Eating out is big business. The share of spending Americans dedicate to buying food away from home surpassed grocery spending for the first time in 2010. The restaurant business has kept expanding and might even speed up over the next decade with the proliferation of home food delivery.
It's a brutally competitive industry, though, characterized by low profit margins and a high rate of failure among newly launched businesses. Those factors make investing in restaurant stocks a risky affair.
However, armed with the right knowledge and a long-term focus, you can earn solid long-term returns by investing in restaurant stocks. Below, we'll take a look at the important things to know before buying restaurant stocks. We'll also dive into a few attractive stock candidates that are good buys today.
Image source: Getty Images.
What is the restaurant industry?
The term "restaurant" covers a wide range of dining experiences that could include everything from a formal sit-down meal with table service to grabbing lunch at a nearby food truck. Yet the industry is broadly segmented into three camps: full-service dining, casual dining, and fast food. The overall industry has been growing quickly and is steadily soaking up a greater proportion of Americans' food spending.
Eating out is a discretionary purchase, though, and so it tends to rise and fall with broader economic moves. As incomes grow, people tend to dedicate more toward restaurant spending. The reverse occurs during recessions.
Restaurant stocks mainly make money in two ways: through markup on their food sales and through the fees and royalties charged in exchange for lending their branding, marketing, and logistics support to private entrepreneurs. These managers are called "franchisees," and many of the biggest restaurant chains, particularly in fast food, are run almost exclusively using a franchise model.
While the broader industry is growing, those gains haven't applied evenly to all niches. The fastest growth lately has come from casual dining specialists, which bring together value elements from fast food with quality aspects, like fresher food and pleasant ambiance, from the full-service world. Chipotle Mexican Grill (NYSE: CMG) was a pioneer of this approach, which allowed the Tex-Mex chain to post massive sales growth in the past decade. More recently, home delivery is catching on with consumers in a trend that promises to impact the industry in many ways going forward.
Many fast-food chains operate within a portfolio that's controlled by an umbrella corporation. Yum! Brands (NYSE: YUM), for example, includes Taco Bell, Pizza Hut, and KFC, while Restaurant Brands controls the Tim Hortons, Popeyes, and Burger King franchises. By pooling several brands together, these companies can operate more efficiently and spread risk out along more food niches.
The United States is the biggest market opportunity, but also the most developed, with many entrenched competitors in each neighborhood. China is the second biggest target among most global players, as a growing middle class could eventually push it to many times the size of the U.S.
Overall, the informal eating segment, the industry's biggest by far, rang up $1.3 trillion of sales in 2017. McDonald's is the single biggest operator in that global sandbox and was responsible for roughly 7% of those orders.
Many restaurant chains are private, and so investors can't directly benefit from their growth. These include chains like Subway, which have never been public, and eateries like Panera Bread, which took itself off of public markets in 2017.
What terms do restaurant investors need to know?
If you're investing in restaurant stocks, you'll need to be familiar with a few key operating terms and metrics, including:
Same-store sales: This metric describes the change in sales at an established location -- as opposed to growth that happens simply through the addition of more restaurants to the store footprint. Also referred to as "comparable-store sales" or "comps," the figure captures the health of a restaurant stock's business by combining customer traffic trends and pricing -- all when compared to the prior-year period.
For example, if a chain reports "same-store sales growth" of 3%, that means its established stores, on average, improved sales by 3% when compared to the same period a year earlier. A restaurant that can consistently show positive comps will improve its earnings power over time. A growth rate that exceeds the industry, meanwhile, implies market share gains.
Operating margin: This metric tells you how profitable a chain's restaurants are and can help you judge whether the business is growing stronger, weakening, or holding stable. It also lets you compare companies against each other. As is the case for most businesses, a high and growing operating margin is ideal since it suggests this restaurant company has a prime market position that rivals are finding hard to challenge.
Dividend yield: Most well-established restaurant stocks deliver a quarterly dividend, or a regular payout of a portion of profits directly to shareholders. The dividend yield is the annual return of that payout as a percentage of the share price. For example, a stock that pays $4 of dividends in a year and is priced at $80 per share would carry a yield of 5%.
Market capitalization: Restaurant stocks vary wildly in size, with market capitalization, or overall value, depending on factors like global store footprint and earnings power. McDonald's is the industry's largest player at well over $100 billion of market cap. Companies with more limited reach, like the food and entertainment specialist Dave & Buster's, command valuations closer to $10 billion.
What is a restaurant franchise stock?
The world of restaurant stocks can be segmented into two groups: businesses that franchise, and those that don't. The two financial setups create significant differences that investors should understand.
A company that chooses to franchise, like McDonald's, or Yum! Brands' Taco Bell, will give a local entrepreneur the use of its brand, along with valuable access to its supply network, operating know-how and marketing support. In exchange, the franchisee usually is responsible for paying real estate and start-up costs, along with a host of recurring fees and royalties.
