The restaurant industry is a tough nut to crack. Consumer tastes can be fickle, competition is fierce, and profit margins are low. Plus, only a handful of restaurant stocks -- nearly all of them here in the U.S. -- have provided big gains for investors over the long-term. For the most part, small and upstart restaurant businesses struggle, or don't make it at all.
Nevertheless, every once in awhile a chain creates and maintains a loyal following and profitably expands. According to research from the Perry Group, restaurants that have been around for at least a decade are incredibly resilient. Although volatile and still at risk from negative industry trends, restaurant stocks that have stuck around for awhile are a solid bet on the growing global trend toward someone else doing the cooking. Five that are buys for 2020 (and beyond) are McDonald's (MCD -0.05%), Starbucks (SBUX 1.00%), Texas Roadhouse (TXRH -0.07%), Shake Shack (SHAK -0.45%), and Yum China (YUMC 1.15%).
Image source: Getty Images.
First, an update on the state of the restaurant industry
Consumer spending on eating out has steadily been on the rise ever since the financial crisis of 2008/09. In fact, according to the U.S. Census Bureau, money spent eating out is equal to that spent at grocery stores for the first time this year. That should mean a boon for restaurants.
But not so fast. The industry has been expanding faster than consumer demand can keep up with. That results in "cannibalism," when new stores steal traffic away from existing ones. That's bad news as lower traffic means lower comparable store sales (a combination of foot traffic and average guest ticket size), which in turn means lower profit margins for restaurants.
Plus, delivery services have been on the rise, hastened by the likes of GrubHub (GRUB) and Uber (UBER -2.03%) Eats. Paired with years of over-expansion within the restaurant industry itself, demand for delivery and other digital food ordering methods has meant already thin bottom-lines have gotten even thinner for many establishments. Simply put, though eating out is on the rise, not everyone has been a winner. According to industry researcher TDn2K, average store foot traffic has been in all-out decline for years and comparable store sales have been hit-or-miss at best.
Data source: TDn2K. Chart created by author.
After showing some initial signs of improvement in 2018 and early 2019, the comparable store sales ("comps" from here on out) problem is rearing its ugly head again and have turned slightly negative. Ufortunately, that jives with fear that the economy is headed for a serious slowdown -- maybe even a recession -- neither of which would be good news for consumer-sensitive food preparation businesses.
Five restaurant stocks to buy now
Nevertheless, with that industry backdrop in mind, some chains are besting the average. While it remains to be seen if a dreaded recessionary event actually transpires or not, bad news doesn't mean everyone will perform poorly. Even in a period of declining economic activity, some restaurants remain a stalwart pick, catering to value-conscious diners, picking up on new food trends, or just generally winning with new and innovative food experiences. McDonald's, Starbucks, Texas Roadhouse, Shake Shack, and Yum China may just be five of those establishments.
McDonald's, the king of the burger mountain
The iconic fast-food chain has been on a relentless rise, with shares doubling in value over the last five years. Even as the world's largest restaurant, McDonald's is still winning as it is a highly coveted experience in emerging markets in Eastern Europe, Asia, and Latin America. During the third quarter of 2019, for example, systemwide sales grew 5% year-over-year, with an 8.1% comparable sales increase for its "International Developmental Licensed" segment.
Even in developed markets including the U.S., though, McDonald's growth strategy has been working as of late. In Q3 2019, comps in the U.S. grew 4.8% -- far better than the average U.S. restaurant fared. In recent years, the strategy has revolved around refranchising stores to its partners (a higher profit and lower risk proposition than managing stores through corporate) and improving its menu mix with premium items that carry better profit margins. More recently, technology has become the pivot. Online ordering, delivery services, and order-ahead and pickup options have been getting promoted; even a technology acquisition was made to improve drive-thru menus and increase customer upsell via add-on suggestions.
But what about the "R" word? In case of a recession, McDonald's could be one of the best picks in the industry -- as it was a decade ago during the financial crisis. Food-at-a-value is still a powerful lever the golden arches can pull on, and the company's massive scale means it can play the price war game profitably. Plus, the stock yields a 2.6% a year dividend after a recent quarterly pay raise in the autumn of 2019. That payout will help soften the blow from a pullback in the stock.
McDonald's stock actually rose during the financial crisis in 2008/09. Data by YCharts.
