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 Chipotles (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.
EINSTEIN NOAH (BAGL): Free Stock Analysis Report
CHIPOTLE MEXICN (CMG): Free Stock Analysis Report
DENNY'S CORP (DENN): Free Stock Analysis Report
DOMINOS PIZZA (DPZ): Free Stock Analysis Report
DARDEN RESTRNT (DRI): Free Stock Analysis Report
BRINKER INTL (EAT): Free Stock Analysis Report
MCDONALDS CORP (MCD): Free Stock Analysis Report
PANERA BREAD CO (PNRA): Free Stock Analysis Report
RUBY TUESDAY (RT): Free Stock Analysis Report
STARBUCKS CORP (SBUX): Free Stock Analysis Report
CARROLS RESTRNT (TAST): Free Stock Analysis Report
WENDYS CO/THE (WEN): Free Stock Analysis Report
YUM! BRANDS INC (YUM): Free Stock Analysis Report
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