Source: Zacks Equity Research

Restaurant Industry Stock Review – March 2012 MCD,YUM,SBUX,DRI,DENN,TAST,DPZ,PNRA,CMG,EAT, RT,WEN,BAGL The restaurant industry appears well positioned for gradual improvement in the first half of 2012. The global economy had been affected by challenges mainly in the second half of 2011 due to concerns about the nagging sovereign debt issues in Europe and the health of the U.S. economy. While these remain issues, the outlook for the U.S. economy has significantly improved lately.

But despite these odds, restaurant operators have managed to post improved results in the last few months on the back of modest traffic improvement and the consequent rise in comparable store sales. Easy comparisons from the prior year placed performance of 2011 in a brighter light. Encouraging guidance delivered by most of the companies also indicate a return to solid comps.

With some expected turnaround in Greece’s debt situation and a slowly reviving U.S. economy, consumers are expected to attain confidence in the market and increase their discretionary spending. Alongside, restaurant operators are also focusing on cost containment, value-for-price and last but not the least international expansion to tide over the difficulties.

A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index ( RPI ), measuring the present condition and outlook on the U.S. restaurant industry, was 101.3 in January, down from December’s extremely strong level of 102.2. Despite the decline, January characterized the third consecutive month in which RPI stood above 100. This RPI run-rate in the last three months connotes improvement in comparable store sales and customer traffic.

Restaurant operators reported positive same-store sales for the eighth consecutive month, and a majority of them expect business to continue to improve in the months ahead.

The Current Situation Index, which measures comparable store sales, traffic count, labor costs and capital expenditures in the restaurant industry, was 100.6 in January, down 1.5% from December’s seven-year high of 102.1. The Expectations Index, which measures restaurant operators’ six-month outlook on the above indicators, stood at 102.1, almost flat from the prior month’s level of 102.3. This was the fifth consecutive month that the Expectations Index remained above 100. Restaurant operators’ capital spending plans are also riding uphill, strongly reaffirming their positive outlook on the industry.

All these culminate to the general optimism in the sector. We are hopeful that restaurant companies will continue to deliver better numbers in the upcoming quarter as opposed to the year-earlier period. An improving outlook can be validated by the NPD foodservice market research report, which stated that annual visits to restaurants will increase by 8% over the next ten years.

Road Ahead

Looking ahead, we see modest top-line as well as bottom-line trends. According to a research conducted by National Restaurant Association, the restaurant industry is projected to expand in 2012 despite sluggish U.S. recovery. The research firm estimates total restaurant industry sales to increase 3.5% year over year to a record high $632 billion, thus marking the second consecutive year of total industry sales of more than $600 billion.

Most of the restaurant operators are passing on higher costs to consumers in order to mitigate commodity pressure this year, and we expect this trend to continue in 2012. The companies that are well positioned are likely to enjoy pricing power and, in turn, same-store sales increase. The improvement in the U.S. economy is slow but palpable. But a sluggish labor market, over-supply of restaurants in the industry, higher gasoline prices, food cost inflation, a still elevated unemployment level, credit unavailability, and weak income growth may weigh on industry profitability.

Restaurants have been trying to win back cash-conscious guests by revamping promotions, offering discounts and focusing on value-for-meal menus. However, the tendency to offer discounts has been moderating. We remain cautiously optimistic over the near-to-medium term, with consumers continuing to look for value, distinct dining experiences, as well as convenient and enhanced menu deals in a gradually improving economic backdrop.

Drivers of the Restaurant Industry

The U.S. restaurant industry consists of Quick Service Restaurants (QSR), Fast Casual, Casual Dining, Non-Commercial and Fine Dining/Upscale restaurants.

In the midst of what might be called a lukewarm recovery, there are four potential drivers of net income growth for the restaurant industry: unit expansion, same-store sales, cost-containment efforts and marketing tools.

