Fast Food: Take a Bite?

McDonald's and Yum! Brands look like tasty opportunities, an analyst says.

These days, diners are eating out less and choosing more budget-friendly restaurants on account of lofty gas prices and rising interest rates. While many casual dining chains such as Applebee's and Cheesecake Factory feel the pain, fast-food chains appear to be holding up, thanks to their lower prices and convenient locations.

Goldman Sachs analyst Steven Kron thinks two of the best investing opportunities in the restaurant sector are McDonald's (symbol MCD) and Yum! Brands (YUM). On Tuesday, he upgraded both stocks from "neutral to "buy," citing their wide geographic exposure, free cash flows and strong sales approaches.

Yum! Brands, the Louisville, Ky., parent company of fast-food chains Pizza Hut, Taco Bell and KFC, has had a good run since spinning off from PepsiCo in 1997. But the stock, currently $48, is down from its 52-week high of $53 in May. In a note to clients Tuesday, Kron said this recent sell-off signals an opportunity to build positions. Kron cited catalysts he believes will move the company's stock to $57 over the next 12 months. These include Yum's nearly $1 billion in free cash flow, which Kron believes should lead to a dividend increase before the end of 2006. (The present 60-cent dividend yields 1.3%.)

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Yum trades at 17 times the $2.83 per share that analysts think the company will earn in 2006, according to Thomson First Call. The company will announce second-quarter earnings on Wednesday.

As for McDonald's, Kron thinks shares of the world's largest hamburger operator are also poised for renewed growth. McDonald's stock hasn't moved much over the past year, but Kron believes it will take off in the second half of 2006. One reason: The company will likely return more cash to shareholders during 2006 and 2007, in the form of dividends and share buybacks, than the $5 billion to $6 billion it has already committed, Kron says. The present 67-cent dividend yields 2%.

On Monday, McDonald's stock jumped 5%, to $35, after the company said it would post higher-than-expected profits for the second quarter, due to strong breakfast sales and increased sales in Europe during its World Cup marketing extravaganza. The Oakbrook, Ill., company, which will make its earnings known next Tuesday, projected a second-quarter profit of 67 cents a share, compared with Wall Street's estimate of 56 cents per share.

McDonald's trades at 16 times the $2.21 per share that analysts expect the company to earn in 2006. Concludes Kron: "We believe the market is not currently rewarding McDonald's for its balance sheet strength, free cash flow flexibility, and fundamentals in both the U.S. and now in Europe." His 12-month price target for the stock is $41.

Staff Writer, Kiplinger's Personal Finance