SG - Tasty Value In Restaurant Stocks - Here Are 3 Picks For 2023

Summary

• We track the performance of restaurant industry stocks.
• Easing inflationary cost pressure can be positive for margins and earnings as a bullish catalyst for share prices.
• We highlight the themes to watch and share 3 stock picks.

The restaurant industry has been on something of a stomach-churning drive-thru over the past several years. From the pandemic lockdowns in 2020, it's been a difficult return to normal, facing challenges like headline-making worker shortages and inflationary cost pressures as a theme last year. Entering 2023, the uncertainties are now directed at the strength of the economy.

Still, we're highlighting the relatively solid performance of high-profile restaurant stocks with leaders like McDonald's Corp. ( MCD ), Starbucks Corp. ( SBUX ), Chipotle Mexican Grill, Inc. ( CMG ), and Restaurant Brands International Inc. ( QSR ) all generating a positive return over the past year.

People always need to eat, and that dynamic has helped to support restaurant traffic, representing a relatively defensive side of consumer spending. There is even some evidence that, in some cases, dining out may be more affordable than groceries at home amid stubborn inflation, which has worked as a tailwind for the quick service or fast food segment.

Overall, restaurants are a diverse group where we see several opportunities. Easing inflation cost pressures may be positive for restaurant margins and earnings going forward. Loosening labor market conditions allows the operations to be run more efficiently. The bullish case for the group also considers that the economic outlook can rebound, adding a boost to sales on the demand side, allowing the companies to outperform expectations.

Performance of Restaurant Stocks

From the table below, what stands out is the momentum from restaurant stocks in recent months. Just year-to-date, 50 of the largest restaurant stocks by market value have returned an average of 18%. It's also notable that consensus estimates indicate both earnings and sales growth in 2023 for most of the group.

Big winners over the past year include Yum China Holdings, Inc. ( YUMC ) and Luckin Coffee Inc. ( LKNCY ), each up 27% and 85%. The main factor at play there has been the end of China's "Zero-Covid" policies, marking a reopening of the economy. In this regard, both stocks have rallied based on an improving macro outlook in the region.

On the other side, laggards include a group of recent IPOs like Sweetgreen, Inc. ( SG ), down -66% over the past year, along with coffee-shop concept Dutch Bros Inc. ( BROS ) off -27%. In these cases, the sense is that the companies reached lofty valuations at their peak in 2021 that simply got ahead of themselves into the market euphoria at the time.

Generally, high-quality restaurant stocks with more consistent cash flows have outperformed. We can also point to some dividend ideas. QSR and Darden Restaurants, Inc. ( DRI ) both yield 3.2% supported by overall solid fundamentals. Cracker Barrel Old Country Store, Inc. ( CBRL ) is a stock we covered with a bullish article last year, reaching the conclusion that its 4.7% dividend yield remains attractive. From there, we offer some of our favorite picks in the group right now.

Domino's Pizza, Inc. ( DPZ )

Domino's Pizza is a beaten-down name, with shares off -20% over the past year and -36% from its all-time high. The company had a record 2021 on the heels of a pandemic boom with the wave of diners ordering takeout and delivery. Fast forward, as that demand surge waned, the challenge in 2022 was marked by both inflationary cost pressures which included record gasoline prices in the first half of the year creating a shortage of delivery drivers .

What we find now is that the selloff has largely reset valuations. DPZ is trading at a forward P/E of 25x, which is well below the 5-year average closer to 33x. The spread is similar in terms of its EV to EBITDA multiple. The bullish case here is that stabilizing operating conditions and financials through 2023 as margins get some relief can be positive for the stock. Favorably, gasoline prices have settled, and it's business as usual with the company gearing up for Super Bowl later this month.

We rate DPZ as a buy, with a price target of $480 taking its P/E multiple right back to the long-running average. The key is to recognize that Domino's is highly profitable and generates significant free cash flow through its franchisee model, adding to its quality justifying a market premium. An ongoing global expansion adds to the long-term attraction as the pizza category leader.

Arcos Dorados Holdings Inc. ( ARCO )

Arcos Dorados is the world's largest independent McDonald's franchisee, running more than 2,300 restaurants in 20 countries across Latin America. The stock was a big winner last year , and we see more upside in 2023. The attraction here is the company's strong growth in several markets that remain underpenetrated supported by the global brand recognition of those "Golden Arches".

While the Arcos faced several challenges over the past decade amid disappointing economic conditions in the region, the sense now is that the company is emerging stronger from the pandemic. Indeed, the last reported Q3 results were highlighted by impressive sales momentum and firming profitability. What stood out to us is the comment from management suggesting the group continues to gain market share .

The current market consensus is for revenues to climb by 5% in 2023 while EPS can accelerate above 22%, which is in the context of already strong 2022 comps. We see an upside to that forecast as margins improve on easing food input cost pressures through strong operating leverage.

What we like about the stock is that it captures several positive dynamics between its exposure to emerging markets and also the impact of a weakening U.S. Dollar, which has been the trend in recent months. At a forward P/E of 13x, ARCO is a buy in our book, targeting a breakout toward its highest level since 2017.

Cheesecake Factory Inc. ( CAKE )

Cheesecake Factory is famous for its extensive casual dining menu where you can choose from everything between tacos, burgers, Italian, fresh desserts, and more. For one reason or another, the stock is a heavily shorted name, implying short-sellers and bears are highly skeptical of its outlook.

The way we see it, that pessimism is unwarranted considering CAKE is both profitable and continues to generate growth while even offering a 2.1% dividend yield. Even as earnings were pressured in 2022, the consensus is for a sharp rebound as margins normalize.

The good news is that the stock is already up more than 40% from its lows in 2022, benefiting from those same dynamics of easing inflationary cost pressures and otherwise resilient same-store sales trends. Going back to our table above, it's notable that CAKE trading at a 13x forward earnings multiple is at a discount to the sector. In other words, we like the value of CAKE as a good option to capture exposure to high-level trends in the industry.

The scenario where economic conditions in the U.S. rebound going forward should be positive for its restaurant traffic and the bottom line. Looking at the stock price chart, a move in the near term above $40.00 could mark a technical breakout that is backed by solid fundamentals. From there, short-sellers rushing to cover their bets can add to the upside momentum into a classic short squeeze.

Final Thoughts

We hope the list above serves as a good starting point for further due diligence. We've been bullish on stocks and see the backdrop for equities as positive, but it's important to cover the key monitoring points.

In terms of risks, a deeper deterioration in the macro conditions would open the door for renewed volatility. We want to see consumer spending and the labor market remain at least stable as a core demand driver for the restaurant industry. Separately, a sharp resurgence of inflationary pressures and energy prices would force a reassessment of the bullish case for stocks.

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