2 top restaurant stocks to buy

Recent federal tax reforms in the US will have a positive effect on restaurateurs’ tax bills, says Jason West, lead Credit Suisse analyst for the US restaurant sector. He predicts that, on average, restaurants will enjoy a tax rate decrease of 10 per cent and picks the two global restaurant chain stocks he likes best to benefit from this.

Restaurant_StocksAsk analyst Jason West how he feels about the state of the food-service industry in 2018 and he would give you a mixed response, though notably, his greatest faith lies with franchisors. Mr. West, based in New York City, covers the restaurant industry for international investment bank Credit Suisse.

He says: “Overall, we would describe the sales backdrop for restaurants as ‘less bad’ but still not great, supported by low unemployment, rising incomes, and soaring consumer confidence.”

Speaking to the negative factors that restaurant stocks face, the analyst adds: “However, industry traffic remains broadly negative and January sales got off to a slow start. Labour inflation, a battle for market share, and reinvestment spending will likely continue to weigh on margins.

“A key question for 2018 will be the impact of lower tax bills on consumer spending. We should begin to see some evidence of this in February.”

The recent federal tax reforms in the US will also have a positive effect on restaurateurs’ tax bills, the analyst says. Credit Suisse predicts that on average, restaurants will enjoy a tax rate decrease of 10 per cent.

In light of the industry’s circumstances, Mr. West says: “If we were starting a restaurant chain today, we’d still prefer to be a franchisor rather than a restaurant operator given traffic challenges and rising labour costs.

“We remain most cautious on companies with exposure to US oversupply and labour inflation, with vulnerable margins.” The analyst cites Starbucks Corp. as an example of a company fitting that theme.

Restaurant Brands International HQ’d in Oakville, Ontario

Following the release of 2017 fourth-quarter numbers, the analyst touts a restaurant chain franchisor as his first ‘best buy’, Tim Hortons, Burger King and Popeyes Louisiana Kitchen parent company Restaurant Brands International Inc. (TSX—QSR; NYSE—QSR).

Mr. West points out that the company has underperformed compared to its peers in the last few months due to concerns about trends at Canadian Tim Hortons stores along with less exposure to the US tax reform.

He argues that the markets have paid too much attention to corporate valuations based on enterprise value (EV) divided by EBITDA (earnings before interest, taxes, depreciation and amortization), which he estimates to be about 17 times in 2018, driving Restaurant Brands’ diminished stock price.

Because of that focus, the markets have missed the company’s “key attributes” of a low tax rate and low capital spending.

“With roughly five per cent to six per cent global store growth and low single-digit same-store sales growth, QSR is one of the best growth stores in large-cap consumer,” says Mr. West.

From a cash flow-based valuation perspective, the company is “severely discounted relative to growth prospects”, he adds.

“Restaurant Brands’ cash flow is primarily driven by contractual franchisee store development commitments, with low sensitivity to same-store sales and operating costs.” To wit, when the Ontario minimum wage rose to $14 an hour in February, franchisees were responsible for making up the difference although their ability to raise menu prices, set by corporate headquarters, was limited. Credit Suisse assigns a target share price of US$71 to the company.

In the next one or two quarters, one potential driver for Restaurant Brands shares that Mr. West names includes possible price increases at Canadian Tim Hortons locations, thereby easing franchisee complaints and improving sales visibility. Risks it faces include a competitive environment, the possibility of higher interest rates, and foreign exchange rate hiccups.

Texas Roadhouse HQ’d in Louisville, Kentucky

Mr. West’s second ‘best buy’ is not a franchisor but a chain restaurant operator, Texas Roadhouse Inc. (NASDAQ—TXRH). Nevertheless, he praises the company’s high exposure to middle-income customers along with its opportunities to expand sales at existing locations. The analyst projects a unit growth rate of five per cent to six per cent.

As its name suggests, Texas Roadhouse operates about 450 western-themed steak restaurants. (Contrary to its name, the company is headquartered in Louisville, Kentucky.)

The company has restaurants in almost every US state, in addition to locations in Saudi Arabia, the United Arab Emirates, Qatar, Philippines, and Taiwan.

Mr. West says there is potential for Texas Roadhouse’s EV/EBITDA multiple to expand as the tax reform provides better visibility for 2018 discretionary spending. The reform could also spur higher unit growth in the longer-term for Texas Roadhouse, including at its emerging second brand, Bubba’s 33. Credit Suisse sets a target price of US$65 per share for Texas Roadhouse.

This is an edited version of an article that was originally published for subscribers in the March 23, 2018, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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