This is an appealing way for a large business to operate for several reasons. It allows for quick growth, for example, since it's the franchisees who pay the bulk of the fixed costs for new restaurant openings. It also results in a steady stream of fee income which, unlike food sales, is highly profitable and less susceptible to swings in the broader economy. It's no wonder that most fast-food companies, including McDonald's, operate under this model.
Choosing not to franchise, meanwhile, gives a company greater control over how each individual store is run and how the brand is portrayed. It helps a restaurant make more aggressive pivots when needed, as was the case with Chipotle in recent years. The fact that the burrito and taco chain doesn't franchise its shops proved instrumental in management's ability to right the ship in 2018 following disastrous results over the preceding two years.
What are the trends driving restaurant growth?
Like most consumer-focused businesses, restaurants' sales are highly dependent on wider economic trends like the unemployment rate and growth in average wages.
The industry is also being impacted by specific trends as rivals battle for market share. Home delivery is one of the biggest today, since customers are increasingly looking to add convenience to their shopping by ordering online and skipping the checkout line.
Diners are increasingly opting for fresher ingredients and higher-quality preparation methods, too. That's why investors are likely to see more changes like McDonald's recent move to never-frozen beef in its Quarter Pounder sandwich.
Risks to investing in restaurant stocks
Restaurant stocks carry a few specific risks that don't apply to many other types of investments. Their businesses are highly dependent on economic growth, for one, and that reliance gets more pronounced as you move up the value ranking from fast food to casual dining to full service. That's not a reason to avoid the industry, but it does mean investors should be prepared to see volatile results over short time periods.
Image source: Getty Images.
Second, restaurant stocks operate in a highly competitive industry with few barriers to entry. It's relatively easy for a new rival, whether it's a local neighborhood pizza place or a well-funded challenger with national ambitions, to come along and disrupt established players.
In recent years, these upstarts have mainly included casual dining specialists like Chipotle, Shake Shack (NYSE: SHAK), and Panera.
Third, big restaurant chains deliver a product to thousands of consumers each day that, if improperly handled, could cause sickness or even death. That fact puts food safety at the top of investors' worry list. And it doesn't just mean a company must have all the right procedures in place at its restaurants. The restaurant has to ensure that its suppliers are all following the right processes, too. A string of mistakes here that results in virus outbreaks could seriously hamper a brand for years, as Chipotle learned in 2015 and the two painful years that followed for the business.
It may seem that food tastes rarely change. McDonald's, after all, just celebrated the 50-year anniversary of its Big Mac sandwich. However, consumer trends are constantly shifting, and companies that can't adjust will be left behind.
Leadership industry positions often keep fast-food chains in the spotlight, and any marketing slip-up or food-quality challenge can easily be amplified through social media. As a result, restaurants must maintain robust advertising and PR departments so that their brands remain in good standing with diners.
Mickey D's has had to completely revamp its menu in recent years by improving ingredient and preparation quality to better compete with fast-casual challengers. It also splurged on its largest acquisition in decades in buying a tech start-up to help it optimize marketing and sales as more spending shifts to its mobile app. Other chains, like Subway, haven't had as much success and their businesses have shrunk as a result.
Restaurant stocks are among the biggest employers in the U.S., and so they are sensitive to changes in the minimum wage. The chains are also subject to a wide range of federal and state laws around food safety, advertising, and nutrition, and efforts to regulate these areas are on the upswing.
Three stocks to consider buying
The good news for investors is that they have a wide range of choices when selecting restaurant stocks. These run the gamut from well-established global giants with steady businesses to upstarts aiming to build a national footprint.
You also have your pick up and down the value chain, with fast-food restaurants like Taco Bell, fast-casual places like Shake Shack, and full-service providers like Darden Restaurants (NYSE: DRI) or Cracker Barrel.
There are solid reasons why certain investors might prefer one of these companies. Yet three other companies stand out as more attractive purchases today.
McDonald's (NYSE: MCD)
Domino's Pizza (NYSE: DPZ)
Dave & Buster's (NASDAQ: PLAY)
Sales growth and profit margin are for the most recent complete fiscal year. Data source: Company financial filings.
Dave & Buster's is turning around
It posted a slight sales decline in fiscal 2018, but that slip shouldn't keep investors away from Dave & Buster's. The food and entertainment specialist is on track for a return to steady growth in 2019, after all, and recently notched its first comps increase as it won market share despite difficult selling conditions. The chain is finding success with its recent push into exclusive VR video game releases -- so much so that management has raised prices on titles like Jurassic World, Halo, and Dragonfrost VR.
CEO Brian Jenkins and his team are hoping that these wins, plus a revamped food menu, will help generate steady customer traffic growth in the years to come. But the more exciting reason to like this stock is the chain's growth potential.