In the meantime, a recent McDonald's stock drop after the firing of CEO Steve Easterbrook presents a buying opportunity. McDonald's trades for 25.4 times trailing 12-month earnings and 22.9 times 12-month forward earnings -- neither of which is value. Average one-year forward earnings per share for the S&P 500 (the 500 largest public companies in the U.S.) is 18.7. Wall Street is pricing in double-digit bottom-line increases in the year ahead, and thus the hamburger giant is going for a premium. But with top-line sales still going strong, it doesn't seem like a totally unreasonable price to pay given the world's largest restaurant's history of solid execution.
Starbucks' coffee empire keeps expanding
Much like McDonald's, Starbucks is also down from its recently set all-time high. Granted, shares were up over 50% in 2019 to-date through the summer months, overshooting actual business results; but the numbers have nonetheless been rolling in showing positive momentum here and abroad, so the coffee titan's double-digit pullback looks like an opportune time to make a purchase.
Already well-ingrained in coffee culture in the U.S. and many other developed markets, Starbucks has also turned to technology and menu innovation to drive results -- really, one of the pioneers of restaurant technology here in the states. Through its app and rewards program and a revolving list of seasonal specials and promotions, Starbucks in America had a stellar 2019. U.S. comps increased 5%, including a 6% surge during the fourth quarter.
Image source: Starbucks.
The other half of Starbucks' growth strategy lies across the Pacific in China. One might conclude that a slowing economy in the Middle Kingdom exacerbated by a trade war with the U.S. would be bad news for high-end coffees, but not so. Comps in China grew 4% in 2019 and international store count grew 11% driven by a mid-teens percentage increase in China. Trade war or not, the consumer in the world's second largest economy is doing just fine.
Starbucks management also issued ambitious goals for 2020: another 3% to 4% global comps growth, and another mid-teen percentage increase in stores in China. In total, the company expects to open about another 2,000 stores for a total of over 33,000 by the end of the 2020 fiscal year. That would further solidify Starbucks as the second-most valuable restaurant stock and continue to narrow the gap with leader McDonalds. Shares don't come cheap -- valued at 24.7 times one-year forward earnings -- but this is still a growth company with a 2% yielding dividend as an added bonus. This is a quality company worth buying and holding for the long-haul.
Texas Roadhouse's casual dining is a big hit
While the rest of the stocks here focus on fast-food and its healthier higher-end peer fast-casual (which combines elements of fast-food with sit-down service), Texas Roadhouse dwells in the casual dining full-service segment. As such, the Texas-themed steakhouse has had to manage sharp increases in state minimum wages that started to go in effect in late 2018. The pay increases have taken big bites out of the bottom-line this year, and the stock is down some 20% from all-time highs as a result.
Looking beyond the pay increases, though, Roadhouse remains a best-in-class restaurant operator. Even while average industry comparable sales and foot traffic have declined, the chain has maintained positive and consistent traction. Comps at company-operated stores grew 4.4% and franchised store comps grew 3.2% in Q3 2019 -- both handily topping the industry average. In fact, it's been posting positive comps growth for years. Paired with management's slow-and-steady approach to building new locations, total sales are up 10% through three-quarters of 2019. Not shabby at all for a restaurant operator with some 600 stores.
A bad start to the year for the bottom-line (primarily due to the wage hikes) is also moderating as Roadhouse finishes lapping the initial round of state-mandated minimum wage increases. Earnings surged 29% higher in Q3, a trend that should continue as pay increases begin to moderate over time. 2019-to-date, earnings per share are now up 4%. Along the way, the company continues to invest in the development of new stores and is still forecasting mid single-digit comps growth at existing ones. It's strategy of targeting suburban America and serving generous portions of food at a value is a dining proposition that is resonating with diners.
Image source: Texas Roadhouse.
In addition to its namesake brand, Texas Roadhouse is also early on in building out its new sports bar chain Bubba's 33. There are fewer than two dozen at the moment, but early results are promising. During Q3, the handful of stores had a comps increase of 8.8% -- so another eight will be built in 2020 to double-down on the success. The stock trades for 22.1 times one-year forward earnings, which could be a more than fair valuation if the double-digit earnings rebound continues. A 2% yielding dividend certainly doesn't hurt either.
