a lot of growth, I'd say that China remains a very big opportunity for them. That's one of the key markets where they lag behind Yum Brands.

Central and Eastern Europe is also a big opportunity for them. I think India will be a huge opportunity for them down the road. And if you look at Latin America and Africa, those areas could be longer-term opportunities as well.

So, we have a new leader and some innovation going on. Are shares fairly valued?
Hottovy: The markets recognize the turnaround. At this point, shares are fairly valued. It is an intriguing name for investors looking for a balance of growth and income. I still think there are some tremendous growth opportunities in international as the turnaround happens, and obviously the company does pay a pretty healthy dividend.

Can you explain the different segments of the restaurant industry?
Hottovy: Quick-service and casual dining restaurants are the traditional restaurant types--typically McDonald's, Burger King, KFC, or Taco Bell--where you place your order at a counter or drive-thru and get it at the counter or drive-thru. The average price point for that group is typically between $5 and $7 per order. They skew more toward lower- to middle-income consumers.

Casual dining is a little bit more upscale, such as Olive Gardens ( Darden (DRI)), Carrabba's (Bloomin Brands (BLMN)), and The Cheesecake Factory (CAKE). These chains have higher price points and better-quality products. Typically, you're going to be sitting down, ordering through a wait staff, and have the food delivered to your table.

Over the past decade, however, the real sweet spot in the restaurant industry has been what we call the fast-casual concept. This is the Chipotles and the  Paneras (PNRA) of the world, where you do have higher price points and better-quality ingredients than what you find at quick-service restaurants. Typically, the average price point is about $10--higher than quick-service restaurants but cheaper than casual dining.

It's easier and cheaper to operate these restaurants than it is casual dining. You don't need as much space and you don't have wait staff. Consumers are still ordering at the counter, but they are willing to pay up for it.

That's been the fastest-growing category within the restaurant industry, and I think they'll continue to grow. This group has done a great job catering to what consumers are looking for, whether it is new taste profiles, better-quality products, the ability to customize, or ordering through a mobile app. These firms are ahead of the curve on that end.

In a recent research paper, you focused on fast-casual chains and how they've done a really good job of catering to millennials and other demographic groups. Is it that millennials prefer healthy, organic menus, or is it convenience?
Hottovy: What consumers are looking for has changed quite a bit the last few years. In the restaurant industry, executives always heard that consumers wanted healthier items. But at the end of the day, when they made that final purchase decision, often they went for the more indulgent fare. The last three years we've seen a more sustainable, more pronounced, and more definitive movement toward consumers actually capitalizing on and ordering those healthier products.

What is the challenge for these chains when they offer customization on menu items? How does it affect their costs? If they're emphasizing locally sourced food, does it make it harder for a firm to control costs?
Hottovy: The cost angle comes more in configuring the workforce and the assembly line. A lot of the restaurant chains, especially the quick-service restaurant chains, are set up so that you put your order in, it goes through, and you get what you order. Putting in the capabilities to make customizable orders--that is a large cost component.

If you do offer better-for-you products or locally sourced products, those are obviously more expensive to get, even for the companies that do have a lot of bargaining power, such as McDonald's. It's a cost element for sure, but typically what you're going to see is higher prices on those products. It gives those restaurant companies the ability to charge premium prices for those products. That's typically how they make it more manageable without a direct hit to profitability.

Earlier in 2015, you warned about a possible bubble in the restaurant space due to some valuations looking pricey. Do you still have those concerns?
Hottovy: Valuations have come down a bit. But you have to take each restaurant chain in isolation. A lot of the quick-service guys--and some of the fast-casual players--have reached a point of being much more attractive. It still looks like a lofty multiple on strictly a P/E basis. You are still talking about a group that's trading at 24 times earnings, which is above what we've seen across the broader consumer space.

That said, the restaurant space is an interesting group, particularly when you compare the broader restaurant and retail space, just because you don't have that one category killer like an  Amazon (AMZN) that's stunting all the growth. A lot of the restaurant concepts do warrant a premium valuation.

You have to be careful of stretch valuations, such as Shake Shack, which is still north of 100 times earnings. I think that's an interesting growth concept. But when the bandwagon gets too full, that's when it gets the most dangerous. These stocks can have meteoric rises, but can fall just as quickly, too.

In terms of your coverage list, you like Panera Bread and Yum Brands.
Hottovy: Panera Bread is doing a few interesting things. It is undergoing a major upgrade on the technology side. That includes putting in mobile ordering kiosks and handheld order taking--just making it a lot simpler for consumers to order.

One of the underappreciated aspects of its story is catering. What they're doing is tacking on a couple thousand square feet to either existing restaurants or a standalone location where they can do a large catering and delivery business. This is something that can end up being a multibillion-dollar revenue stream for the company.

The company's also going to be putting more locations in the hands of its franchisees. Typically, that makes for a lot more financial stability and a lot less capital required on the part of the company.

Those all add up to being very key drivers for this company going forward.

What about Yum Brands?
Hottovy: The decision to spin off Yum China--it will effectively become a franchisee of Yum Brands--will mean that the company will be almost 96% franchised. That will make for a stable and a more diversified operating income stream. Previously, China represented between 30% to 40% of the operating income. By going to this structure, income will be closer to 16%.

The interesting aspect is you create two companies. One is a global company with a very income-focused bent to it. At the same time, you still have exposure to Yum China, which is going to be one of the more compelling growth stories in the space. Even though it is the leading restaurant chain in terms of number of units and sales in China, there's still a lot of room for it to grow. Right now, it has about 7,000 units. It could be a 20,000-unit chain over time.

Fair value right now is $92. It's a 4-star stock.

Any other restaurant stocks worth mentioning?
Hottovy: Chipotle is an interesting story right now, because the company is under fire for two incidents: an E. coli outbreak in a couple of its restaurants in the Pacific Northwest and a norovirus outbreak in a Boston location. Those events called into question the quality of its supply chain and its food, especially when so much of its brand is tied to the food-with-integrity mantra. It is going to be an interesting story in 2016. We've seen sales under pressure, and I think they'll continue to be into early 2016.

Typically, consumers forgive and forget after a period of time. After six to nine months you're going to start to see a pretty big bounceback in sales, as consumers become more aware of what the company's been doing on the product safety side. Chipotle is also getting into the delivery and catering business. It is aggressively taking advantage of second assembly lines in their restaurants.

Additionally, it is starting to build a portfolio of other brands, such as ShopHouse Kitchen, which is an Asian-themed concept, and Pizzeria Locale, which is a fast casual pizza chain. You'll start to see more emphasis on these brands going forward. That'll get people excited about the growth potential there.

Food safety is one obvious risk to the restaurant sector. What are some other risks investors should keep in mind?
Hottovy: Labor costs. We've seen a lot of minimum wage increases kick in across a number of markets. You're going to start to see--particularly for those chains that are more company-owned locations as opposed to more franchised--labor cost become a bigger issue.

For those who have a more franchise concept, higher labor costs is something they can withstand because they take a percentage of the sales from that restaurant, not a percentage of the operating income. The franchisees are on the hook for the increased labor costs. That being said, you'll probably see some menu prices increase to offset those labor costs.

If you look broadly, valuation does become a concern. We do still have pockets of names where the market's bidding them up, just because there's this idea that there's a lot of growth ahead. A lot of times there is, just because we don't have a ton of growth concepts in the consumer cyclical space anymore. But be wary of those names with lofty multiples. Are they really appropriate for a company that is in a very competitive space with low barriers to entry?

This article originally appeared in the February/March 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.

Rob Wherry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.