The restaurant industry is showing improvements and seems poised
for long-term growth, but concerns about the health of the U.S.
economy and the nagging sovereign debt issues in Europe pose some
risks to this outlook. However, if we look back at the last few
months, restaurant operators managed to post improved results
riding on the back of modest traffic improvement and the consequent
rise in comparable-store sales.
A recent survey by the National Restaurant Association revealed
that the Restaurant Performance Index (
), measuring the health and outlook on the U.S. restaurant
industry, was 100.1 in September, up 0.7% from August. It was the
highest level since June. The RPI run-rate in the last three months
connotes improvements in same-store sales and customer traffic.
The Current Situation Index, which measures comparable-store sales,
traffic counts, labor costs and capital expenditures in the
restaurant industry, was 100.1 in September, up 0.8% from August.
The Expectations Index, which measures restaurant operators'
six-month outlook on the above indicators, stood at 100.2, up 0.7%
from the prior month. Restaurant operators' capital spending plans
are also on the rise, reaffirming their positive outlook on the
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.
Looking ahead, we see modest top-line trends. 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 thus same-store sales
However, we expect guest count to remain subdued in the first half
of 2012. The U.S. economy is improving, albeit at a lower rate, but
a sluggish labor market, over-supply of restaurants in the
industry, higher gasoline prices, food cost inflation, a
still-elevated unemployment level 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), Midscale Restaurants, Casual Dining, Non-Commercial and Fine
In the midst of what might be called a lukewarm recovery, these are
the potential drivers of net income growth for the restaurant
industry: unit expansion, same-store sales, cost-containment
efforts and marketing tools.
Emerging from a lackluster economy in 2008-2009, most of the
companies have accelerated their pace of restaurant openings,
though not aggressively. A relative recovery in consumer confidence
has also encouraged companies to return to unit expansion.
In fact, the companies are also exploring international markets.
While Chipotle is primarily concentrating on European countries
including U.K., Germany and France,
Buffalo Wild Wings Inc.
) will expand its overseas footprint by opening more than 50
company-owned and franchised restaurants in Canada over the next 5
years. Additionally, the company is also looking for expansion
opportunities in other international markets like the United
Kingdom and Middle East. Another restaurant,
P.F. Chang's China Bistro Inc.
) is also eying the Canadian market.
Darden Restaurants Inc.
) will also spread its operations in the Middle East. Several food
Pollo Tropical of Carrols Restaurant
) intend to tap the fast-growing Indian market.
Yum! Brands Inc.
) already have considerable coverage in India. Companies like Yum!
Brands and McDonald's are aggressively expanding in China to
capitalize on the fast-paced economic growth in Asia. The companies
are also targeting South-East Asia for expansion.
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.
Some cost cuts have been achieved through integrated information
systems, including point-of-sale, automated kitchen display,
labor-scheduling and theoretical food cost systems.
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 increasingly into their marketing mix over
the next two years.
With the economic outlook improving, the fortunes of a number
industry players have turned around. These companies promise
long-term growth opportunities.
Buffalo Wild Wings
) 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,
) 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.
- Boasting of a unique position in the hyper-competitive bar
and grill segment, yet another stock,
) offers investors a strong growth story with a viable business
strategy and debt-free balance sheet. The company delivered
impressive second quarter results in terms of earnings per share
and same-store sales growth.
BJ'S RESTAURANT (
Improved Californian Market
The core California market, which was badly hit by the recession
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. (
) 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 the 12 months ended October 2011, restaurant
employment increased 1.7% from 1.1% for the same period a year
earlier. According to the National Restaurant Association, Texas
and Florida will likely show the strongest job growth over the next
Remodels and Menu Innovations Remain Key to
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.
While Darden has embarked on an extensive remodeling plan for its
core brands like Olive Garden and Red Lobster to spur its
same-store sales, Chipotle Mexican Grill is introducing typical
Southeast Asian cuisine along with the naturally raised food, for
which it is well known.
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. The
introduction of small plates or individual appetizers by several
chains such as
California Pizza Kitchen
), BJ's Restaurants and Buffalo Wild Wings have already tasted
success. Limited Time Offers are also on the rise.
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
Panera Bread Co.
