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For One Of This Year's Hottest Industries, 2014 Could Be Much Tougher

Friday, December 20, 2013 - 8:30am

Despite an impression that too many investors focus only on quarterly results, most investors assess a stock's value on future trends. The notion that "the market looks ahead" is based on the idea that 2013 share prices reflect projected financial results in 2014 and 2015.

That's the only way you can explain the stunning gains for casual dining stocks. Recently, they've been continually setting new all-time highs, even as consumer confidence and spending remain in a funk.

According to Deutsche Bank, this group of stocks trades for 24 times 2014 profits. That's well above the five-year average of 18. "Our biggest concern heading into 2014 is that investors decide restaurant stocks are too expensive and seek out better values elsewhere," Deutsche Bank's analysts noted in a recent report. To my mind, such a rotation appears inevitable.

Better Days Ahead?
To be sure, restaurants are expected to benefit from falling agricultural prices. On an aggregated basis, these restaurant operators predict that their food costs will rise just 2% in 2014, which would be the lowest rate since 2010. "However, lower food inflation can be a double-edged sword to the extent this leads to heightened discounting," note the Deutsche analysts. Labor costs may also rise in 2014 as talks build around a hike in the minimum wage.

Analysts expect to see generally improving sales trends, thanks in large part to falling unemployment. The Deutsche analysts expected restaurants to generate 2.4% same-store sales growth next year, up from 1.7% in 2013. But that view may be too rosy. In his recently released Knapp-Track casual dining results, industry consultant Malcolm Knapp reported that same-store sales were down 1.5% in November, with guest counts down 3.1%.

"The return to negative comps in November is discouraging," note analysts at Merrill Lynch, adding that "we expect the compressed Christmas retail season (six fewer days between Thanksgiving and Christmas) to be challenging for restaurants, with consumers likely to allocate limited spending dollars to gifts as opposed to dining out." Whether these recent negative trends spread into 2014 remains an open question.

The Stretched Valuations
Trading above $500 a share, or roughly 40 times projected 2014 profits, Chipotle Mexican Grill (NYSE: CMG) would appear to the epitome of an overvalued restaurant stock. But any short sellers challenging this stock's rich valuation in the past has been trampled, and it's hard to keep panning what is a now-proven business model. This is truly an "own at any price" stock for some investors, and there's no need to fight that.

Analysts are now assuming that next year's falling chicken prices could mean a strong profit boost for Buffalo Wild Wings.

Buffalo Wild Wings (Nasdaq: BWLD) also trades for a lofty 30 times projected 2014 profits, in part because analysts are now assuming a strong profit boost next year from falling chicken prices. But the high multiple already bakes that factor in, and any reversal in chicken prices as we head toward 2015 might hammer this stock. Panera Bread (Nasdaq: PNRA), even after a recent pullback, still trades for 23 times projected 2014 profits, even though profits are expected to grow just 10% next year. (My colleague Dave Goodboy wasn't too high on Panera Bread in a recent column.)

I'm more focused on the steady-as-she-goes food chain operators such as Darden Restaurants (NYSE: DRI), which operates Red Lobster, Olive Garden, and the Capital Grille, among others, and Brinker's International (NYSE: EAT), which operates Chili's and other chains. These chains used to trade for 11to 12 times forward earnings in the face of very mature business models -- but suddenly, their 2014 multiples are above 15. That's not nosebleed territory, but shares are already reflecting the gains to come from falling food costs.

On Thursday, Darden announced weak quarterly results. To bolster sentiment, the company acceded to activist shareholders' demands to spin off the Red Lobster unit, but shares slumped 5% anyway. Though both Darden and Brinker continue to tinker with new dining concepts, with varying degrees of success, investors should realize that more nimble, focused restaurant operators such as Chipotle and Panera have shown a capability for far better execution. In other words, just because Darden and Brinker's multiples are lower, that doesn't make them bargains.

Perhaps the only clear value in the group is Yum Brands (NYSE: YUM), which is expected to see a solid 24% jump in EPS in 2014 (to around $3.60 a share), and trades for around 20 times that figure. In effect, this is the only stock in the group that doesn't have a PEG ratio (P/E ratio divided by earnings growth rate) above 1.0.

Yum also happens to be one of the few restaurant stocks (along with Del Frisco's Restaurant Group (Nasdaq: DFRG)) that Deutsche Bank is recommending right now. Those analysts see more than 20% upside for Yum Brands to their $90 price target.

Risks to Consider: As an upside risk, a sharp drop in the national unemployment rate in 2014 would lead to gains in consumer discretionary spending at restaurants and elsewhere.

Action to Take --> Even if these restaurant chains deliver solid results in 2014, the current valuations more than reflect that. Simply put, this has been a great sector rally that now looks tired. You should go elsewhere in search of value.

P.S. Investing doesn't have to be complicated. If you invest in simple businesses that dominate their industries, you stand to make a killing in the market over time. It works. In fact, the stocks in our latest report, "The Top 10 Stocks For 2014," have delivered a total return of 237% over the past five years following this simple strategy. To learn more about our top picks for 2014 --including several names and ticker symbols -- click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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