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Beat Cyclicality with These Restaurant Stocks
Posted by: Damian Illia (IP Logged)
Date: September 17, 2013 04:29PM

Although many investors choose to stay away from industries as cyclical as that of restaurants, a few companies offer brand names strong enough to make them safe bets. This seems to be the case with Yum! Brands (YUM) and Dunkin’ Brands Group (DNKN), two worldwide restaurant chain holding companies that hold compelling growth prospects for the years to come.

(Not Just) a China Growth Story

With approximately 38,000 restaurants worldwide, Yum! Brands is the largest restaurant company in the globe – as measured by system units. Holding category-leading brands like KFC, Pizza Hut and Taco Bell, brand equity is certainly not a concern. And neither is scale. With a market cap of more than $32 billion, its leverage over suppliers is not to be underestimated.

Although the negative publicity derived from the questionable quality of the chicken delivered to KFC in China in late 2012 and the bust of avian flu in mid-April impacted on Yum!´s s top line last quarter, the company still looks like an attractive investment. In fact, Mark Hillman (Hillman Capital Management), Manning & Napier Advisors, and Steven Cohen (SAC capital advisors), started a position in the firm not long ago. In addition, several other famed stockholders like Joel Greenblatt (Gotham Capital) and Louis Moore Bacon (Moore Capital Management, LP) also incremented their participation.

So, if these gurus are investing in Yum!, should you too? Well, trading at 23 times its trailing earnings, just around the industry average, while offering a 1.85% dividend yield and a 65.4% return on equity (more than double the industry mean), this looks like a stock to buy and hold.

Going forward, the company looks well positioned to grow, mainly on the back of international expansion. A strong presence in the Chinese and Indian market (and growing incidence in Africa and Russia), coupled with considerable marketing efforts and menu innovations, bode well for the firm´s future. Growing urban and young populations and an increasing disposable income in developing economies should lead to greater spending over the next few years. Morningstar analysts estimate that “with most of Yum!'s brands already successful in emerging markets, 50,000 Yum! locations are possible by 2020.” Furthermore, in China, Yum!´s established distribution chain and local site development teams fuel the company´s growth potential. Meanwhile, the firm’s U.S. segment is recuperating slowly but steadily, mainly due to menu innovations and refranchising initiatives.

Dunkin’ Brands Will Not Dunk Soon

Dunkin’ Brands Group owns, operates, and franchises quick-service restaurants –specialized in coffee, doughnuts and ice cream- around the world. With its stock experiencing an uptrend over the last few days and its dividends on the rise as well, is this a good time to chip in?

International and domestic expansion continues to fuel growth and cash flow generation. Recent news include the announcement of Dukin´ Donuts (the company´s most renowned brand) disembarking in the U.K. and the expansion in Texas. At both locations, the company signed agreements with two franchise groups (in each one), as it continues to build up its asset-light business model. By ameliorating franchisee´s cash-on-cash returns, the management can boost expansion rates and reach its goal of doubling Dunkin's U.S. store count to 15,000 locations over the next 20 years.

Improving franchisee returns and one of the strongest brands in the industry bode well for Dunkin’s expansion in the U.S., especially in the Southeast, Midwest, and West. These same characteristics should also drive expansion in overseas markets, pushing the top-line even further. Although Dunkin´s overseas locations outnumber those of Starbucks (SBUX), one of its main competitors, room for expansion is still much.

Despite the promising prospects and industry leading margins and growth story, Dunkin´s stock looks a little overvalued. Trading at 39 times its trailing earnings and 25 times its forward earnings, I´d say it would be best to wait for a more attractive entry point, even though Steven Cohen and Jim Simmons have increased their participation in the firm lately.

Bottom Line

Although both Yum! and Dunkin´ offer compelling growth prospects and plenty of expansion opportunities in overseas markets, Yum! looks like a more attractive investment in account of its reasonable valuation. I´d say buy and hold, you won´t regret it: Yum! will help you beat the cyclicality inherent to the restaurant industry.

Disclosure: Damian Illia holds no position in any stocks mentioned

Guru Discussed: Steven Cohen: Current Portfolio, Stock Picks
Joel Greenblatt: Current Portfolio, Stock Picks
Stocks Discussed: YUM, DNKN, SBUX,
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