Time to Buy a Value Meal?

Time to Buy a Value Meal?
Tags: Burger/Steak/BBQ, Food & Beverage
November 10, 2004

Provided By The Motley Fool Logo

As my Foolish colleagues unpack their lunches, including a bag from McDonald's (NYSE: MCD), and the sweet aroma of burgers and fries drifts my way, my thoughts turn to one of the biggest regrets I've had over the past couple of years: not buying McDonald's when it was thoroughly beaten-down a couple years back. It didn't take a genius to realize that a company with this much history of success would eventually figure things out, and when the turnaround came, it was richly rewarding. And you would have done even better had you bet some skin on Sonic's (Nasdaq: SONC) drive-ups and Yum! Brands' (NYSE: YUM) Taco Bell, Pizza Hut, and KFC. So after these run-ups, it's natural to wonder whether the good times are all in the past. Is there any value left at these big chains and peers such as Wendy's (NYSE: WEN) and CKE Restaurants (NYSE: CKR)?

After all, most of us drop more than a few bucks in these joints every year. We might as well see whether we can get a little something back for our trouble besides jiggly thighs, no?

A quick drive-through In order to orient ourselves in the fast-food neighborhood, it's helpful to take a look at the basics. McDonald's is obviously the sector's gorilla guy, with sales double its diversified peer Yum!, and nearly triple the market cap. What's surprising -- at least to me -- is that despite their big run-ups, the top two still trade at P/E ratios below their five-year averages. Well below. Fast-grower Sonic trades at a premium to earnings and well ahead of its usual valuation. CKE can't be judged on its P/E because, well, it simply doesn't have the E. A quick check of some other basic numbers explains why. We'll have fries with that Hungry for more? Adding a few items to our bag of assessment metrics yields a more interesting meal. As is so often the case, the answer to valuation is written in the margins. More important, to my mind, are the trends in the margins. They let you see who's spinning their wheels, who's doing better, and who's on a downhill run. Big fat loser Let's start by taking a look at the bargain bin. If you're not familiar with CKE's Hardee's and Carl's Jr., think of big food. The trademark Western Bacon Thickburger -- alone, with nothing else -- provides nearly half the calories that most adults require for an entire day. As a hyperactive lightweight who can easily pack away 3,500-4,000 calories a day, I don't mind these portions one bit. But I wonder whether they're in step with the healthy-lifestyle push we see at other fast food places. Even if you see the fitness fad at competing restaurants as mere window dressing, it at least keeps step with the times. The halfhearted Hardee's solution is simply to wrap a dripping, half-cow burger in a hunk of lettuce. But enough critiquing the menu; from an investment standpoint, CKE is much less filling than what it serves. Take a look at the table above and try not to think, "Dude, what the heck is up with CKE?" The firm's gross margins thump the bejeezus out of every one of its peers, yet it manages to snatch defeat from the jaws of victory year in and year out by turning that advantage into a consistently negative net. It hasn't delivered a profit since 1999. It now sits on $37 million in cash and $360 million in long-term debt. Still, every dog seems to have its day, or rather, year. There are plenty of strong buy ratings on the stock, and somehow, somebody seems to be listening to the analysts, because this stock has been a double over the past 12 months. On the other hand, it delivered about the same performance over the past five years. If you like contrarian plays, this may be the ultimate -- if you can set aside the fact that you'll be agreeing with Wall Street Wisdom. Betting that this perennial loser can eventually deliver will take a big dose of faith. I know I couldn't muster up the trust. McDonald's gets tastier The second chart goes a long way toward explaining the investor enthusiasm for Mickey D's. McDonald's net margins have improved markedly from a few years back, which is why we've been able to step back and say "Wow" so often after eyeballing the earnings reports. The firm's sales trends have also been positive, but nothing compared with the way they've been able to bag earnings. The 11% sales growth has translated into 64% at the bottom line and an incredible 148% increase in free cash flow (FCF) per share. Here's the best part:The team at the Golden Arches still has a long way to go to reach net margins in the range of the low- to mid-teens, levels that were routinely achieved in the late '90s. That suggests that gains in earnings and free cash flow can continue to outpace revenues for a while. Can Sonic go supersonic? Sonic is one of my favorite places to get some chow. I loved visiting its Missouri restaurants and would happily open my wallet if it'd just provide a few D.C.-area drive-ins -- hint, HINT. But it's tougher to make a decision on the stock. As a smaller player with a unique concept, it's possible -- at least theoretically -- for Sonic to grow more quickly than its behemoth competition. It has more open turf to exploit, and its niche gives it an edge on the competition. But while the firm's 20-ish-percent sales growth outpaces the big guys, its earnings growth can't match up. EPS growth stands around 19%. Why's that? Again, a peek at the margins tells the tale. The near-12% net is respectable, but it's pretty much a lock. The constant level means that earnings aren't being leveraged by greater efficiencies as the company grows. That's why Sonic looks a bit pricey to me at more than 3 times sales and nearly 30 times earnings. Wendy's under the weather My Foolish colleagues have reported on Wendy's woes over the past few quarters. Its top-line growth has been OK, but earnings have not seen the big jumps at peers like McDonald's. The slight decline in margins over the past few years is evidence that the firm just isn't getting the job done. Beef prices got the blame the last time around, but commodity gouging is something all these firms experience, and the rest of this crowd -- CKE excepted -- has held the line. Yum!? Let's call it "palatable" This diversified fast food empire has also outrun the market by significant margins over the past couple of years. Like McDonald's it's done things the old-fashioned way, increasing sales and earnings. Unlike the rest of the crowd, Yum! has joined McDonald's in managing to leverage earnings growth that's outpacing revenue growth. The firm's margins are still shy of McDonald's, but the steady improvement has been enough to boost FCF. Unfortunately, the firm's price-to-FCF ratio is still a bit high, near 40. That's more than double the figure at McDonald's, where FCF is growing more quickly. The bottom of the bag We come to the end, down with the loose salt, the grease stains, and the last cold fry-let. From where I now sit -- in the front seat with a Coke between my knees, mayo on my driving hand, a cell phone at my ear, and this laptop on the passenger seat -- McDonald's not only looks like the best value in the bunch; it looks like a bargain by any measure. It's gaining momentum, focused on increasing profitability even further, and if it ever sees a turnaround in its European operations, where sales have been sagging, it could really fly. You don't always get a second chance to get in on the turnaround of a major global brand, but with McDonald's, it looks like there's still time to benefit from the billions of happy customers.