Tuesday's Top Upgrades (and Downgrades)

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines focus on the restaurant sector, where one analyst has just downgraded shares of Buffalo Wild Wings (NASDAQ: BWLD  ) , while a second analyst has initiated coverage on... just about everybody else. Let's dig right into the details, beginning with the new coverage.

Good (and not so good) eatin'
Tuesday was a big day for restaurant stock investors, as investment banker Stifel Nicolaus "initiated coverage" on everyone who is anyone (and a few companies who aren't anyone) in the casual dining segment. Panera, Ruby Tuesday, Brinker -- pretty much every restaurateur out there got a rating of some sort or other. Only a handful got actual buy ratings from Stifel, however. And as we're about to see, even those few didn't deserve the buy ratings...

Let's focus in on a couple of the higher-profile plays on eating out: Pizza Hut operator Yum! Brands (NYSE: YUM  ) and Cheesecake Factory (NASDAQ: CAKE  ) . Taking them one at a time...

Yum! Brands
According to the financial number-crunchers at finviz.com, Yum! sports a 23.4 P/E ratio. Finviz's assertion that Yum! costs nearly 66 times free cash flow, however, is a bit off. In actual fact, S&P Capital IQ data confirm that the stock's only trading for about 34 times its annual cash profits.

But even so -- that's a higher valuation than the P/E makes things seem. And given that Yum! only pays a 1.9% dividend yield, and is only expected to grow its earnings at about 11% annually over the next five years, any way you look at it, the price on this stock looks much, much higher than it should be to offer investors a decent chance at earning a profit from investing in it.

Long story short, I'm going to have to disagree with Stifel. Yum! Brands is fully as overpriced as I said it was earlier this month.

Cheesecake Factory
At first glance, Cheesecake Factory bears a similar valuation to Yum!'s. Its P/E is almost a mirror image of Yum!'s at 23.4 times earnings. The Factory has a couple of things working in its favor, however, that Yum! Brands lacks.

For one thing, it's generating more free cash flow than it reports as net income under GAAP, rather than less. $114 million in cash profits generated last year gives Cheesecake Factory a more palatable 20-times-FCF valuation on its stock.

Cheesecake Factory is also growing faster than Yum!, with an expected growth rate approaching 14%. And Cheesecake Factory has no net debt, versus the $1.5 billion more debt than cash on Yum!'s balance sheet.

All in all, I find Cheesecake Factory a tastier investing proposition than Yum!. It's still not cheap enough to entice me personally, but I like it a lot more than Stifel's Yum! pick.

Buffalo Wild Wings
Now, let's wrap up with the big restaurant downgrade of the day. R.W. Baird cut its rating on Buffalo Wild Wings one notch, to "neutral," this morning. It also clipped $7 off its targeted stock price, lowering that to $105. That's the good news. The bad news is that while Baird was right to downgrade, it didn't cut Buffalo Wild far enough.

Costing more than 34 times earnings today, Buffalo Wild is, on its face, too expensive for the 18% earnings growth estimates that Wall Street assigns it. With no dividend to redeem it, the shares are clearly overpriced.

Even worse than the lack of a dividend at Buffalo Wild, however, is the lack of any free cash flow whatsoever with which to pay a dividend. Over the past 12 months, this restaurant chain reported earning more than $55 million. But its cash flow statement clearly shows that the firm actually burned through more than $10 million in free cash flow.

Put another way, its business ate cash, rather than serving it up to shareholders. To my mind, that's no way to run a business. It's no way to run a restaurant, either. And it means Baird was right to downgrade this stock... and probably should have downgraded Buffalo Wild Wings even more steeply than it did.

Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Buffalo Wild Wings and Panera Bread.


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  • Report this Comment On July 19, 2013, at 11:46 AM, hwolfmuller wrote:

    Dear Mr. Smith:

    You need to do more research on what a true growth company is. Definitely off the mark for what The Fool usually publishes. You missed the point on so many counts it's not even worth identifying them all.

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