) bread is more inclined toward company-owned unit openings, which
speak well of its fundamental strength and make us optimistic on
Breakfast Menus a Key Driver
Breakfast has accounted for nearly 60% of the U.S. restaurant
industry and remains a key driver of traffic growth in recent
years. Over the past five years, morning meal traffic has increased
at an average rate of 2% per year, while lunch visits were flat,
and supper traffic declined 2% per year on average.
We can thereby conclude that growth potential remains mainly in the
QSR markets. Leveraging the trend,
The Wendy's Company
) has expedited its breakfast menu in different markets. The
company targets to have about 1,000 restaurants serving its new
breakfast by the end of this year. The comps of
) also gained traction in the recent quarters through its breakfast
wraps. The company expanded this product line to 270 company stores
in May and will spread further in 2012. 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.
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. While Starbucks has
stepped beyond coffee and ventured into the $50 billion category of
healthy juices, Yum! Brands is also on the verge of acquiring
China-based restaurant chain Little Ship. Recently, the
Minneapolis-based Granite City Food & Brewery agreed to acquire
the assets of seven Cadillac Ranch All American Bar & Grill
restaurants. Darden has also inked a deal to purchase two Eddie V's
restaurant brands -- Eddie V's Prime Seafood and Wildfish Seafood
Apart from acquisitions, the companies are also divesting their
slow-moving brands in order to spur growth. The recent sale of Long
John Silver's and A&W of Yum! Brands as well as the departure
of Arby's from Wendy's confirm the trend.
Currently, there are a number of stocks in the restaurant with a
Zacks #1 Rank (short-term Strong Buy rating). These include
Domino's Pizza Inc.
). Companies with Zacks #2 Rank (short-term Buy rating) include
Panera Bread Co.
Papa John International
Higher Food and Gasoline Prices
Food costs account for about one-third of restaurant sales.
Wholesale food prices have been on the rise this year. Prices of
corn, wheat, coffee and other commodities have also trended up,
compelling many restaurants to raise prices on some of their
products. The companies are expecting industry-wide increases in
commodity and energy costs to continue in 2012. Dairy and beef
prices witnessed a steep rise on a year-over-year basis.
Companies like Red Robin Burger, McDonald's and Texas Roadhouse,
which are exposed to the beef market, or
CEC Entertainment Inc.
The Cheesecake Factory Inc.
), which are regular buyers of cheese, often feel the brunt of
price inflation. Chicken wing prices, which have been favorable in
third quarter 2011, are rising now. A continued rise in traditional
wing prices is expected for 2012.
With food being more expensive and gasoline prices always on the
rise, people have less disposable income and prefer to dine at
home. In our opinion, most of the restaurants will try to safeguard
their margins by passing the cost hikes 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. 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 West.
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 the company's same-restaurant sales growth.
Shut Down of Regional Restaurant Chains
The majority of independent U.S. restaurant units are closing,
while restaurant chains remained steady. Large national chains,
which attract mainly higher-income visitors are performing better
than regional restaurants as upscale-customers are recovering
faster than the lower-income group.
Lag in Traffic Growth Barring Fast Casual
According to a recent NPD foodservice market research report,
visits to the leading fast casual restaurant chains grew more than
15% over the last three years while the rest of the industry
experienced its sharpest traffic declines. However, fast casual
unit availability increased 12% since 2007. Visits to the leading
fast casual restaurant chains, like
) and Panera, were up 6% for the year ending December 2010 versus a
year ago. This compares with a 1% decline in total industry visits
for the same time period.
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.
), Yum! Brands, The Cheesecake Factory,
Einstein Noah Restaurant Group Inc.
) and McDonald's, all of which retain the Zacks #3 Rank (short-term
Ruby Tuesday Inc.
Jack in the Box Inc.
) still hold the Zacks #4 Rank (short-term Sell).
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 look to be in good shape
financially. Easy comparisons from the prior year will likely place
this year's performance in a brighter light.
On the consumer front, while they were previously struggling to
survive in a recessionary environment, they are now grappling with
steeply rising commodity costs, a still-high unemployment rate and
dreary wage gains. These factors are still compelling consumers to
tighten their belts. In our opinion, a set of focused efforts will
help restaurant companies operate with a cautiously optimistic
outlook in 2012.
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CARROLS RESTRNT (TAST): Free Stock Analysis
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YUM! BRANDS INC (YUM): Free Stock Analysis