How You Can Beat the Cyclicality in the Restaurant Industry

How You Can Beat the Cyclicality in the Restaurant Industry

After a weak 2012, the restaurant industry seems to be recuperating. Lower food-cost inflation, growing same-store sales (mainly on the back of extra value-for-price initiatives) and international expansion boosted the industry's prospects for the year.

Actually, the National Restaurant Association expects a 3.8% year-over-year increase in total restaurant sales to $660.5 billion this year. In this context, I will take a look at Tim Hortons , Yum! Brands and Darden Restaurants in order to evaluate whether or not they stand as good long-term investment opportunities.

Canadian value
Tim Hortons is the largest quick-service restaurant chain in Canada, with a market capitalization of $8.6 billion. Growth prospects for the company abound, not only in Canada but also in the U.S. and other international markets where the penetration potential is substantial.

In Canada, Tim Hortons benefits from its scale and its front-runner position in the industry. These features allow it to use leverage on suppliers, access superior retail real estate, and make hefty investments in advertising.

In the U.S., the restaurant chain faces two big problems: limited brand awareness and strong competition from Dunkin' Brands . However, a combination of quality and value should help it make a name for itself and allow it to successfully compete with Dunkin. Furthermore, with double the market capitalization, scale advantages still favor Tim Hortons.

Going forward, its franchise-based business model (approximately 99% of Tim Hortons' restaurants are operated by franchisees) will provide the company with the necessary cash and predictability to weather the cycles inherent in the industry.

The management has put in motion several initiatives to invigorate growth. These developments include changes in key managerial positions (including the designation of Marc Caira as president and CEO), and the incursion into some Middle Eastern markets like Kuwait, among others.

After experiencing a 3 week uptrend, Tim Hortons now trades at 22 times its earnings, a slight discount to the industry average. I should also highlight that Tim Hortons boasts a ROE of 35%, versus Starbucks' 28.7% and Dunkin' Brands' 23.2%.Moreover, Tim Hortons yields 1.8% of the current stock price in the form of dividends. With such a compelling value proposition, this is a stock to add to your long-term portfolio.

Yum! Brands is a yummy investment
Yum! Brands is a quick-food behemoth with more than $32 billion in market cap. As the owner of several category leading brands like KFC, Taco Bell and Pizza Hut, brand awareness is not a problem for Yum!. The fame of these names should help it expand into new markets and continue to establish its dominance in some of its main markets, especially in China.

In China, proven distribution infrastructure and local site development teams should make the expansion easier, according to Morningstar. In other mature markets, like the U.S., menu innovations and refranchising initiatives should lead to wider margins for the upcoming years.

Emerging economies also provide plenty of opportunities for expansion as urban populations, disposable incomes and young populations grow. Actually, analysts believe that 50,000 Yum! locations are possible by 2020, with major growth opportunities coming from India and Africa.

Yum! also enjoys of scale advantages, which help it bargain with suppliers, reducing costs considerably. Although margins are just respectable (good, but not great), returns on equity are astonishing. The company boasts a ROE of 65.4%, more than double the industry average.

Trading at 23.6 times its earnings, Yum! seems a little overvalued. However, compelling growth prospects, strong brand names and a 1.9% dividend yield make it an attractive long-term investment.

A recovering business
Darden Restaurants is the world's largest casual-dining restaurant as measured by market share, sales, and the number of company owned-and-operated restaurants. With a wide portfolio of recognized brands, including Red Lobster, Olive Garden, LongHorn Steakhouse, and several specialty restaurants, the company enjoys not only sales diversification but also substantial cost synergies.

Although the business has been quite slow during fiscal 2013, Darden´s fourth- quarter results show improvements in its same-store sales and revenue. This ameliorates the company's prospects going forward and makes it an investment worth considering.

In addition, a history rewarding shareholders (both through dividends and share repurchases) regardless of economic conditions and cycles adds incentives for long-term stockholders. Currently, the dividend yield stands at 4.44% of the stock price. This, added to the substantial discount to industry average valuations at which it trades, make of this stock one to buy and hold.

Going forward, management has made some decisions that should help enhance Darden´s financial standing, which has been quite unstable lately. One of the most encouraging initiatives, in my view, is that of reducing capital expenditures by more than 10% in fiscal 2014. Savings will be achieved through reduced core brand unit growth. In addition, some of the resources will be reallocated to improving the company´s competitive positioning, particularly in the specialty restaurant chains segment.

Bottom line
As the restaurant industry recoups, refranchising and revamping initiatives, menu innovations, cost control measures, an easing in inflation in the U.S., and an improving economy (globally) bode well for the restaurant chains analyzed above.

If I were to chose, I'd go for Yum!. Its international expansion opportunities and brand equity make it the safest and most appealing option. Poised to grow in emerging markets, and paying out dividends in the meantime, this is definitely a stock to add to your long-term portfolio. However, Tim Hortons also looks well positioned to grow (and certainly has space to do so), in spite of the fact that it's brand is not as recognized globally. Keep track of its developments and consider making space in your portfolio for this company as well.

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patricio kehoe has no position in any stocks mentioned. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Darden Restaurants and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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