The year 2012 started on a relatively positive note for U.S.
restaurants. That scenario changed gradually as sales momentum
slackened in the sector as the macroeconomic tension,
presidential election and the "Fiscal Cliff" raised uncertainties
in the market.
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Even this year, the industry remains on the receiving end of
global economic concerns, fragile consumer confidence, a more
expensive food cost environment in the U.S., a sluggish labor
market, "Obamacare" and an excess of restaurants in the industry.
As a result, we anticipate subdued store sales growth in the
Statistics also bear out this relatively unfavorable environment.
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 99.7 in December, down 0.2% sequentially. The figure dropped
from the steady-state score of 100.
The Current Situation Index, which measures comparable store
sales, traffic count, labor costs and capital expenditures in the
restaurant industry, was 99.1 in December, down 0.7%
sequentially. This was the fifth below-100 score in six months
and the lowest level in almost two years. However, the
Expectations Index, which measures the restaurant operators'
six-month outlook on the above indicators, was 100.3, up 0.3%
This RPI number connotes that the industry is stressed. Weak
sales momentum, a sluggish labor market and slowdown in capital
spending suppressed the Current Situation Index.
The Expectations Index managed to beat the safety threshold of
100 for the first time in three months, but the score still
reaffirms operators' bearish outlook on the industry over the
Performance of Key Players in Fourth-Quarter
So far, industry behemoth
) delivered stronger-than-expected results in the fourth quarter
while another renowned
Brinker International Inc.
) -- posted in-line earnings. However, most of the company's
results are yet to release.
A look at the Earnings ESP (Expected Surprise Prediction - Zacks'
proprietary methodology for determining which stocks have the
best chance to surprise with their next earnings announcement)
shows that the overall earnings picture for the industry remains
mixed. To beat the estimate, a stock needs to have both a
positive Earnings ESP (Read:
Zacks Earnings ESP: A Better Method
) and a Zacks Rank #1, #2 or #3.
Among the leading players of the industry,
Krispy Kreme Doughnuts, Inc.
Red Robin Gourmet Burgers Inc.
) will likely beat fourth-quarter earnings.
However, our proven model does not conclusively show that the
The Cheesecake Factory Inc.
BJ's Restaurants Inc.
Yum! Brands Inc.
Burger King Worldwide Inc.
Chipotle Mexican Grill Inc.
) will likely beat the Zacks Consensus Estimate in the upcoming
Despite these hurdles, the restaurant sector is expected to
sustain its pace of recovery this year, albeit at a slower clip.
According to the National Restaurant Association, the restaurant
industry is projected to expand in 2013 on the back of U.S.
recovery, albeit at a slow clip. Like 2012, focus on cost
containment, extra value-for-price and international expansion
will be on most restaurateurs' wish-list to tide over the macro
difficulties this year.
The National Restaurant Association estimates total restaurant
sales to increase 3.8% year over year to $660.5 billion in 2013.
However, inflation-adjusted sales suggest only 0.8% growth. If
realized, this would mark the third straight year of total
industry sales exceeding the $600 billion mark.
According to the industry association, while the full-service
restaurant segment is expected to post 2.9% growth to reach
$208.1 billion in 2013, the limited-service eating-place segment
is expected to generate $225.4 billion in sales, up 4.6% year
Tough Comps Waiting for 1Q13
Thanks to favorable weather and industry recovery after the
recessionary impact faded, we believe most restaurateurs will
fail to exceed the year-ago quarter's solid comparable sales
Continued Job Growth in the Sector
The restaurant industry has been one of the major contributors to
job growth in the U.S. over the last couple of years. The sector
employs around 10% of the U.S. workforce. According to the
National Restaurant Association, in 2011 and 2012, total U.S.
employment grew a respective of 1.0% and 1.4% while restaurant
employment increased 1.9% and 3.0%.
The National Restaurant Association expects restaurant industry
to create 2.4% more jobs compared to a projected 1.5% gain for
total U.S. employment.
