McDonald's eats Applebee's lunch

By Barron's

Seems like yesterday that America's burger chains looked like goners, their triple-deckers and secret sauces melting away in the glare of increased health-consciousness. But McDonald's and its ilk have defied the naysayers.

In fact, they've done so well at diversifying into chicken wraps, Asian sesame salads and other nonburger fare that they're now eating the lunch of the sit-down "casual dining" chains.

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The stock prices tell the story: McDonald's (MCD, news, msgs) stock is up 27% in the past year, and Jack in the Box (JBX, news, msgs) has climbed 67%, both on strong profits. Meanwhile, the shares of dining chains such as Landry's (LNY, news, msgs) and Ruby Tuesday (RI, news, msgs) have climbed far more modestly or even declined.

Earlier this month, the pressure grew so great for casual-dining icon Applebee's International (APPB, news, msgs) that the company said it would consider selling itself. Its shares, after rising just 5% in the previous 52 weeks, jumped 9% on the day of the announcement and have since edged higher, to about $27. A hedge fund led by former U.S. Securities and Exchange Commission Chairman Richard Breeden had been pushing Applebee's to make changes.

Applebee's travails -- its earnings plunged 21% last year -- epitomize the rift between sizzling burger companies and tepid casual-dining outfits.

"It's the biggest dichotomy we've seen in the 12 years I've been covering the industry," says Bank of America analyst Andrew Barish.

He calls it another case of middle-income Americans getting squeezed by high gas prices, rising interest rates and weak home prices.

Faced with spending five or six bucks per person for the new offerings of the burger chains, or twice that at the sit-down outfits, many families are happily forgoing the latter group's tablecloths and softer seats.

Bring home the bacon

Despite the sharp run-ups in burger shares, the giant of the group, McDonald's, may still have room to run. The golden arches have unmatched global scale and steady double-digit earnings growth. Operating profits were up 21% in 2006. The company's newly spruced up breakfast menu, including griddle cakes and premium coffee, could do its bit to help bring home the bacon.

Goldman Sachs (GS, news, msgs), for one, sees the stock, recently about $45, hitting $50 within the next 12 months. McDonald's shares have been changing hands at a reasonable 17 times earnings, below the multiples of most rivals.

McDonald's, like its traditional rivals at the burger counter, has been reaping the rewards of heavy investments in becoming more like casual dining: sharper service, more ambience, soups and salads, and umpteen kinds of chicken. As a result, same-store sales are on the rise at fast-food chains and declining in the casual trade.

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Still, the burger sector may already have seen its biggest stock gains. Burger King Holdings (BKC, news, msgs) is up 30% just since its initial public offering in May. In a sign of a possible top, early investors and other insiders last week carried out an add-on stock offering of 21 million shares, worth $462 million. Wendy's International (WEN, news, msgs), though up 22% in the past 52 weeks, has yet to prove itself as a sustainable turnaround play; earning are expected to fall about 10% this year, to $1.22 a share. But some investors do see value in Wendy's: Longleaf Partners Small Cap Fund has amassed a 3.5% stake.

Start flipping assets

In general, caution remains the watchword for casual-dining shares. Though the earnings of this group have been sagging, the stocks have yet to fall commensurately. In fact, many of the companies' price-earnings ratios are above the 17.1 of McDonalds, which has been posting some of its best profits ever.Analyst Barish thinks the casual-dining chains "in general would appear to have around 10% to 15% potential downside to reach more normalized valuation levels."

The best hope for the group may be more buyout activity. Ruby Tuesday could be the next to come under pressure, after sizable purchases of the stock by Capital Research and New York adviser Cramer, Rosenthal.

The burger sector certainly gained last year from moves like the spinoffs of Chipotle Mexican Grill and Tim Horton coffee shops from McDonalds and Wendy's, respectively. It now looks like time for the sit-down chains to take a cue from the burger world and start flipping assets.

This article was reported and written by Richard Phalon for Barron's.