Unit Expansion: Emerging from a lackluster economy two years back, most of the companies have accelerated their pace of restaurant openings. A relative recovery in consumer confidence has also encouraged companies to return to unit expansion.

In fact, the companies are also exploring international markets. Restaurateurs are primarily concentrating on Canada, the Middle East and Southeast Asia for expansion. Some European countries including U.K., Germany and France are not far behind.

Several food chains, including Denny’s Corp. ( DENN ), Pollo Tropical of Carrols Restaurant ( TAST ) and Starbucks Corporation ( SBUX ) intend to tap the fast-growing Indian market. McDonald’s Corp. ( MCD ) and Yum! Brands Inc. ( YUM ) already have considerable coverage in India. They are now aggressively expanding in China to capitalize on the fast-paced economic growth there.

Same-Store Sales: The second driver consists of menu price increases and traffic counts. Most of the restaurant operators reported positive same-store sales and customer traffic growth in the recent months. Growth in menu price has accelerated, as per figures from the Bureau of Labor Statistics.

Cost-Containment Efforts: Some cost cuts have been achieved through integrated information systems, including point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems.

Marketing Tools: Social media as a marketing tool has taken the industry by storm. Most of the operators rely on social media for promotion. Hence, we believe they are likely to incorporate Facebook, online review sites, Twitter and blogs aggressively into their marketing mix going forward. National Television advertising is also an important tool for promotion. A company like Panera Bread Co. ( PNRA ), successful even in time of recession, plans to increase its advertising spending by 26% in 2012 over an above-32% increment in 2011.

OPPORTUNITIES

Popular brands generally have the potential to drive growth. The following companies promise long-term growth opportunities.

 

• Buffalo Wild Wings ( BWLD ) offers investors one of the strongest growth stories in this space. It had also been able to consistently deliver positive comps during the height of market turmoil.
• With steady earnings and a healthy balance sheet, McDonald’s ( MCD ) provides relative safety and moderate growth opportunities in the current scenario, as well as exposure to faster-growing international markets. McDonald’s U.S. comparable-store sales have been showing a continued uptrend since the last few months on strong sales of beverage as well as core menu products. In February 2012, McDonald’s U.S. comp growth was as much as 11.1%, way above 2.7% recorded in the year-ago month.
• Boasting a unique position in the hyper-competitive bar and grill segment, BJ’s Restaurants ( BJRI ) offers investors a strong growth story with a viable business strategy and debt-free balance sheet.

Improved Californian Market

The core California market — badly hit by the recession and resulted in a high rate of unemployment and weak consumer confidence — has turned around. We see plenty of growth opportunities in the California and Texas markets. BJ’s Restaurants and Red Robin Gourmet Burgers Inc. ( RRGB ) are expanding rapidly in California.  

Job Growth in the Sector

The restaurant industry is one of the major contributors to job growth in the U.S. In 2011, total U.S. employment grew 1.0% while restaurant employment increased 1.9%. According to the National Restaurant Association, overall restaurant industry employment will reach 12.9 million in 2012, accounting for 10% of the total U.S. workforce.

This projected employment figure represents a year-over-year growth of 2.3%, while total U.S. employment is believed to grow 1.3%. Among all markets, Texas and Florida should see maximum job growth, among all other markets in the restaurant industry over the next 10 years.

Remodels and Menu Innovations: Keys to Success

Additionally, restaurants are accessing different means to plug the problems of heightened competition in a somewhat over-supplied domestic market. Companies continue to reduce their energy consumption and are remodeling their restaurants to give an upmarket feel. They are rolling out new, smaller prototypes to augment the perception of value and drive traffic, thereby reducing construction and occupancy costs to enhance returns on capital. McDonald’s is continuously benefiting from its reimaging. This year, the company expects to see a comps lift of 5-6% from these sorts of facelifts.

