2 Tasty Restaurant Stocks Trading at a Discount

Dining out has gotten much more expensive. Between 2019 and 2024, restaurant prices increased 30%. Unsurprisingly, traffic has fallen off. That’s created a difficult environment for these companies, but Morningstar analysts say there are opportunities to be had for long-term investors. There are stocks with healthy margins and strong loyalty programs that can keep customers coming in the door—or drive-thru.

“All of a sudden, strong restaurant margins and unit economics are important again, with flagging sales momentum requiring restaurants to compete more aggressively on value to attract a shrinking pool of customer visits,” says Morningstar senior equity analyst Sean Dunlop. “In this environment, we like companies with strong loyalty programs that can attract traffic, a margin cushion that can help absorb sales headwinds, and durable cost advantages.”

Dunlop offers two top restaurant picks:

• McDonald’s MCD
• Papa John’s PZZA

McDonald’s, trading at a 14% discount to Morningstar’s fair value estimate of $292 per share, is Dunlop’s top pick. “Papa John’s is our second-favorite name for investors with a higher risk appetite. The latter trades at such a significant discount—35% below our $69 fair value estimate—that it has been increasingly floated as an acquisition target.”

Inflation Bites Into Restaurant Traffic

Restaurants are struggling mainly because of the post-pandemic inflation surge that began in 2022. Though inflation has declined, higher prices on the menu are having a lingering impact. Against this backdrop, with a shift toward cheaper grocery and convenience store options, “restaurants are still struggling to get guests through the door,” says Dunlop. “Industry traffic has declined for 24 sequential months, kicking off a value war in the United States,” and “margins are unlikely to recover until 2025 or 2026,″ as this value sensitivity promotes more discounting.

Median US same-store restaurant sales growth declined to 2.5% in the first quarter from 10.9% in the first quarter of 2023. Morningstar expects “lackluster growth” this year and in 2025.

But Dunlop notes that it’s not all bad news. He explains that falling food costs will help provide a floor for restaurant profits, wage inflation is trending downward, and consumers should start to see some relief from food inflation overall.

Traffic performance will separate the winners from the losers. Dunlop notes that “brands that have outperformed year-to-date have traffic share gains in common, with share price performance at Chipotle CMG and Wingstop WING materially outperforming proportionately struggling competitors like McDonald’s, Yum Brands YUM, and Wendy’s WEN.”

Dunlop points to Wendy’s and Yum as facing particularly challenging conditions. “Brands with weaker economic profiles have proportionately less firepower in the current environment and may see a larger proportion of their franchise base come under pressure,” he says. Those two stocks “stack up proportionately worse on this basis.”

Here’s a closer look at Dunlop’s top restaurant stock picks.

McDonald’s

• Fair Value Estimate: $292.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Wide
• Fair Value Uncertainty: Low

Dunlop offers the following highlights for McDonald’s:

• It’s the highest-quality restaurant company in our coverage and rarely trades at a discount.
• The MyMcDonald’s loyalty program should generate a roughly 2% annual lift to comparable store sales over the next half-decade.
• The firm is quietly returning to net store growth in the US, and it plans 10,000 store openings in 2023-27.
• The company is well-positioned to capitalize on critical digital technology trends, and its large real estate footprint in its system provides a unique lever for long-term margin expansion.
• In an industry set to grow increasingly top-heavy, McDonald’s offers a great long-term narrative, even if traffic trends soften for a couple of quarters.

Read more of Dunlop’s commentary here.

Papa John’s

• Fair Value Estimate: $69.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Narrow
• Fair Value Uncertainty: High

Dunlop has these observations on Papa John’s:

• The firm is cheap enough that it’s increasingly identified as an acquisition candidate.
• The “premium QSR” pizza chain is navigating a tough spell, with negative comparable store sales growth in the first quarter and projected for 2024 in its core US market.
• While the loss of CEO Rob Lynch is meaningful (particularly amid a handful of key changes), we believe the firm’s brand intangible asset remains intact and its prospects are broadly underappreciated.
• Papa John’s boasts healthy restaurant margins of over 20% and cash-on-cash returns of more than 20%. A recent emphasis on improving marketing efficiency, franchisee cash return on investment for new stores, and rolling out the best US operation innovations to international markets looks like the right playbook.

Read more of Dunlop’s coverage here.