Forget McDonald's, Here's a Better Restaurant Stock to Buy

By Markets Fool.com

Investors who bought McDonald's Corp. stock at any time over the past two years are likely disappointed with the company's poor performance. The fast-food giant's stock fell 3% in that time, while the S&P 500 rose 33%. McDonald's underperformance might cast a negative light on the restaurant industry as a whole, but lesser-known restaurant stocks have offered greater rewards.

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DineEquity might fly under your radar, but the stock is up 46% in the past two years -- beating the market and absolutely trouncing McDonald's.

DineEquity, operator of the IHOP and Applebee's chains, has much to offer all types of investors. The company is growing far faster than McDonald's, thanks largely to its aggressive refranchising strategy. This has resulted in stronger dividend growth than McDonald's as well, which should attract income investors.

Key growth strategies
DineEquity operates 3,600 restaurants, and the stock holds just a $2 billion market capitalization. By comparison, McDonald's has almost 10 times as many restaurants and a market cap over $90 billion. But don't let its small size fool you: According to the company, IHOP and Applebee's have held No. 1 positions in their respective categories for seven consecutive years.

The company has also significantly transformed its operating model in recent years, through an aggressive refranchising campaign to improve its balance sheet and earnings growth. The rationale made sense, since the franchise model lucratively passes most maintenance and renovation costs to the franchisee. For example, DineEquity cut its general and administrative costs by 24% from 2007-2014, while capital expenditures fell by 81% from 2008-2014. In addition, the franchiser collects a steady stream of royalties and fees, which smooth cash flow and reduce volatility. The company's balance sheet has improved as well, as DineEquity has reduced its debt by $1.2 billion since 2007.

Now that DineEquity is a leaner, more efficient company, it can use these savings to grow. Indeed, DineEquity still has a lot of room for growth in the United States and abroad. The majority of U.S. states have fewer than 50 IHOP or Applebee's restaurants, while international locations represent just 5% of DineEquity's total restaurant count.

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DineEquity is now 99% franchised, and sales were good last year. Same-restaurant sales, which measure sales at restaurants open at least one year, rose 3.9% for IHOP and 2.8% for Applebee's last year. These results compare very favorably to McDonald's, which suffered a 1% decline in global same-restaurant sales in 2014, due to negative guest traffic across all of its major segments.

The more consistent cash flow has also allowed DineEquity to adopt a generous capital allocation program.

Cash returns won't leave investors hungry
Perhaps the most attractive quality DineEquity offers to investors is its cash return policy. Since initiating its new capital allocation plan in 2013, the company has returned over $161 million, or 70% of free cash flow, to shareholders via quarterly cash dividends and stock repurchases.

Last year, DineEquity generated $112 million in free cash flow and paid just $42 million in dividends. That resulted in a very comfortable 37% free cash flow payout ratio. This is why DineEquity was able to increase its dividend by 16% recently.

DineEquity stock yields 3.3%, which is lower than McDonald's 3.5% dividend yield. But DineEquity makes up for this with far greater growth, in both free cash flow and dividends. For investors fed up with McDonald's struggles, DineEquity is a stock to consider.

The article Forget McDonald's, Here's a Better Restaurant Stock to Buy originally appeared on Fool.com.

Bob Ciura owns shares of McDonald's. The Motley Fool recommends McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.