Costs Taking a Bite Out of Restaurant Stocks - Industry Outlook

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With the onset of spring, the restaurant industry finally has something to cheer about after a dismal run last quarter. People are now more than willing to leave the confines of their homes and spend on dining out. Though the cautious spending mindset of consumers persists overall, the restaurant industry can breathe a sigh of relief in view of this encouraging trend. Leaving behind the woes of last year and the inclement weather in Jan and Feb 2014, the U.S. restaurant industry began the second quarter of the year on a rather positive note.

According to Black Box Intelligence and People Report, the restaurant industry reported positive same-store sales in the months of March and April, a relief from the negative comps seen since Nov 2013. Comps increased 0.7% and 0.6% in March and April, respectively, owing to improved weather.

Moreover, improving Restaurant Performance Index and the Current Situation Index reflect accelerated economic expansion and underlying strength in the industry. The strength in the U.S. restaurant industry is backed by pent-up demand from consumers to live and eat well.

Going forward, we expect the outlook for the restaurant industry to get better driven by innate fundamental strengths, reflecting an improving economic backdrop. Statistics bear out this relatively favorable environment. Restaurant-and-foodservice sales are anticipated to be $683.4 billion in 2014, up 3.6% year over year, as per the National Restaurant Association. In real terms, this will mark the fifth consecutive year of growth in restaurant sales.

However, the industry has its share of challenges, the most concerning being the rise in food costs. Food costs were up 0.4% in April, the fourth straight month of increase. Moreover, meat prices increased 8.4% in April this year. These factors indicate that inflation may be creeping up.

The overall economic environment is improving. However, the year-over-year decline in guest count remains a concern. Though up sequentially, same-store traffic for the month of April declined 1.1% year over year. As per media reports, the industry has yet to achieve an improving same-store guest count since the end of the recession.

Meanwhile, the industry is dependent on broad macroeconomic factors, with dining out being a largely discretionary activity. The economic climate largely influences restaurant choices for customers. The Consumer Confidence Index declined sequentially in Apr 2014 as consumers deemed current business and labor market conditions less favorable. Further, we believe issues related to "Obamacare," volatility in housing data and fuel prices and excess supply may continue to cast shadows on the long-term picture.

OPPORTUNITIES

Domestic and International Unit Expansion

After emerging from a lackluster economy that lasted for three years, most of the companies had stepped up their pace of restaurant openings. Not content with domestic expansion alone, the companies were looking to test waters as well as developing taste buds in foreign shores. Restaurateurs are primarily concentrating on emerging markets that provide ample opportunities for expansion.

The burgeoning middle income population in emerging countries encourages these companies to shift their spotlight from the somewhat saturated domestic market. Burger King Worldwide, Inc. ( BKW ), The Wendy's Company ( WEN ) and Popeyes Louisiana Kitchen, Inc. ( PLKI ) have been quite active on this front.

Refranchising, Revamping & Innovating Menus - A Common Trend

Though refranchising was common in the restaurant sector, it has gotten a boost lately given the benefits of this business model even in an anemic economy. The franchise-centric model helps to reduce volatility in earnings and enhances cash flow generation. Companies like Yum! Brands, Inc. ( YUM ) and DineEquity, Inc. ( DIN ) are examples of highly franchised brands.

Additionally, restaurants are responding in different ways to address heightened competition in a somewhat over-supplied domestic market. Most industry players are remodeling their restaurants to give an up-market feel as well as rolling out new and smaller prototypes to augment the perception of value and drive traffic, thereby reducing construction and occupancy costs and enhancing returns on capital. Jack in the Box Inc. ( JACK ) and Wendy's Company have been working along these lines.

Apart from reimaging, Brinker International, Inc. ( EAT ), Red Robin Gourmet Burgers Inc . ( RRGB ) and Texas Roadhouse, Inc. ( TXRH ), are also working on smaller prototype restaurants that help to accelerate growth in non-traditional locations, drive traffic, thereby improving return on investment. Companies such as Darden Restaurants, Inc. ( DRI ) and BJ's Restaurants, Inc. ( BJRI ) are busy investing in kitchen equipments to improve capacity and speed.

Having stabilized their financial positions, the operators are constantly striving to add new offerings to their menu card in order to cater to the ever-changing palates of customers while making food presentation better. Buffalo Wild Wings Inc. ( BWLD ), Brinker International and Texas Roadhouse are keenly focusing on this strategy.

Restaurateurs like BJ's Restaurants, and Panera Bread Company ( PNRA ) are offering loyalty programs at their units to enhance value dining. This is a ploy to encourage sales at a time when customers are spending less on dining and need added incentives. Most of the operators rely on social media for promotions by incorporating Facebook ( FB ), online review sites, Twitter ( TWTR ) and blogs aggressively into their marketing mix. National Television advertising is also an important tool for promotion.

