Friday's Top Upgrades (and Downgrades)

Longbow Research ranks restaurateurs Texas Roadhouse, Buffalo Wild Wings, and Dunkin' Brands.

Feb 7, 2014 at 12:42PM

This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense and which ones investors should act on. Today, we'll be focusing on restaurant stocks, as analyst Longbow Research introduces new buy recommendations for both Texas Roadhouse (NASDAQ:TXRH) and Buffalo Wild Wings (NASDAQ:BWLD). On the other hand, this analyst warns that...

Dunkin' Donuts are stale
Might as well get the bad news out of the way first, and for shareholders of Dunkin' Brands (NASDAQ:DNKN), the bad news is this: Longbow Research hates your stock.

Yesterday, Dunkin' reported strong earnings of $0.39 per share, and noted that its pro forma earnings were $0.43 -- beating estimates by $0.03. The company raises its quarterly dividend by more than 20% (to $0.23 per share), and to put icing on the donut, promised investors $1.79 to $1.83 per share in profits for the current fiscal year -- ahead of estimates once again. So what's not to like?

Well, for one thing, there's the valuation. At nearly 36 times earnings today, Dunkin' Brands shares sell for a huge premium to the 15.5% profits growth they're projected to produce. The quality of the company's earnings is also questionable, given that Dunkin' generated only about $111 million in real free cash flow last year, but claimed to have "earned" $147 million in profits.

In fact, 2013 was the third year in a row that Dunkin' reported strong growth in GAAP profits, despite cash from operations declining, and capital expenditures growing. Historically a strong cash producer, in 2013, Dunkin' crossed the line to become just another one of those companies that generate less cash than it claims to be earning. Seems to me, Longbow has picked a good time to short it.

Little meat at Buffalo Wild Wings
And yet, if poor free cash flow is a reason to avoid Dunkin' Brands stock, you have to wonder about the stocks that Longbow likes: Buffalo Wild wings, for example. This morning, Longbow initiated coverage of the chicken wings hawker with a buy rating -- just days after Buffalo reported an outstanding fourth quarter highlighted by a $1.10-per-share profit that beat estimates by an even bigger margin than Dunkin' did.

Same-store sales at B-Wild franchise locations were up 3.1% in the fourth quarter, while company-owned restaurants scored an even more impressive 5.2% rise in same-store sales. CEO Sally Smith called 2013 "a great year for Buffalo Wild Wings," and predicts that 2014 will be even better, with earnings growing about 20%. In response, the company won buy ratings from not only Longbow but Miller Tabak as well (which says the stock will hit $148 within a year, just shy of Longbow's $165 prediction).

And yet, from a valuation perspective, Buffalo Wild shares are arguably an even worse deal than those of Dunkin' Donuts, the stock that Longbow panned. True, Buffalo Wild is growing faster (again, 20% growth projected) than Dunkin', but it pays its shareholders no dividend. Its shares sell for a P/E ratio near that of Dunkin' Brands, yet its free cash flow falls significantly short. Last year's $41 million free-cash-flow haul meant that Buffalo Wild was bringing in only about $0.57 for every $1 it reported in GAAP earnings.

At the resulting valuation of 60 times free cash flow, I'd be more inclined to sell it than to buy it.

Don't mess with Texas Roadhouse, either
Wrapping up Longbow's road trip of restaurant stock picks, we come finally to Texas Roadhouse -- like Buffalo Wild Wings, a buy according to the analyst.

At first glance, this stock seems to hold more promise for investors. For one thing, it pays the best dividend yield of the three discussed so far -- 2%. It carries the cheapest P/E as well, at just 22 times earnings. And Texas Roadhouse's projected growth rate is modest to the point of perhaps even being attainable -- 13%.

The problem with the stock, though, is that just like its peers, Texas Roadhouse simply costs more than it's worth. Twenty-two times earnings for a 13% grower is bad enough. But much like Buffalo Wild Wings, Texas Roadhouse has a problem with quality of earnings. Namely, its free-cash-flow tally of $61 million for the past 12 months backs up only about 79% of reported earnings ($77 million).

This works out to a price-to-free cash flow ratio of more than 27. While not as expensive as the other restaurant stocks, it's still not cheap enough to buy.

Rich Smith has no position in any stocks mentioned, and doesn't always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends Buffalo Wild Wings and Texas Roadhouse, and The Motley Fool owns shares of Buffalo Wild Wings. 


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