Two Restaurant Penny Stocks for 2010

July 29, 2010By: Jonas ElmerrajiArticles RSS feedPrintPrint

The investment choices on Wall Street have been harder to come by lately - the massive rally of 2009 has left few bargains on the table right now, and with increased volatility adding fuel to the fire in 2010, it's painfully clear that the days of grossly undervalued companies are over. Here's a look at two restaurant penny stocks for 2010...

While stocks have overwhelmingly made up for the enormous losses they suffered in 2007 and 2008, investors have mistakenly overlooked the companies that were already offering good value in pre-bubble 2007. After all, while they may have bounced back to their 2007 levels, they're still far from reasonably priced. That's exactly the kind of opportunity we're going to be taking advantage of this month, with a familiar name.


Some of the biggest gains to be found come from highly competitive industries in which the smallest signs of weakness snap investors into sell mode. Take the restaurant industry, for instance...

The restaurant business can be one of the most profitable businesses out there - and the most unforgiving. With low barriers to entry, the restaurant industry is a sort of revolving door for would-be businessmen and their investors. In total, more than 60% of new restaurants close their doors permanently within a year, according to a study by Ohio State professor H.G. Parsa - and despite appearances, being backed by a big brand doesn't change things that much.

Only around 43% of franchise locations are around three years after serving their first plate...

Things have only been made worse in the last several years. With discretionary spending slashed across the board and unfavorable lease terms still in place in most cases, scores of dining establishments were forced to close their doors during the recession. And while 2009 brought more consumer cash into restaurant registers, hopes of a consistent recovery have started to wane in the last quarter.

So with such a bleak outlook, what kind of investment opportunity could we be looking at in restaurants? As is the case with most things Wall Street, things are rarely as they seem.

The competitive tenor of the restaurant business has only been accelerated in the recession, as investment dollars in once-attractive dining chains shifted into high-growth businesses like mid-cap Chipotle (NYSE:CMG), inflating its valuation to more than 6 times the industry average.

So, where's a small-cap investor to turn? Here's a glimpse at two small-cap restaurant stocks worth watching this year...

DineEquity (NYSE:DIN): While DineEquity has quite a bit of debt to deal with, investors shouldn't underestimate the power of its Applebee's and IHOP brands. With the largest casual dining and breakfast chains under its belt and generating substantial cash flows, the company should be able to slowly chip away at its financial obligations. That said, I wouldn't recommend getting into shares until DineEquity's fundamentals improve...

Brinker International (NYSE:EAT): On the other end of the spectrum is Brinker International, home to the Chili's, On the Border, and Maggiano's chains of restaurant brands, which trail only Applebee's in unit size. Unlike DineEquity, Brinker benefits from decent margins and relatively moderate debt.
A switch over to more franchises in its restaurant base should help the company grow its income in the coming quarters...

I'm not recommending that you get into either of these stocks right now (truth be told, I'm a much bigger fan of a third restaurant stock), but I think that they could emerge as attractive investments later on.

Until then, continue to keep an eye on their fundamental performance.

[Independence Note: Unlike scores of other penny stock resources, we're 100% independent from the companies we talk about in the Sleuth – that means that we never accept compensation in exchange for profiling a company, and our editors never own a position in any stocks they talk about.]

This article originally appeared on Penny Sleuth.

Jonas Elmerraji
Managing Editor, Penny Sleuth
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