Eateries looking tasty despite bite of high food costs

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Harsh weather and growing demand around the world are driving food prices into the stratosphere and putting pressure on restaurant owners large and small.

Since last July, the cost of staple ingredients has surged. Commodity prices for coffee, sugar, corn and wheat have each risen by more than 50 per cent.

But, in a surprising twist, restaurant stocks are doing just fine despite the rising costs. Some analysts believe restaurateurs could post double-digit returns this year as an improving North American economy, international expansion and new products boost their bottom lines.

Largest Dividend-Paying North American Restaurant Stocks

Keith Siegner, of Credit Suisse Securities LLC, calculates that modest gains in employment, combined with the recent tax cuts in the U.S., will more than compensate for commodity inflation. He thinks the sector will boost sales by an average of 6 per cent this year, which compares with the Street's estimate of 4-per-cent growth.

The difference could be enough to lift share prices by 10 per cent or more, he writes in a recent report, although he cautions that "a rising tide will lift some boats more than others."

Mr. Siegner lists his top picks as McDonald's Corp. , Texas Roadhouse Inc. and Starbucks Corp. He has set a 12-month price target on McDonald's of $87 (U.S.), a nearly 20-per-cent gain from its current level below $75.

"A $75 entry point is an opportunity to buy a stable multinational at near trough valuations when near-term expectations have come down," he writes.

In addition, the company's 3-per-cent dividend yield is "better than a bond investment in a low-interest rate environment."

McDonald's warned in January that its food costs will rise at least 2 per cent in the U.S. and 3.5 per cent or more in Europe, but it is expected to raise prices to compensate. Almost two-thirds of the analysts who follow the stock are bullish on it, in part because of the company's upgraded restaurants and new products, such as espresso drinks.

Texas Roadhouse, which specializes in steak and ribs, caters to a low-to-middle income demographic, which Mr. Siegner expects will show disproportionate gains in disposable income as the economy improves.

He recently increased his 12-month target for Texas Roadhouse to $21 a share, from $19, even after factoring in inflation of between 2 and 3 per cent for its key food ingredients. The new target is based on a price to earnings multiple of 20, which Mr. Siegner says is lower than other players in the casual dining segment.

Starbucks for Growth

Starbucks, meanwhile, "offers the best growth of the consumer multinationals, with the lowest capital requirement to get there," he says. Among the factors likely to drive the stock are its push into international markets, including China.

His 12-month $38 target price on Starbuck's stock is based on 21 times estimated earnings. That compares with an average of just 16 times for the shares of other consumer multinational companies. But he says Starbuck's annual return on invested capital of 10 per cent justifies the premium.

The company's forecast for second-quarter profit disappointed the Street after executives said last week that rising coffee prices will cut into profits. Chief financial officer Troy Alstead reassured analysts that the company has locked in some coffee prices to reduce risk this year. "These headwinds we face over the balance of 2011 may well become tailwinds in the future," he said.

Analysts are now evenly split among "buy" and "hold" camps on the stock.

Lukewarm on Tims

The sentiment is less positive about another purveyor of coffee, Tim Hortons Inc. Seventy per cent of analysts rate the stock a "hold."

The company had a banner year in 2010, but some now question whether the stock has got ahead of itself. RBC Dominion Securities Inc. analyst Irene Nattel recently downgraded her rating on the shares to "sector perform" from "outperform," citing valuation as a concern after the share price jumped 28 per cent last year. Tims shares now trade at 18 times forecasted earnings, a richer valuation than that of McDonald's, the industry benchmark, whose stock trades at 14.5 times expected earnings.

Ms. Nattel, who maintained her $45 price target on Tims stock, still sees plenty of growth potential for the company. She forecasts annual growth in earnings per share will be about 16 per cent, lifted in part by 4-per-cent growth in same-store sales and further share buybacks. Longer-term, international expansion beyond the U.S. could add an additional revenue stream, she said.

Not every analyst is so confident about the outlook for the sector. Just a few weeks ago, Bryan Elliott, of Raymond James and Associates Inc., was optimistic about prospects for small- and mid-cap restaurant companies given their modest stock valuations and improving consumer demand. But he has now lowered a number of investment ratings and estimates on some restaurant stocks, including Texas Roadhouse and Chipotle Mexican Grill Inc.

Food inflation is just one of his worries. Another is high gasoline prices, which he says could reduce the number of families travelling to restaurants.