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This Just In: Upgrades and Downgrades

By Rich Smith - Updated Apr 5, 2017 at 8:04PM

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Citi chows down on the restaurant sector.

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we'll be tracking the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

Citigroup ... hungry
Wall Street megabanker Citigroup got up with the sun this morning, showered, shaved, dressed, and headed right out to catch the early bird special at the NYSE House o' Restaurants. Grabbing a menu from the waitress, Citi then pulled out a red pen and proceeded to mark it up, like so:

  • Burger King (NYSE:BKC): Buy
  • Domino's Pizza (NYSE:DPZ): Hold
  • McDonald's (NYSE:MCD): Hold
  • Yum! Brands (NYSE:YUM): Hold

Let's go to the tape
In industry lingo, what happened this morning counts as an "initiation of coverage" because, as recently as yesterday, Citi did not cover these stocks.

But hold on a sec. Didn't I see Citi upgrade at least a couple of these stocks only last year? Why ... (checking the CAPS archives) yes it did! Seems Citi has been so busy following the fortunes of higher-profile wunderkinder like Monsanto (NYSE:MON) and PotashCorp (NYSE:POT) that the banker plumb forgot how, last year, it was quite active in following the restaurant sector:

Company

Citi Said:

CAPS Says:

Citi's Pick Beating (Lagging) S&P 500 by:

Wendy's (NYSE:WEN)

Outperform

**

15 points

Burger King

Outperform

**

24 points

Domino's

Outperform

**

(37 points)

Judging from the evidence, Citi got so distracted by sexier stocks that it dropped coverage of the restaurant sector entirely (at some point after the summer of '07) -- yet forgot to report the fact to Briefing.com. As a result, all those investors who took Citi at its word that Wendy's, Burger King, and Domino's were buys last year were left assuming that Citi was thinking the same thing -- up until this morning's "initiation" of coverage, at least.

No more
Now that it has finally deigned to update its advice for the investing public, it appears the banker has changed its mind in a big way. This year, only Burger King still makes the cut as a Citi buy recommendation. Why?

According to Citi:

Initiatives centered on menu innovation, remodels, and extended hours can continue to drive positive ... U.S. SSS [same-store sales] of 1% in F2Q [fiscal second quarter] ...We believe the current risk/reward is attractive for Burger King. The shares appear to be pricing in an earnings miss for the company. If Burger King were to simply meet consensus expectations in the near-term we would expect the multiple to expand.

Which, when you think about it, is actually a pretty crazy thing for Citi to be saying. Sure, in a recessionary environment, you'd expect more consumers to dine out on hamburger than on steak. That's a trend that could work to Burger King's benefit -- but it's a relative trend. Objectively, recessions tend to mean worse business for everybody.

Even if Burger King fares less badly than, say, Jean Claude's House of Steak and Caviar (Ticker: $$$$) this year, that doesn't mean that Burger King's going to do gangbusters business with a clientele suffering from pinched-wallet syndrome. Yet Citi thinks investors are going to ante up an expanded multiple if Burger King just meets expectations? Madness.

Foolish takeaway
Fact is, Burger King's multiple already stretches the definition of "fairly valued." The stock sells for a 15 P/E, with growth projected at 16% long-term, which looks all right -- until you turn to the cash flow statement. There you'll see that while Burger King reported $191 million in net earnings under generally accepted accounting principles over the past year, its free cash flow was a mere $68 million.

Because the company is trading for 40 times its cash profits on a mere 16% growth rate, I see little prospect for Citi's hoped-for multiple expansion at Burger King. To the contrary, I would expect to see multiples contract at BK, along with the rest of the market, as we muddle through this little recession. For that reason, I'm going to have to disagree with the analyst on this one. This is one stock where the burger in real life looks a whole lot smaller than the one in the advertisement.

Fool contributor Rich Smith does not own shares of any companies named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's ranked No. 836 out of more than 120,000 members. The Fool has a disclosure policy.

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Stocks Mentioned

Yum! Brands, Inc. Stock Quote
Yum! Brands, Inc.
YUM
$118.16 (0.38%) $0.45
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$262.18 (1.12%) $2.90
Domino's Pizza, Inc. Stock Quote
Domino's Pizza, Inc.
DPZ
$412.24 (2.01%) $8.11
The Wendy's Company Stock Quote
The Wendy's Company
WEN
$21.40 (0.52%) $0.11
Nutrien Stock Quote
Nutrien
POT
Monsanto Company Stock Quote
Monsanto Company
MON

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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