It is expanding its store base at a record 14% annual rate these days, adding about 15 new locations per year. The latest crop of restaurants is running a bit smaller than Dave & Buster's previous launches, and this class is stressing entertainment options more than food. Those shifts have improved store economics and provide more room for the company to reach its long-term target of as many as 251 locations, up from around 110 today. Assuming growth holds up at its existing stores, Dave & Buster's has a good shot at perhaps doubling its current annual sales base of $1.3 billion.
McDonald's has the track record
McDonald's has dominated the fast-food landscape for decades, and that kind of impressive sales streak is exactly what shareholders need when they're aiming to turn a modest initial investment into a serious chunk of retirement income. Mickey D's has a host of competitive assets that just don't exist in most other investments -- let alone all wrapped up in one tasty package.
It has a truly global sales base, one of the world's most valuable brands, and a market position that allows it to profit from the sale of almost exclusively value-priced foods. McDonald's boasts market-leading profitability thanks to the premium fees it can charge franchisees. It also pays a steady dividend that cushions investor returns through those inevitable industry downturns.
But the best reason to like McDonald's is its resiliency. It wasn't long ago that the restaurant chain was losing ground to fast-casual rivals, but under the leadership of CEO Steve Easterbrook, it fought its way right back into the center of many fast-food fans' dining out habits. Comps were up 4.5% in the most recent fiscal year to mark just a modest slowdown from the prior year's 5.3% increase. That result trounced rivals like Shake Shack and Taco Bell, even though, like these chains, McDonald's still struggled with customer traffic losses in the key U.S. market.
As for the finances, you'll be hard-pressed to find a restaurant chain with more attractive numbers. McDonald's generated $7 billion of operating cash flow last year, its profit margin improved to 43% of sales from 39%, and return on invested capital, a key measure of efficiency, routinely passes 20%.
Shares today are selling for a high price-to-earnings multiple of 25 that reflects McDonald's many attractive characteristics. But investors who hold on to this stock are likely to see the company earn that premium valuation over time.
Domino's has room to run
Pizza is one of the simplest food products to assemble and cook. In fact, any restaurant with a hot oven and a few ingredients can put together a respectable pie and profit from its sale to a hungry customer. Yet despite that core branding challenge, Domino's, has built a formidable business around crafting pizzas and delivering them to homes and businesses around the world -- one that stock investors should consider owning for themselves.
This isn't your average restaurant chain. Domino's focuses on delivery and carryout orders rather than dine-in service. This approach reduces the burden of expenses like real estate, store upkeep, and staffing. It's a strategy that, combined with an almost fully franchised operating model, has allowed for phenomenal growth over the past few decades. An almost record launch year allowed Domino's to pass 5,900 locations in the U.S in 2018, up from 5,200 a year earlier. Globally, its network has risen to 15,900 from 9,000 a decade earlier.
Image source: Getty Images.
This growth has been well supported by robust demand. Domino's share of the U.S. pizza-delivery market was 31.1% at the end of 2018, compared to 24.7% five years earlier and 18.4% in 2008. In the most recent year, comps were up 7% in the U.S. and 5% internationally, which blew past rivals like Pizza Hut and Papa John's.
With most of its sales already occurring online, this company is well positioned to take advantage of the trend toward home delivery. Domino's sees its technological leadership, in addition to its diverse value-focused menu, as a key advantage it can lean on to continue mopping up market share. It faces significant challenges in that fight, to be sure. Domino's has already blanketed the U.S. with stores and its newest additions threaten to steal sales from established units. CEO Richard Allison and his team aren't worried about that so-called cannibalization since it ensures faster delivery time and a more defensible overall market position.
Another risk for investors to watch is debt. Domino's carries a significant burden -- over $3.5 billion at last count -- that the company uses to fund its aggressive global expansion. Those liabilities haven't pressured earnings much as sales shot higher in the last decade. However, a sharp or prolonged downturn might change that calculation for shareholders.
Still, few restaurant chains have as clear a path toward surging global store growth as this industry leader. If Domino's can extend its market-share streak while establishing a competitive lock on more neighborhoods in the U.S. and internationally, then its next 15 years of operating results could be just as impressive as its previous 10.
Start buying restaurant stocks
By focusing on proven industry winners like Domino's, Dave & Buster's, and McDonald's, investors have the best possible shot at securing sustainably strong financial returns by investing in restaurant stocks. That's not to say there's no room for disrupting businesses to elbow aside the established players, just as Chipotle did in the past decade. However, the companies that succeed over the next decade are likely to be the ones that deliver world-class value, quality, and convenience, both at physical locations and through digital ordering and delivery.
Investors can benefit from these successes, and from the broader trend toward more away-from-home eating, by adding a few restaurant stocks to their portfolios. Alternatively, they can choose to gain exposure to the wider industry by purchasing a restaurant-based ETF. In any case, there are plenty of ways to profit from the continued shift in eating habits toward more away-from-home dining.
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Demitrios Kalogeropoulos owns shares of Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool has the following options: short October 2019 $82 calls on Restaurant Brands International. The Motley Fool recommends Dave & Buster's Entertainment. The Motley Fool has a disclosure policy.