With the success of fast-casual chains like Chipotle Mexican Grill, Inc. (NYSE:CMG), companies far and wide are trying to deal with the niche segment that sits between fast-food giants like Yum! Brands, Inc. (NYSE:YUM) and casual players like Darden Restaurants, Inc. (NYSE:DRI).
Fast casual tries to be the best of all worlds, with better quality than fast food and lower prices than casual dining. The star of the industry is Chipotle Mexican Grill, Inc. (NYSE:CMG), which has seen its top and bottom lines grow steadily since 2007, notably the start of the deep recession that lasted into 2009 and stalled growth at many a competitor.
The company’s sales have more than doubled since 2007, going from $1.1 billion to $2.7 billion. Earnings have advanced from about $2.15 a share to $8.75. A powerful combination of store openings and repeat business have been the driving force behind this explosive growth. The shares trade with a price to earnings ratio of around 44, however, so they are far from cheap.
Copycats
Still, fast food companies are working hard to compete. Yum! Brands, Inc. (NYSE:YUM) is one of the more aggressive ones in the space. It has already tried to spruce up its Taco Bell brand’s offerings. There it brought out the “Cantina” menu with higher quality fare, including a bowl dish that is a clear rip-off of a core Chipotle Mexican Grill, Inc. (NYSE:CMG) offering. More recently, the company has announced plans to test a higher-end KFC concept called KFC Eleven.
Yum! Brands, Inc. (NYSE:YUM) shares have been trading roughly sideways for about a year. That’s not surprising since it has been dealing with major chicken quality issues in China, a market that it has pegged as core to its long-term prospects and that made up about 40% of its profits last year. That said, investors seem to have looked past those problems despite what appears to be the start of an economic slowdown in the Asian giant, pushing the company’s shares generally higher since the middle of April.
That’s odd since sales have been lower quarter over quarter for the last three quarters and earnings have been lower for the last four quarters. That said, the company reports that KFC’s China business is starting to recover, which should help put a floor under the company’s results. And domestic results have been relatively strong.
With a P/E of around 24, however, the still recovering company is being afforded a premium of about five percentage points above its trailing five-year P/E. Trying to ape fast casual concepts won’t likely change the company’s fortunes enough to justify that premium.
In fact, even a return to growth in China probably isn’t enough, either. Investors should wait for this industry giant to pull back, noting that its efforts to test fast casual fare are nice to see but not transformational at this point.
Cutting prices
On the casual side of the business, Darden Restaurants, Inc. (NYSE:DRI) shares have been moribund since late 2010 as Olive Garden has hit a growth road block. Darden Restaurants, Inc. (NYSE:DRI) operates that brand, Red Lobster, and LongHorn Steakhouse, along with smaller, but generally upscale, concepts like Capital Grille. Olive Garden and Red Lobster, however, account for the lion’s share of its restaurants and its top and bottom lines.
The fast casual concept has been drawing customers away from these older brands. To combat this trend, Darden Restaurants, Inc. (NYSE:DRI) has been working on its value proposition, particularly at Olive Garden. It’s been dropping prices to get customers in the doors, willingly sacrificing margins to maintain market share.
And, despite the headwinds, this casual giant has managed to grow its top line in each of the last three years. Still, after a couple of years of growth, earnings fell last year, going from about $3.60 a share in 2011 to around $3.15. The profit margin falling from about 9% to around 7.5% was the main culprit. However, market share is top of mind at the management ranks, so this drop shouldn’t be a surprise and, more importantly, isn’t likely to reverse in the near term.
Although the shares trade with a P/E of about 16, around 3 points higher than its five year average, there’s still turnaround potential here. Fast casual restaurants are great, but the sector is quickly filling up and old standbys like Olive Garden and Red Lobster are likely to see their day in the sun again before too long. While waiting, income investors can collect Darden Restaurants, Inc. (NYSE:DRI)’s 4.5% dividend yield.
And, Darden Restaurants, Inc. (NYSE:DRI) is using its dominant brands to build its collection of smaller brands and to expand overseas. Both add a growth component to the company that weak sales at Olive Garden appear to be hiding. Darden isn’t a one-trick pony.
Watch out for fast movers
Yum! Brands, Inc. (NYSE:YUM) is kind of expensive today, but a good company to watch for a price dip. Darden appears to be a good value right now for long-term income investors. Chipotle Mexican Grill, Inc. (NYSE:CMG), meanwhile, might interest aggressive growth investors, but you will need to be prepared for a rocky ride. For example, the company’s shares fell around 40% in about six months in mid-2012. They have come roaring back since, but could easily see another big drop if results start to slow.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and Darden Restaurants. Reuben is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Dealing With the Fast Casual Threat originally appeared on Fool.com is written by Reuben Brewer.
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