(SSS) Restaurant Industry Review – August 2010 – Industry Outlook

The second half of 2010 should continue to bring gradual improvements to restaurant industry fundamentals. The industry faced extremely tough challenges through the end of 2009 due to the economic turmoil that resulted in weak labor and tight credit markets, resulting in lower discretionary spending.

Riding on the back of a slowly reviving U.S. economy and the consequent rise in comparable-store sales along with a drop in costs, restaurant operators posted improved results in the first half of 2010. We expect the companies to continue delivering better numbers for the remainder of 2010 compared to the year-earlier period.

Restaurants have been trying to win back cash-conscious guests who have been reluctant to shell out more disposable income, preferring to dine at home or spend less per meal. Eateries are tweaking entrées, revamping promotions and focusing on value-for-meal menus.

We expect these trends to remain in place over the near-to-medium term, with consumers continuing to look for value, distinct dining experiences, convenience and enhanced menu deals. Although the economy is continuing to improve, albeit at a modestly lower rate than earlier expected, the sluggish labor market, over-supply of restaurants in the industry, and food cost inflation will continue to weigh on industry profitability.

Drivers of the Restaurant Industry

The U.S. restaurant industry consists of Quick Service Restaurants (QSR), Midscale Restaurants, Casual Dining, Non-Commercial and Fine Dining/Upscale Restaurants.

In the midst of what is considered to be a moderate recovery, there are three potential drivers of net income growth for the restaurant industry: unit expansion, same-store sales (SSS) and cost-containment efforts.

Unit Expansion

There appears little chance of any upside from aggressive unit expansion, as most of the companies have slowed their pace of restaurant openings in the wake of the economic downturn. BJ’s Restaurants, Inc. (BJRI) plans to open 10 restaurants in fiscal year 2010. In the first half of 2010, BJ’s opened 4 restaurants and plans to open 4 and 2 new restaurants in the third quarter and fourth quarters, respectively. In 2009, the company opened 10 restaurants compared with 15 opened in 2008.

Darden Restaurants Inc. (DRI) opened 53 net new restaurants in 2010, drastically down from 71 restaurants opened in the last fiscal year.

By the end of fiscal 2010, Chipotle Mexican Grill Inc. (CMG) plans to open 120 to 130 new restaurants, reflecting year-over-year net growth of 12.6% to 13.6%. The company opened 45 restaurants in the first half of 2010. In fiscal 2009, the company opened 121 new restaurants and closed 2 locations, reflecting net growth of 14.2%.

Same-Store Sales

The second driver, same-store sales, consists of menu price increases and traffic counts. Most restaurant operators have been reporting net declines in same-store sales in recent months. Of the total operators, 46% reported same-store sales decline in May, up from 41% of operators who reported negative sales in April.

Soft customer traffic accounts for most of this weakness. However, on a year-over-year basis, the rate of decline in traffic has been moderating in recent months, with QSR performing the best with the lowest decline rates. Improved performance has helped to soften the traffic declines to some extent. However, non-commercial and upscale dining continues to suffer, with much steeper decline rates.

Growth in menu price has remained modest, according to figures from the Bureau of Labor Statistics for the month of June. This was the third consecutive month in which menu prices were up 0.1%.

Menu price growth was strongest in the Northeast and South regions in recent months. In the 12 months ending June 2010, menu prices in both the Northeast and South regions increased at rates of 1.5%, slightly above the 1.2% gain posted on the national level.

Cost-Containment Efforts

Finally, some of the cost cuts have been achieved through integrated information systems Incorporatedluding point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems. Restaurant companies try to optimize their operations and achieve decent operating cash flow margins.

Over the last five years, Darden has been able to keep its restaurant operating cash flow margins stable at 22%?23%, despite the current economic headwinds.

OPPORTUNITIES

Despite a sluggish environment for the overall restaurant industry, there are several stocks that promise long-term growth opportunities. Buffalo Wild Wings Inc. (BWLD) offers investors one of the strongest growth stories in this space, with an annual growth target of 13% to 15% in units and 20% in net earnings. Buffalo Wild Wings has also been able to consistently deliver positive comps during the height of market turmoil.

With consistent 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 improving trends. After dipping 0.7% in January 2010, SSS grew by 0.6% in February, 4.2% in March and 4.8% in May. Its global comparable store sales rose 4.8% during second quarter 2010, led by encouraging strength in Europe as well as solid performance in the U.S. and APMEA segments. The recent relatively weak numbers out of Europe primarily reflect exchange rate fluctuations.