This is not the end. Having stabilized their financial positions, the operators are well positioned to bring newer offerings to their menu card in 2012 in order to cater to the ever-changing demands of customers. Limited Time Offers (LTOs) are also gaining attention.

Loyalty Programs

As per a research conducted by National Restaurant Association, restaurateurs are offering loyalty programs at their units to enhance value dining. Amid the prevailing environment where customers spend less enthusiastically on dining and seek incentives for doing so, approximately 30% of restaurant operators are frequently coming up with diner programs to hone sales further.

 

Hence, the operators started to leverage the trend. For example, Panera Bread rolled out “My Panera” loyalty program in November 2010. Since its inception, the program has developed a database of over 9.5 million registered users in December 2011 (up from 8.3 million last quarter).

Pricing Power

We have seen most of the companies take pricing action in last few months. The faster-rising inflation of food at home compared to food away from home might allow the U.S. eateries some room to take additional pricing actions in the near term.

Growing Fast-Casual Segment

According to a recent NPD foodservice market research report, this is the only restaurant segment growing at a steady pace in the last five years. The segment quintessentially offers healthier options with respect to menu with an upscale setting and at a reasonable price points. The USP of this segment is the counter service, which considerably reduces labor costs.

 

The

Chipotle

s ( CMG ), the Panera Breads, the Noodles & Companys, the Five Guys and the Pei Weis are some restaurateurs who are enjoying their positioning in this category. The segment comprises a small part of the industry sales leaving further scope for growth.

Franchise-Driven Business Model

Most of the companies are transforming to more a franchise-centric model to reduce the volatility in earnings and increase cash flow generation.  Franchising is also an important factor for international development. However, Panera Bread is more inclined toward company-owned unit openings, which speak well of its fundamental strength and make us optimistic on the stock.

Breakfast & Beverage: A Breakout

Breakfast has accounted for nearly 60% of the U.S. restaurant industry and remains a key driver of traffic growth in recent years.

 

We can thereby conclude that growth potential remains mainly in the QSR markets. Leveraging the trend,

Jamba Inc.

( JMBA ),

The Wendy’s Company

( WEN ) all have expedited their breakfast menu. McDonald’s is yet another beneficiary of the increasingly popular breakfast menu.

 

According to an analysis by NPD, which has a ten-year projection of foodservice trends based on aging, population growth and trend momentum, servings of breakfast sandwiches are projected to outpace the industry’s growth forecast. Annual servings per capita of breakfast sandwiches at foodservice are expected to jump from 11 in 2004 to 14 in 2019.

 

Non-alcoholic beverages remain a sweet spot in the U.S. eateries. According to Mintel Global Market Navigator, the US fruit juice drinks market expanded by 1% in 2011. This was an improvement on the 1.7% fall recorded in 2009 and breakeven in 2010. The market also has the ability to grow further through innovation, especially in healthier solutions. We see juicing giant Jamba geared up to leverage the trend by adding all fruits to its line-up.

 

There are other players like sector behemoths Starbucks venturing into the $50 billion category of healthy juices and McDonald’s specializing in both frozen as well as hot beverages. McDonald’s has been delivering strong comparable sales in the U.S. buoyed by its McCafe line.

 

We see continued sales recovery in the next few months as cold beverage provides a higher lift in comps as against hot beverage in winter.

M&A Activity

Merger and acquisition activity is also gaining momentum in the sector. The companies are looking at potential business partners to foray into different zones and unlock value. Apart from acquisitions, the companies are also divesting their slow-moving brands in order to spur growth.  For example, while Yum! Brands acquired China-based restaurant chain Little Ship, it also disposed two of its brands, Long John Silver’s and A&W, at the same time.

 

Currently, there are a number of stocks in the restaurant industry with a Zacks #1 Rank (short-term Strong Buy rating). These include

Texas Roadhouse Inc.

( TXRH ). Companies with Zacks #2 Rank (short-term Buy rating) include Pollo Tropical of Carrols Restaurant,

Domino’s Pizza Inc.