Global Unit Expansion
Besides expanding in their home country, the companies are also
testing waters on foreign shores. Restaurateurs are primarily
concentrating on emerging markets that provide ample
opportunities for expansion. The burgeoning middle income
population in emerging countries encourages the companies to
shift their spotlight from the somewhat saturated domestic
Several food chains, including
), Krispy Kreme and Dunkin are tapping the fast-growing Indian
market. McDonald's and Yum! already have considerable coverage in
India. They are aggressively expanding in China to capitalize on
the fast-paced economic growth there. Latin America has also
become a preferable venue for expansion.
Refranchising, Revamping & Menu Innovations - A
Though refranchising was common in the restaurant sector, it has
got a boost of late given the benefits of this business model
amid an anemic economy. The franchise-centric model helps to
reduce volatility in earnings and enhances cash flow generation.
) and Burger King are some examples of highly franchised brands.
Additionally, restaurants are responding in a variety of ways to
address the issue of heightened competition in a somewhat
over-supplied domestic market. Most of the industry players are
remodeling their restaurants for an up-market feel, 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. Operators like McDonald's,
The Wendy's Company
Darden Restaurants Inc.
) are in this suit.
That's not all. Having stabilized their financial positions, the
operators are constantly striving to bring newer offerings to
their menu card in order to cater to the ever-changing palates of
customers. Limited Time Offers, loyalty programs and usage of
social media as a marketing tool are also gaining attention.
Restaurateurs are offering loyalty programs to enhance value
dining as well as hone sales at a time when customers spend less
enthusiastically on dining and seek incentives for doing so. Most
of the operators rely on social media for promotions by
), online review sites, Twitter and blogs aggressively into their
marketing mix. National Television advertising is also an
important tool for promotion.
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. Leveraging the trend, McDonald's, Jamba Inc., Wendy's and
Yum! all have expedited their breakfast menus. Last year, IHOP,
one of DineEquity's breakfast-oriented brands, launched a new
blend of oatmeal in collaboration with The Quaker Oats Company,
Non-alcoholic beverages remain another sweet spot in the U.S.
eateries. 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 through its
Apart from Juicing, both Jamba and Starbucks are brewing more
opportunities in the tea category. While Jamba acquired
Chicago-based Talbott Teas last year in pursuit of continued
innovation in the beverage line-up, Starbucks took over
Atlanta-based Teavana Holdings this year.
Before acquiring Talbott Teas, Jamba had already tried various
tea offerings such as Mightly Leaf, Original Spiced Chai and
fruit tea infusion while Starbucks had an existing core tea
business of Tazo tea. This bullish trend of the segment can be
established from the National Restaurant Association's projection
for snack-and-nonalcoholic-beverage bars' 4.3% growth to $29.1
billion this year.
M&A Activity Gaining Precedence
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. Private equity
firms are citing potential in the restaurant industry and
accordingly making buyout deals. One of the latest acquisition
deals that is worth mentioning is the buyout of Caribou Coffee
Company by JAB Group.
Apart from acquisitions, the companies are also divesting their
relatively slow-moving brands in order to spur growth. One of the
latest divesture deals that warrants a look is the sell-off of
Mimi's Cafe concept of
Bob Evans Farms Inc.
) to LeDuff America.
Currently, one stock in the restaurant sector is carrying a Zacks
Rank #1 (Strong Buy) and that is
). Companies with a Zacks #2 Rank (short-term Buy rating) include
Jack in the Box Inc.
). These companies have positive earnings estimate revision
trends, highlighting the favorable momentum in their underlying
Bleak Economic Backdrop
The strengths aside, the companies are caught up with
macroeconomic tensions like implementation of austerity measures
in Europe owing to the sovereign debt crisis, decelerating growth
in Asia and increasing commodity costs in the U.S.
The overcast European financial atmosphere has slowed down the
overall growth rate in the region since the second half of 2011.
Some food companies that have hitherto endured the economic
turmoil fairly well are finally under stressed by the
implementation of austerity measures in Europe.