Modern Technology, Digital Ordering, & Delivery Gaining Precedence

The digital wave has hit the U.S. fast casual restaurant sector as more and more restaurants are deploying technology to enable a better guest experience. The National Restaurant Association notes that technology will make pervasive inroads into the restaurant sector. Smartphone apps will lure consumers to the restaurants while video menu boards in quick-service restaurants and the growing application of tabletop devices in casual dining give operators some of the latest tools to push sales. A few restaurants chains that are aggressively moving on this track are Panera Bread, Buffalo Wild Wings and Krispy Kreme Doughnuts, Inc. ( KKD ) that use Tablets and Kiosks to drive traffic.

Restaurateurs are also fast catching up on this growing trend of digital ordering. So far, Domino's Pizza, Inc. ( DPZ ) has been a huge beneficiary of this trend. A few others following the footsteps of this leading pizza brand are Papa John's International Inc. ( PZZA ) and Cracker Barrel Old Country Store, Inc. ( CBRL ).

Though delivery was common in the restaurant sector, especially among pizza chains, increasingly busy lifestyles have given it a boost. A couple of dining chains like Burger King and BJ's Restaurants now cater to deliveries. Apart from this, catering initiatives are also doing the trick for companies like Panera Bread and Chipotle Mexican Grill, Inc. ( CMG ).

Change in Consumer Preference: The latest trend at U.S. eateries is to serve a healthy menu, owing to consumer preference for fresh, organic, nutritious and low calorie food.  Rising health concerns and increasing awareness about obesity and related diseases have led to the shift in consumer preference toward healthy and "good for you" products. Focus on child nutrition is also a priority. A few companies like Burger King, Chipotle Mexican Grill, Kellogg Company ( K ) and The Hershey Company ( HSY ) are coming up with low-calorie offerings to improve revenues and profits.

Currently, Buffalo Wild Wings carries a Zacks Rank #1 (Strong Buy). A few companies with a Zacks Rank #2 (short-term Buy rating) include Carrols Restaurant Group, Inc. ( TAST ), Fiesta Restaurant Group, Inc. ( FRGI ), Ruth's Hospitality Group Inc. ( RUTH ) and Yum! Brands. Despite having a Zacks Rank #3 (Hold), we are optimistic about Chipotle Mexican Grill, Wendy's Company and Domino's Pizza owing to their strong results and future outlook.

WEAKNESSES

Commodity Cost Inflation: Food costs account for about one-third of restaurant sales, thus making the industry excessively vulnerable to food cost inflation. Increase in demand for a commodity is always good news for producers. However, it is only when there is inadequate supply of a particular commodity that prices start to rise. Currently, beef prices are soaring and have hit their highest level in almost three decades. (Read More: Soaring Beef Prices: 3 Stocks to Feel the Bite )

Moreover, the situation is not expected to improve in the near-term. The U.S. Department of Agriculture forecasts that food-at-home inflation as well as food-away-from-home inflation index in the U.S. is expected to grow year over year in the range of 2.5-3.5% in 2014. This would likely leave less room for consumer companies to exercise pricing action, which would put pressure on restaurant sales.

The brunt of government budget cuts, higher gasoline prices, payroll tax increases and delayed tax refund checks leave less room for consumer companies to pass on the rising food costs to customers, thus pressurizing profits.

Global Economy Yet to Recover Fully: According to the European Central Bank, though financial markets in the region have improved, they are yet to reach pre-crisis levels. The big chains have considerable exposure in European nations like France and Germany and in Asian countries like China. Despite improving economic data, German customers remain extremely value-sensitive. Among the emerging nations, China and Brazil have their own share of problems. Japan also continues to be a dampener as it is still recovering from the 2012 earthquake.

Affordable Care Act to Hurt Margins: Since the sector plays a key role in the nation's employment picture, the recent Affordable Care Act by President Obama, commonly known as Obamacare, is expected to have an adverse impact on the operators' margins starting 2014. The law entails companies to provide coverage for workers or face government penalties, though it is not applicable for employees who log less than 40 hours per week on an average. To avoid these austerities, most companies are trying out different labor models like involving more part-timers and cutting work hours, which would hurt margins at the restaurant chains.

There are some names that induce our cautious to bearish outlook. These include Bob Evans Farms, Inc. ( BOBE ), The Cheesecake Factory Inc. ( CAKE ), Dunkin' Brands Group, Inc. ( DNKN ) and Jamba, Inc. ( JMBA ), all with a Zacks Rank #4 (Sell).  Though Bloomin' Brands, Inc. ( BLMN ) has a Zacks Rank #3, we have a bearish outlook over the company as we expect it to be impacted by food cost inflation owing to its focus on beef offerings. We also have a pessimistic view on Darden Restaurants due to its soft third-quarter fiscal 2014 results and full-year outlook.