Shake Shack and the better-burger boom keep advancing
We'll take a departure for a moment from well-established but still-growing chains and look at Shake Shack. The New York-based better burger, hot dog, and milkshake chain is nowhere near a sensible purchase point using profitability as a metric (12-month forward price to earnings values the stock at 98.9 times). Nevertheless, this one is all about the future as the fast-casual concept continues to expand at breakneck speed at the expense of bottom-line returns now.
Working off of its base of stores primarily based in the northeastern U.S., the average Shack does over $4 million of sales a year -- one of the best rates in the restaurant business, rivaling the runaway success of Chick-fil-A which also averages over $4 million a year per location -- and comps grew 2% in Q3. The company has been taking that success to cities throughout the rest of the U.S., as well as franchising Shacks to partners internationally. 11 domestic stores and six international ones were opened in Q3 alone, bringing the total count to over 250. However, as Shake Shack expands to new markets, some of its newer locations aren't as busy as the original ones in the northeast U.S.
That doesn't make the new stores a failure, though. Shack-level profit margin (restaurant sales less restaurant-level expenses) is expected to come in at 22% to 22.5% by year-end, a healthy rate for a busy and growing chain and more than enough room to provide a healthy bottom-line return someday when the chain's torrid growth moderates. Thus, after opening dozens of Shacks in 2019, management expects to cut ribbons for at least another 40 in the U.S. and 20 to 25 internationally in 2020.
I've been critical of Shake Shack in the past, but not because the business is doing poorly. In fact, though the burger business is crowded, Shake Shack continues to surprise with solid execution and exuberant crowds at its stores. My criticism has been primarily over the stock valuation, like after it more than doubled in less than a year's time through the summer of 2019. There has been a steep pullback since the Q3 report, though, bringing things closer to earth and resetting shares in-line with sales growth over the last few years. Now trading for 3.4 times 12-month sales (versus over 5 times sales over the summer), this fast-growing better burger company looks like it's worth nibbling on again.
Data by YCharts.
Yum China still thinks KFC has big potential in China
This last pick is also unique: It's the only non U.S.-based company on the list. Though it earns the lion's-share of revenue from Kentucky Fried Chicken, and to a lesser extent Pizza Hut stores, Yum China pays for the rights to those names from its former parent company Yum! Brands (YUM 1.22%). However, Yum China is the exclusive licensee of KFC, Pizza Hut, and Taco Bell in China, and incidentally is the largest restaurant operator in the country.
Image source: Yum China.
Like Starbucks and its reliance on the world's most populous nation for growth, one might think that China's sluggish economy the last couple of years would compromise Yum China. However, the middle class consumer is nonetheless still developing and spending on eating out is growing. To wit, Yum China's sales have increased 4% through the first three-quarters of 2019, and adjusted earnings per share have increased 15%. It isn't as robust a figure as in the recent past, but nevertheless solid figures from a massive chain that operates over 8,900 stores across China.
Over time, management thinks there is plenty of room to keep growing. Fried chicken is an incredibly popular food in the massive Chinese market. Thus, Yum China's long-term goal is to expand its base to 20,000 stores; but, if you're skeptical, it has more than just KFC and Pizza Hut at its disposal to do so. It also has Taco Bell (it only has three so far, located in Shanghai); it recently launched its own coffee shop brand COFFii & JOI early in 2019 to capitalize on China's growing interest in the beverage (tea still dwarfs coffee consumption, but that's quickly changing); and it also recently purchased a controlling interest in hot pot chain Huang Ji Huang that it will add to a handful of other small Chinese-based brands it already owns outright.
Ultimately, Yum China is really a bet on the rising prosperity of Chinese consumerism. And, in spite of economic weakness, that consumer is doing quite well. Shares are off recent highs by double-digits and trade for 21.9 times forward earnings. I think KFC will continue to do well in China, funding its licensee's expansion efforts with other home-grown brands. While the Chinese economy is still down, now looks like good buy timing.
Keep betting on the winners
The restaurant industry is a brutal one, and the declining foot traffic problem (as well as the recurring comparable sales problem) isn't showing signs of letting up anytime soon. Even still, there are restaurants that are beating the averages, and in a business where tight profit margins are the norm, that kind of momentum is important. Thus, these five stocks that have a good track record of executing on growth but off of their high-points look like good buys headed into 2020.
