Casual dining chains have not been left out of the current stock market rally, but their profits are likely to improve at least as much as their stock prices as the U.S. economy continues to recover. As the unemployment rate falls, foot traffic will likely pick up again — leading to higher earnings for these companies.
However, not all causal dining chains are equally appealing. Some stocks have run up higher than others, and some companies have brighter outlooks than others. One company, Darden Restaurants, Inc. (NYSE:DRI), is more attractive than its casual dining peers.
Outlasting the competition
Darden Restaurants, Inc. (NYSE:DRI) has an advantage over many of its peers due to its size. This allows it to spread out fixed costs across a larger number of units than its competition, which should lead to higher profit margins.
Upon closer inspection, however, Darden’s margins are in line with those of DineEquity Inc (NYSE:DIN) and Brinker International, Inc. (NYSE:EAT), despite Darden Restaurants, Inc. (NYSE:DRI) having a clear advantage in size. The reason that Brinker International, Inc. (NYSE:EAT) and DineEquity Inc (NYSE:DIN) are about as profitable as Darden is due to the nature of their operations.
Brinker International, Inc. (NYSE:EAT)owns the Chili’s restaurant chain. The Chili’s brand is ubiquitous in the casual dining industry, giving it an advantage over local competition. However, Chili’s does not have the same scale that Darden Restaurants, Inc. (NYSE:DRI) has with its numerous brands. Instead, Chili’s earns high margins by selling franchises.
Franchises allow Chili’s to expand without having to invest a significant amount of cash. This enables Brinker to invest in other brands and return capital to shareholders.
DineEquity, on the other hand, owns the number one casual breakfast chain in the United States — International House of Pancakes (IHOP). The company owns other well-known casual chains such as Applebee’s. Although Applebee’s has more locations than Chili’s, it earns lower returns on capital because it does not utilize a franchising strategy to the same extent as Chili’s. Therefore, DineEquity does not produce as much value for shareholders as Brinker.
Although Darden Restaurants, Inc. (NYSE:DRI) is not any more profitable than DineEquity Inc (NYSE:DIN) and Brinker, it has a much better future ahead of it than its peers. The company is investing heavily in its higher-priced brands like Eddie V’s, which earn higher margins and are not as sensitive to U.S. employment rates as casual chains like Chili’s and Applebee’s. The company’s portfolio of premium specialty chains should drive above-average growth going forward.
Despite the run-up in its share price over the last few months, Darden Restaurants, Inc. (NYSE:DRI) still trades at a reasonable 16 times earnings. This is lower than Brinker’s earnings multiple — 18 times earnings — and higher than DineEquity’s multiple — 12 times earnings.
DineEquity does not have nearly the same scale and reliability that Darden has, so it should trade at a lower multiple of earnings. Darden is closer to Brinker in terms of earnings stability.
In addition to being as reliable as Brinker, Darden has revenue-increasing and margin expansion opportunities that give it a slightly better outlook than Brinker. As a result, Darden Restaurants, Inc. (NYSE:DRI) should trade at least as high at Brinker on a trailing earnings basis, which makes it an interesting investment in a market where few undervalued stocks are available.
The article Time to Buy This Restaurant Chain originally appeared on Fool.com and is written by Ted Cooper.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.