How To Beat The Restaurant Recession

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Restaurants and quick-service dining stocks were some of the hottest in the market over the last several years with high-flyers like Chipotle Mexican Grill (NYSE: CMG ) surging and headliner IPOs from companies like Shake Shack (NYSE: SHAK ).

Non-existent inflation kept wage growth low and a recovering economy had people ready to enjoy a meal out with the family.

But now the industry is facing dual threats from tough price competition against grocery stores and rising labor costs.

As shares tumble across the industry, a few leaders are becoming attractive on a valuation basis and could be relatively safe from the restaurant recession. Strong fundamentals and a long-term trend in eating habits may just mean they jump higher when the environment improves.

Invest At The Bottom Of The Restaurant Recession

Sales at U.S. restaurants grew at the slowest pace since 2009 in the second quarter and that's not the only headwind facing the industry. Growing wage inflation combined with slower growth in overall inflation is pressuring restaurants, which see much of their operating expenses in labor.

Restaurants have increased prices to cover the higher costs but that's leading to a big gap in the cost to eat out versus grocery store prices. Grocery stores haven't been able to pass on higher costs to customers so the price of eat-at-home food has actually fallen.

According to the Bureau of Labor Statistics, the price to eat out has increased 2.4% over the year to September versus a 2.2% decrease in costs for food at home. This difference, the biggest since 1981, is pressuring sales growth for restaurants.

The scenario is leading to shrinking margins and the highest number of bankruptcies in the industry since 2011. The Restaurant ETF (Nasdaq: BITE ) has plunged 5.5% over the past three months, underperforming the S&P 500 by 4 percentage points during the period.

At the same time, restaurants have held up well against the general slowdown in overall retail sales. Sales growth at food services and drinking establishments have beaten overall retail sales since April 2014 and are less volatile than overall spending.

The group also benefits from a steadily increasing share of consumer dollars. The USDA reports that spending on food away from home has grown from 10% of consumer food purchases in 1904 to 50% in 2013.

To find the quality names in the industry, I started with a screen for restaurants with increasing revenue and operational cash flow over the last two years along with stronger profitability (operating margin) over the last year. These companies have not only been able to grow sales and cash in a tough environment but have become more profitable with cost cutting.

Within that list, I narrowed it down to two of my favorites in the quick-service segment of the market. Quick-service names may have a better chance at outperforming their more expensive peers in the fine-dining and casual-dining space due to pricing.

Papa John's International (Nasdaq: PZZA ) may benefit from its franchise model, which means local owners share rising costs. Management expects 7% sales growth this year and has reached 55% of sales through digital orders, helping to reduce labor expenses. Shares trade for 1.9-times sales, under the 2.3 average multiple for peers.

Papa John's is scheduled to report third quarter earnings on November 1, with earnings expected at $0.50 per share on $418 million in sales. That would be an 11% increase over earnings reported in the third quarter of last year and on a 7.5% gain in sales. The company has beaten expectations in six of the last eight quarters.

Sonic Corp (Nasdaq: SONC ) operates the largest chain of drive-in restaurants in the United States, differentiating it from other quick-service peers. The franchise model helps control costs and the company has booked 12 consecutive quarters of same-store sales growth. System-wide sales have grown at a compound rate of 6.2% since 2000 and the operating margin has improved to 16.5%, up 2.4% since 2012.

Sonic reported its fourth quarter earnings on October 24, beating expectations by $0.01 to report $0.45 per share on $165 million in sales. Shares plunged almost 17% when management pointed to the potential for weaker traffic and higher labor costs but I think actual results could be better than expected going forward. Shares are now 34% below their April peak and trade for 1.8-times trailing sales.

Risks to Consider: Investor sentiment for the entire restaurant group may pressure stock prices until market fundamentals improve.

Action to Take: Take advantage of the current weakness in the restaurant industry to position in best-in-class names like Papa John's and Sonic Corp to benefit from an eventual rebound.

Editor's Note: Despite these stocks' hardiness, a market-wide recession could cause them to fall just like the others. Luckily, we've identified the top "crash-protection" stock to buy now . It's been around since the 1800s... and thrives during bad times. During the 2007 to 2009 recession it had record profits. In fact, every time investors panic this company increases its profits. Get the name of this stock here .

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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 Nasdaq, Inc.

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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 Nasdaq, Inc.

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