Chipotle has also largely remained unruffled by the recent economic slowdown. The company is well positioned to expand rapidly while generating improved earnings, margins and returns on invested capital.

Boasting a unique position in the hyper-competitive bar and grill segment, yet another stock, BJ’s Restaurants offers investors one of the strongest growth stories in this space ,with a viable business strategy, and a debt-free balance sheet. The company delivered impressive second quarter results in terms of both earnings per share and same-store sales growth.

Additionally, according to the recently published data from the National Restaurant Association, restaurants are accessing different means to plug the effect of economic uncertainty. Companies continue to reduce their energy consumption.

One restaurant chain, Burger King Holdings Inc. (BKC), debuts its new energy efficient restaurant prototype in June in Waghausel, Germany. The new eco-friendly unit is expected to cut the restaurant’s energy consumption by half.

Companies are also remodeling their restaurants to give an up-market feel, and are rolling out new, smaller prototypes to augment the perception of value and drive traffic that reduce construction and occupancy costs to enhance returns on capital.

Additionally, the introduction of small plates or individual appetizers rolled out by several chains like California Pizza Kitchen Inc. (CPKI), BJ’s Restaurants and Buffalo Wild Wings, has already tasted success. Limited Time Offers (LTO) are also on rise following the success of Buffalo Wild Wings and Red Robin Gourmet Burgers Inc. (RRGB).

Breakfast has accounted for nearly 60% of U.S. restaurant industry traffic growth in recent years and remains a key driver. NPD’s foodservice market research shows that in the year ending March 2010, there were over 12 billion morning meals served at U.S. restaurants, and 80% of restaurant morning meals were purchased from quick service restaurants.

Over the past five years, morning meal traffic has increased at an average of 2% per year, while lunch visits were flat, and supper traffic declined by 2% per year on average. Hence, we can conclude that potential to grow remains in the Quick Service Restaurant (QSR) markets.

According to a soon-to-be-released report by NPD, which will have a ten-year forecast 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 projected to jump from 11 in 2004 to 14 in 2019.

Currently, there are a number of stocks in the restaurant industry universe with a Zacks #2 Rank (Buy). These include BJ’s Restaurant, Chipotle Mexican Grill Inc., CEC Entertainment Inc. (CEC) and Starbucks Corp. (SBUX).

WEAKNESSES

Offsetting the opportunities in the industry are many names whose outlooks remain lackluster. Nearly 50% of Red Robin and two-thirds of BJ’s Restaurants outlets are located in areas that have been hit hard by the housing downturn and economic slowdown. These include California, Arizona, Nevada, Colorado, Oregon and Washington. This outsized regional exposure is expected to dampen restaurants’ growth potential.

According to a recent NPD foodservice market research report, the U.S. restaurant unit count slipped 1% year over year to 579,416 restaurants this spring, with a majority of the closings experienced by independent restaurants, while chain restaurants remained steady. This happened mainly due to a fall in customer traffic and spending.

The recent Gulf of Mexico oil spill has created difficulties for a number of restaurant companies that generally source their seafood requirements from that area. We expect to see a slight adverse impact on consumer demand for seafood at those restaurants like Red Lobster of Darden due to consumer perceptions about the Gulf oil spill going forward.

Competition among casual dining restaurants is expected to remain fierce with respect to price, service, location and concept in order to drive traffic. High discount rates applied to menu prices in order to battle the difficult economic conditions is resulting in price wars among competitors.

Food costs account for about one-third of restaurant sales. Wholesale food prices have been trending higher this year.

According to the survey of the National Restaurant Association, wholesale food prices registered an increase of 4.9% on a year-to-date basis through May 2010.  Wholesale beef and veal prices spiked 7.5% year over year in May. Also, wholesale pork prices rose 7.4% in May. Most of the restaurant operators are expecting modest upward pressure on food costs for the remainder of the year.

Given the lack of overall earnings catalysts, it is difficult to become enthusiastic about a number of restaurant stocks in our universe. These include McDonald’s, Darden, Red Robin and Yum! Brands Inc. (YUM). We also remain concerned about the prospects of Brinker International Inc. (EAT), which currently has Zacks #4 Rank (Sell) and Burger King with Zacks #5 Rank (Sell).

Financial distress has engulfed all business sectors, and the restaurant industry has not been immune, either. Although the industry showing gradual improvement, a high unemployment rate, dreary wage gains, soaring gas prices and a freezing housing market are still compelling consumers to check their expenses.

The recent global downturn of the last couple of years has rocked the restaurant industry, resulting in lower consumer confidence, which will take some time to find its way out of the woods.

Zacks Investment Research

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