Three fast-food stocks that make appetizing long-term investments

These companies look to grow through menu innovation, new practices and global expansion.

Vikram Barhat 15 March, 2017 | 5:00PM
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There's been plenty going on in the fast-food restaurant industry. As competitive pressures mount, the businesses are adding new ingredients to their growth plans to both remain profitable and retain market dominance.

From global expansion to strategic acquisition, and from periodic menu shuffles to tempting value deals, leading vendors are pulling out all the stops to stay ahead of the curve and head off challenges posed by economic uncertainty and fickle consumer preferences.

That the U.S. fast food restaurant market amassed US$203 billion in revenue in 2015 is a sign that the industry has proven itself to be resilient. By 2020, this figure is projected to reach US$224 billion, climbing higher year after year at a steady clip.

Fast food chains, countering sluggishness in their traditional markets, are looking to grow through menu innovation and adoption of new practices, and are spreading their global footprint to faster growing emerging markets.

Some of these companies are compelling growth stories with consistent annual revenue growth, expanding margins and strong cash flow generation, making them appetizing long-term investments, according to Morningstar equity research.

Starbucks Corp.
Ticker SBUX
Current yield 1.65%
Forward P/E 22.1
Price US$54.63
Fair value US$66
Data as of Mar. 13, 2017

 Starbucks Corp. (SBUX) is a global coffee chain with 25,700 stores that sell coffee, cold blended beverages, food and accessories. The firm also distributes packaged and single-serve coffee, tea, juice and pastries through its own stores and grocery store chains, and sells bottled beverages and ice creams through partnerships.

Starbucks recently announced a five-year growth plan that involves adding 12,000 new outlets globally by 2021. As part of the plan, the firm aims to grow revenue by 10%, earnings per share (EPS) by 15% to 20%, as well as mid-single-digit comparable-store growth each year. "Starbucks' international opportunities are undeniable--particularly in China, India, Japan and Brazil," says R.J. Hottovy, sector strategist at Morningstar, in a report, calling it much more than a retail story.

The firm, he adds, is just starting to scratch the surface of its long-term channel, brand and geographic growth potential. "We view Starbucks as one of the most compelling growth stories in the global consumer space today, poised for top-line growth and margin expansion through menu innovations, sustainable cost advantages and evolution into a diversified retail and consumer packaged goods platform," says Hottovy.

Many of Starbucks' competitive advantages extend to international markets, which Hottovy regards as "a critical growth engine over the next several decades." Morningstar forecasts average annual revenue growth of 9%, EPS growth in mid-teens, and operating margins around 24% over the next decade.

In addition, the wide-moat company can sustain a 40% to 45% dividend payout, with average annual dividend growth in mid-teens over the next 10 years, says Hottovy, who appraised the stock's worth at US$66, implying a 3% free cash flow yield and enterprise value/EBITDA of 15 times.

Yum Brands Inc.
Ticker YUM
Current yield 2.69%
Forward P/E 20.3
Price US$64.38
Fair value US$72
Data as of Mar. 13, 2017

With 43,600 restaurant locations,  Yum Brands (YUM) operates one of the largest networks of global quick-service restaurants including KFC, Pizza Hut and Taco Bell. The chain generated US$46 billion in system-wide sales during 2016 of which KFC accounted for 52%, Pizza Hut 27% and another 21% coming from Taco Bell. Yum cleaved into two publicly traded companies--Yum Brands and Yum China--in 2016.

Despite competition nipping at the fast-food giant's heels, it offers "one of the more compelling global consumer growth stories, even after the separation of Yum China as a trademark franchisee," says a Morningstar report.

The wide-moat business' solid competitive advantage is rooted in strong brand intangible assets in KFC, Pizza Hut and Taco Bell, as well as a scalable franchise model. "Yum possesses some of the most universally recognized brands in the quick-service restaurant category," says Hottovy.

The company has been pushing for average unit volume improvement, same-store sales growth and margin expansion across underperforming regions. It's doing so through greater stress on product customization, improved restaurant utilization, increased use of digital ordering, and by making the brands more relevant to millennials, says Hottovy, who recently raised the stock's fair value from US$65 to US$72, incorporating enterprise value/EBITDA of 16 times and a free cash flow yield of 3%.

Management's projection for 2017 includes sales growth of at least 5% and high-single-digit operating profit growth. This means the company will need to crank up top-line and margin growth in 2018-19 to attain its 2019 EPS target of US$3.75, says Hottovy, who forecasts core operating margins to grow from 26.2% in 2016 to the low- to mid-50s by 2021.

Restaurant Brands International Inc.
Ticker QSR
Current yield 1.19%
Forward P/E 37.7
Price US$54.76
Fair value US$59
Data as of Mar. 13, 2017

The third-largest quick service restaurant chain, created as a result of the consolidation of Burger King, Tim Hortons and, more recently, Popeyes Louisiana Kitchen,  Restaurant Brands International (QSR) generated US$27.9 billion in sales from 23,000 restaurants in 2016.

The company is backed by Brazilian investment firm 3G Capital, which owns a 51% stake and has a strong track record for cost-cutting and international expansion. "Under the stewardship of 3G Capital, which has helped to drive a meaningful improvement in franchisee relations and fundamentals across the Burger King system through a simplified menu and aggressive operating cost cuts, the entire RBI portfolio can accelerate their respective strategic plans while leveraging best practices," says a Morningstar equity report.

Hottovy, who recently upped the stock's fair value from US$52 to US$59, says Burger King's global reach, with a large network of franchisees in the United States, Latin America and Europe, will help boost the Tim Hortons and Popeyes brands internationally. "The combined RBI entity boasts some of the restaurant category's strongest profitability metrics," he adds, noting the consolidation with Burger King could deepen Tim Horton's and Popeyes' competitive advantage.

The recent addition of Popeyes to RBI's brand portfolio is of great strategic importance. "Popeyes Louisiana Kitchen fits the mould of what [RBI] looks for in an acquisition: heavy franchise ownership (97% of Popeyes restaurants are franchised), exposure to the fast-growing chicken category (which has ample global appeal), little overlap with existing RBI brands, improving U.S. average unit volumes, burgeoning international potential and cost reduction opportunities," says Hottovy.

The company, projects Morningstar, could have 37,000 restaurants around the world (23,700 Burger King, 7,800 Tim Hortons, and 5,800 Popeyes locations) over the next 10 years, implying 5% annual growth, and operating margin expansion from 40% in 2016 to the low-50s, gained by way of enhanced economies of scale in emerging markets.

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About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry. He also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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