( DPZ ),

Yum! Brands

( YUM ),

Panera Bread Co.

( PNRA ) and

Darden Restaurants Inc.

( DRI ).

WEAKNESSES

Higher Food and Gasoline Prices

Food costs account for about one-third of restaurant sales. Wholesale food prices were increased in 2011. In 2012, the companies are expecting continued industry-wide increases in the cost of some commodities, while price for others to lower. Energy costs are expected to continue in 2012.

 

Beef prices continue to rise on a year-over-year basis. Companies like Red Robin Burger, McDonald’s and Texas Roadhouse, which are exposed to the beef market, often feel the brunt of price inflation.

 

Chicken wing prices, which had been favorable earlier, have been rising. A continued rise in traditional wing prices is expected for 2012. Seafood prices are also creeping up, putting companies like

Darden’s

( DRI ) margin at stake. Some other commodity prices to trend up are flour, coffee, eggs etc. However, some softening will be noticed in dairy as well as produce prices, especially in the latter half of calendar 2012.

 

According to the Green Restaurant Association, restaurants account for one-third of all the U.S. energy used by the retail sector. Hence, rise in energy costs remain another risk to the restaurateurs.

 

With food being more expensive and gasoline prices always on the rise, people have less disposable income. In our opinion, most of the restaurants will try to safeguard their margins by passing the cost hike onto consumers. While big and established chains like McDonald’s, Yum! Brands and Starbucks will survive the price increases due to their broad customer base and larger economies of scale, smaller chains will feel the cost pressure.  

Steep Competition and Promotional Offers

Competition among casual dining restaurants is expected to remain fierce with respect to price, service, location and concept in order to drive traffic. The environment is still value-sensitive. High discount rates applied to menu prices in order to battle difficult economic conditions are resulting in price wars among competitor companies. Hence, the failure of any promotional offer will put pressure on that company’s same-restaurant sales growth.

Shut Down of Regional Restaurant Chains

The majority of standalone U.S. eateries are shutting down, while restaurant chains remained steady. Large chains, which attract mainly higher-income customers, are performing better than regional restaurants as upscale and high-end customers are recovering faster than the lower-income group.

Increased Pressure from Payroll Taxes

Some restaurateurs will likely witness higher state payroll taxes as many states have increased their payroll taxes to help fund their unemployment deficit. One such company,

BJ’s Restaurants Inc.

( BJRI ), incurs increased payroll taxes in the first and second quarter of each year.

 

Recently, the government approved the 4.2% Social Security payroll tax for employees in 2012 compared with 6.2% in effect prior to 2011. However, the employers will continue paying 6.2% tax on employee wages of upto $110,100 this year. Some restaurants also expect labor expense to rise in 2012, due to a hike in minimum wages across a number of states, particularly in the western zone.

Stringent Food Standard

Consumer’s inclination toward a fresh organic menu as well as concerns about nutrition are considered to be tough benchmarks in the restaurant industry. Consumers generally tend to visit restaurants offering locally produced food. While these criteria are giving a competitive advantage to companies like Chipotle, many others are sometimes finding the standard difficult.

 

Given the lack of overall earnings catalysts, it’s hard to be upbeat about a number of restaurant stocks. There are quite a few names on which we have a cautious outlook. These include

Brinker International Inc.

( EAT ),

The Cheesecake Factory

( CAKE ),

Einstein Noah Restaurant Group Inc.

( BAGL ) and

McDonald’s

( MCD ), all of which retain the Zacks #3 Rank (short-term Hold).

Ruby Tuesday Inc.

( RT ) and

Wendy’s

( WEN ) still hold the Zacks #4 Rank (short-term Sell).

Conclusion

The restaurant industry is still not immune to uncertainties in the macro economy. We believe the companies with strong cash flow generation will survive the market volatility. However, there are companies with huge capital budgets that are apparently in good financial shape.