Restaurants are go-to meeting hubs for friends, family, and colleagues. They’re also more insulated from online competition, which has led to a steady demand versus other retail-oriented businesses like department stores. This has been appreciated by the market as the industry was up 8.7% over the past six months compared to 6.5% for the S&P 500.

Nevertheless, investors must be mindful because any operational misstep or unforeseen change in preferences can kill profitability given the sector’s generally thin margins at the store level. On that note, here is one restaurant stock poised to generate sustainable market-beating returns and two we’re steering clear of.

Two Restaurant Stocks to Sell:

Arcos Dorados (ARCO)

Market Cap: $1.71 billion

Translating to “Golden Arches” in Spanish, Arcos Dorados (NYSE:ARCO) is the master franchisee of the McDonald's brand in Latin America and the Caribbean, responsible for its operations and growth in over 20 countries.

Why Does ARCO Give Us Pause?

1. Estimated sales growth of 1.1% for the next 12 months implies demand will slow from its five-year trend
2. Lacking pricing power results in an inferior gross margin of 13.7% that must be offset by turning more tables
3. Poor free cash flow margin of -0.5% for the last two years limits its freedom to invest in growth initiatives, execute share buybacks, or pay dividends

Arcos Dorados’s stock price of $8.32 implies a valuation ratio of 0.4x forward price-to-sales. Dive into our free research report to see why there are better opportunities than ARCO.

First Watch (FWRG)

Market Cap: $1.25 billion

Based on a nautical reference to the first work shift aboard a ship, First Watch (NASDAQ:FWRG) is a chain of breakfast and brunch restaurants whose menu is heavily-focused on eggs and griddle items such as pancakes.

Why Is FWRG Not Exciting?

1. Ability to fund investments or reward shareholders with increased buybacks or dividends is restricted by its weak free cash flow margin of 0.4% for the last two years
2. ROIC of 2.2% reflects management’s challenges in identifying attractive investment opportunities
3. Short cash runway increases the probability of a capital raise that dilutes existing shareholders

At $20.55 per share, First Watch trades at 53.5x forward price-to-earnings. Check out our free in-depth research report to learn more about why FWRG doesn’t pass our bar.

One Restaurant Stock to Watch:

Kura Sushi (KRUS)

Market Cap: $806 million

Known for its conveyor belt that transports dishes to diners, Kura Sushi (NASDAQ:KRUS) is a chain of sushi restaurants serving traditional Japanese fare with a touch of modernity and technology.

Why Does KRUS Catch Our Eye?

1. Fast expansion of new restaurants to reach markets with few or no locations is justified by its same-store sales growth
2. Same-store sales growth over the past two years shows it’s successfully drawing diners into its restaurants
3. Earnings growth has massively outpaced its peers over the last four years as its EPS has compounded at 58.3% annually

Kura Sushi is trading at $66.97 per share, or 34.3x forward EV-to-EBITDA. Is now the right time to buy? Find out in our full research report, it’s free.

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