The pressure is now beginning to be felt on their top and bottom
lines. The underperformance of McDonald's in European region is a
Decelerating Growth in Asia:
Growth has been moderating in Asia, especially in two major
countries -- China and India -- where major eateries are
exploring expansion opportunities in response to the saturation
in the U.S. market. Steep declines in export to developed
economies, lack of foreign capital inflows, and changes in
internal fiscal and monetary policies led to the decline in the
estimated growth rate in China and India. Here again, the recent
same-store sales performance of McDonald's is indicative of this
In fact, the International Monetary Fund slashed its growth
forecast for China and India twice last year for both 2012 and
2013. The IMF has warned that the worsening debt crisis in the
Eurozone will pose a "key risk" to these emerging nations.
On Jan 23, the agency once again trimmed its growth estimates for
some countries, including China and India. Another Asian country,
Japan also continues to be a dampener as it is still on its way
to recovery from last year's earthquake.
Commodity Inflation in the U.S.:
We remain wary of rising commodity costs of the restaurant
industry. Food costs account for about one-third of restaurant
sales. After a high inflationary environment in 2012, we believe
the threat for more inflation lurks in 2013.
As suggested by the USDA report, price inflation for all food is
expected to remain in the range of 3-4%, up from the level of
2.25-2.75%. Commodities like beef, pork, chicken and other meats
as well as most dairy products are expected to see a price rise
in 2013, with beef facing the biggest threat.
The drought in the Midwest growing region last year raised grain
costs, which in turn pushed up the feed costs. Further, the
drought led to a sooner-than-expected supply of cattle in the
market in 2012. This supply glut last year could result in a
medium-term supply crunch this year.
Companies like Red Robin Burger, McDonald's and
) have the broadest exposure to the beef market and will likely
bear the brunt of price inflation.
Rising energy cost is another risk faced by restaurateurs. The
industry accounts for one-third of the energy used by the retail
sector in the U.S., as per the Green Restaurant Association.
Most of the restaurants safeguard their margins by passing the
cost hike onto consumers. While big and established chains like
McDonalds, 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.
Healthcare Reforms to Hurt Margins
Since the sector plays a key role in the nation's employment
picture, the recent Affordable Care Act by president Barrack
Obama, commonly known as Obamacare, is expected to have an
adverse impact on the operators' margins starting in 2014.
The law entails companies to provide coverage for workers or face
government penalties, though not applicable for employees who log
less than 30 hours per week on average.
To avoid these austerities, most the companies are trying out
different labor models like involving more part-timers and
cutting work hours in advance of the implementation of the
healthcare reform. Darden Restaurants is one of these.
Shrinking Margins on Discounting & Value
Restaurants have been trying to win back cash-conscious guests by
revamping promotions and focusing on value-for-meal menus. An
extensive focus on value proposition in the major domestic and
international markets along with less pricing power could prove
detrimental to margins if exercised on a long-term basis.
Stringent Food Standards
Consumers' inclination toward fresh organic menu as well as the
fuss about nutrition is considered to be a tough benchmark in the
restaurant industry. Consumers generally tend to visit
restaurants offering locally produced food. Focus on children's
nutrition has also become a priority. While these criteria are
giving a competitive advantage to companies like Chipotle, many
others are sometimes finding the standard difficult.
In the near term, restaurant and beverage companies in the New
York area will face difficulties in doing business with Mayor
Bloomberg trying to forbid the sale of larger-than-16-ounce sodas
and sugar drinks. This ban, likely to be implemented in March
2013, could prove pricey for the fast-food industry, as soft
drinks carry a high margin.
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
Chipotle, Red Robin Gourmet Burgers, Wendy's,
), Yum!, McDonald's,
Kona Grill Inc.
), Domino's and BJ's Restaurants all of which retain the Zacks #3
Ruby Tuesday Inc.
) still carry a Zacks Rank #4 (Sell). One of the industry's
), currently carries a Zacks Rank #5 (Strong Sell) due to
persistent deceleration in some of its core brands.
The restaurant industry is still not immune to uncertainties in
the macro economy. On the domestic front, although the economy
has been improving, full-fledged consumer response has yet to be
seen. Given the soft international backdrop we expect this
aversion to persist in the near term. Only the cash-rich
companies will likely survive this volatility.