(SSS) Restaurant Industry Stock Review – January 2011 – Industry Outlook

The restaurant industry finally appears well positioned for gradual improvement in the first half of 2011. The industry had been depressed by extremely tough challenges since the end of 2009 from 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, restaurant operators posted improved results in the recent months. We expect restaurant companies to continue delivering better numbers in the upcoming quarters. Encouraging guidance delivered by most of the companies also indicate a return to positive comps.

A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index, measuring the health and outlook for the U.S. restaurant industry, was 99.9 in November, down 0.8% from October. The index dropped below 100 for the first time in three months.

The Current Situation Index, which measures comparable-store sales, traffic counts, labor costs and capital expenditures in the restaurant industry, was 98.7 in November, down 1.3% sequentially. The Expectations Index, which measures restaurant operators’ six-month outlook on the above indicators, stood at 101.2.

Looking ahead, we see solid top-line trends. International travel to the U.S. also continues to grow. We believe well-positioned companies will drive above-average traffic trends and enjoy pricing power leading same-store sales increases in 2011. The economy is continuing to improve, albeit at a modestly lower rate than earlier expected, but a sluggish labor market, over-supply of restaurants in the industry, and food cost inflation will continue to 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, tendency to offer discounts have 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 convenience 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 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: In response to an economy that lacks luster, most of the companies have slowed their pace of restaurant openings. However, with the expected resurgence of consumer confidence, companies are turning back slowing to unit expansion, though not aggressively.

BJ’s Restaurants Inc.
(BJRI) plans to open 12 to 13 restaurants in fiscal 2011 compared with 10 restaurants in fiscal 2010. In the third quarter of 2010, BJ’s opened 4 restaurants and 2 are scheduled for the fourth quarter. In the long run, there still exists room to open at least 300 outlets.

By the end of fiscal 2010, Chipotle Mexican Grill Inc. (CMG) plans to open 122 to 130 new restaurants, reflecting year-over-year net growth of 12.6% to 13.6%. For 2011, the company expects 135–145 new restaurants, maintaining a growth rate of 13%.

In fact, the companies are all set to explore international markets. While Chipotle is primarily concentrating on European countries including the U.K., Germany and France, Buffalo Wild Wings Inc. (BWLD) is expanding its footprint outside the U.S. by opening more than 50 company-owned and franchised restaurants in Canada over the next 5 years. Darden Restaurants Inc. (DRI) also announced a formal area development agreement with Americana Group to develop and operate in the Middle East.

Same-Store Sales: The second driver consists of menu price increases and traffic counts. Restaurant operators reported positive same-store sales and customer traffic growth in recent months and remain optimistic about sales growth in the months ahead. Growth in menu price has accelerated, as per figures from the Bureau of Labor Statistics.

Cost-Containment Efforts: Some cost cuts have been achieved through integrated information systems, including point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems.

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

Although the overall restaurant industry appears torpid, there are several stocks that promise long-term growth opportunities. Buffalo Wild Wings offers investors one of the strongest growth stories in this space, with an annual growth target of 13% 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 Corp. (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 continued uptrend since the last few months on following strong sales of beverage as well as core menu products.

Chipotle has also largely remained unruffled by the 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, BJ’s Restaurants offers investors a strong growth story with a viable business strategy and a debt-free balance sheet. The company delivered impressive third quarter results in terms of 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 effects of the economic uncertainty. Companies continue to reduce their energy consumption and are remodeling their restaurants to give an up-market 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.

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

Companies like Yum! Brands, McDonald’s and California Pizza Kitchen are aggressively expanding in China to capitalize on the economic growth in Asia.

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

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.

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.

Additionally, the core California market, which has been badly hit in the recessionary period resulting in a high rate of unemployment and weak consumer confidence, started to turn around. The market reported modest same-store sales in the last quarter. Stronger performance in certain areas of California outperformed BJ’s Restaurants’ average in the third quarter. We see plenty of quality growth opportunities in California and Texas markets.

Currently, there are a number of stocks in the restaurant industry universe with a Zacks #1 Rank (Strong Buy). These include Biglari Holdings Inc. (BH) and Krispy Kreme Doughnuts Inc. (KKD). Stocks like BJ’s Restaurants, Chipotle Mexican Grill, The Cheesecake Factory Inc. (CAKE), Brinker International Inc. (EAT), Starbucks Corp. (SBUX), Domino’s Pizza Inc. (DPZ) currently retain Zacks #2 Rank (Buy).

WEAKNESSES

There are still quite a few names with lackluster outlooks which offset opportunities in the industry. One such stock is Red Robin Gourmet Burgers (RRGB), which expects negative same-store sales and cost escalation to affect its fourth quarter 2010 earnings.

Food costs account for about one-third of restaurant sales. Wholesale food prices have been trending higher this year. The prices of corn, wheat, coffee and other commodities have also surged, mainly due to a decline in the U.S. and Russian production prospects compelling many restaurants to hike prices on some of their products.

According to a recent NPD foodservice market research report, the U.S. restaurant unit count continues to fall, with majority of the closings experienced by independent restaurants, while chain restaurants 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.

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 difficult economic conditions are resulting in price wars among competitors.

Given the lack of overall earnings catalysts, it is difficult to be enthusiastic about a number of restaurant stocks. These include McDonald’s (MCD), Darden (DRI), Yum! Brands Inc. (YUM). Darden and Yum! currently retain Zacks #3 Rank (short-term Hold), while McDonald’s retains Zacks #4 Rank, which translates into a short-term Sell rating.

The restaurant industry is not immune to uncertainties in the macro economy. Although the industry showing gradual improvement, a high unemployment rate, dreary wage gains, and a freezing housing market are still compelling consumers to check their expenses.

The recent global downturn has rocked the restaurant industry. With time, however, we believe it will find its way out of the woods.

BIGLARI HOLDING (BH): Free Stock Analysis Report

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

BUFFALO WLD WNG (BWLD): Free Stock Analysis Report

CHEESECAKE FACT (CAKE): Free Stock Analysis Report

CHIPOTLE MEXICN (CMG): Free Stock Analysis Report

DARDEN RESTRNT (DRI): Free Stock Analysis Report

BRINKER INTL (EAT): Free Stock Analysis Report

MCDONALDS CORP (MCD): Free Stock Analysis Report

RED ROBIN GOURM (RRGB): Free Stock Analysis Report

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

Zacks Investment Research

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