Zacks Industry Rank - Neutral Outlook

Within the Zacks Industry classification, the restaurant industry is grouped within the broader Retail sector. We rank all 260+ industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank .

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the restaurant industry is currently at #146. This is in the middle 1/3rd of all industries ranked, highlighting the group's near-term Neutral outlook.

We believe that the Neutral outlook comes in the wake of major near-term concerns such as significant food cost inflation (Read more: Will Food Price Inflation Hurt Restaurateurs? ) and meager wages at fast food joints like McDonald's Corp. ( MCD ) and Yum! Brands which is leading to strikes by its employees. (Read more: Fast Food Workers on Strike Globally ). However, these negatives are being offset by the continuing improvement in comps.

Earnings Trends

The restaurant industry falls under the broader Retail-Wholesale sector, which has an earnings beat ratio of 38.5% and revenue beat ratio of 42.3%.
Earnings growth of 0.9% was seen at the sector in the first quarter, down from 1.0% growth in the fourth quarter of 2013 due to higher food costs and other expenses. On the revenue front, the sector recorded an increase of 3.6% in the first quarter, flat sequentially.

Looking at the consensus expectations for second quarter of 2014, earnings are expected to climb 5.1%. For 2014, earnings are expected to increase around 9.3% with growth coming in the third and fourth quarters of the year. Revenue is expected to grow 5.2% in the second quarter of 2014. For 2014, revenues are expected to increase 5.6%, primarily on the back of top line increases in the third and fourth quarters.

For more details about earnings for this sector and others, please read our ' Earnings Trends ' report.

Among the companies in our coverage, Wendy's Company posted solid first quarter results with earnings and revenue beating the Zacks Consensus Estimate on comps growth. However, The Cheesecake Factory missed the Zacks Consensus on earnings due to inclement weather while revenues beat.

A look at the Earnings ESP in the table below shows that Darden Restaurant, Brinker International and BJ's Restaurants could miss the Zacks Consensus Estimate in their upcoming quarterly results (first quarter 2014).



Bottom Line

In hindsight, the performance of the restaurant sector was more or less satisfactory in the March quarter compared to the second half of 2013. For 2014, the industry is expected to generate growth as it focuses on inspired ways of meeting consumer demand. However, the sector will continue to face headwinds from a weak consumer spending environment and higher food costs.

It's high time that these food chains focus on strategies that will help them alleviate the impact of increased costs. Implementing the right pricing strategy, increasing global presence and focusing on supply chain revenues are key for restaurateurs. Overall, the restaurant industry is expected to sustain its general pace of recovery in 2014, albeit a bit slower as it contends with several global economic concerns.

Our proprietary Zacks Rank indicates the movement of the stocks over the short term (1 to 3 months). At present, 30.8% and 53.8% stocks hold a positive and neutral outlook, respectively, while the remaining 15.4% hold a negative outlook.


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BJ'S RESTAURANT (BJRI): Free Stock Analysis Report

BURGER KING WWD (BKW): Free Stock Analysis Report

BLOOMIN BRANDS (BLMN): Free Stock Analysis Report

BOB EVANS FARMS (BOBE): Free Stock Analysis Report

BUFFALO WLD WNG (BWLD): Free Stock Analysis Report

CHEESECAKE FACT (CAKE): Free Stock Analysis Report

CRACKER BARREL (CBRL): Free Stock Analysis Report

CHIPOTLE MEXICN (CMG): Free Stock Analysis Report

DINEEQUITY INC (DIN): Free Stock Analysis Report

DUNKIN BRANDS (DNKN): 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

FACEBOOK INC-A (FB): Free Stock Analysis Report

FIESTA RESTRNT (FRGI): Free Stock Analysis Report

HERSHEY CO/THE (HSY): Free Stock Analysis Report

JACK IN THE BOX (JACK): Free Stock Analysis Report

JAMBA INC (JMBA): Free Stock Analysis Report

KELLOGG CO (K): Free Stock Analysis Report

MCDONALDS CORP (MCD): Free Stock Analysis Report

POPEYES LA KTCH (PLKI): Free Stock Analysis Report

PANERA BREAD CO (PNRA): Free Stock Analysis Report

PAPA JOHNS INTL (PZZA): Free Stock Analysis Report

RED ROBIN GOURM (RRGB): Free Stock Analysis Report

RUTHS HOSPITLTY (RUTH): Free Stock Analysis Report

CARROLS RESTRNT (TAST): Free Stock Analysis Report

TWITTER INC (TWTR): Free Stock Analysis Report

TEXAS ROADHOUSE (TXRH): Free Stock Analysis Report

WENDYS CO/THE (WEN): Free Stock Analysis Report

YUM! BRANDS INC (YUM): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Investing Ideas , Stocks

Referenced Stocks: BJRI , BKW , BLMN , BOBE , BWLD

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