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Industry Outlook

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.

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 medium term.

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% from November.

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 near term.

Performance of Key Players in Fourth-Quarter 2012

So far, industry behemoth McDonald's Corp. (MCD - Analyst Report) delivered stronger-than-expected results in the fourth quarter while another renowned operator -- Brinker International Inc. (EAT) -- 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, Panera Bread (PNRA - Analyst Report), AFC Enterprise (AFCE), Krispy Kreme Doughnuts, Inc. (KKD - Snapshot Report), Dominos Pizza (DPZ - Analyst Report), Red Robin Gourmet Burgers Inc. (RRGB - Analyst Report) and Dunkin Brands (DNKN - Snapshot Report) will likely beat fourth-quarter earnings.

However, our proven model does not conclusively show that the companies like The Cheesecake Factory Inc. (CAKE - Analyst Report), BJ's Restaurants Inc. (BJRI), Yum! Brands Inc. (YUM - Analyst Report), Burger King Worldwide Inc. (BKW), Sonic Corp. (SONC) and Chipotle Mexican Grill Inc. (CMG - Analyst Report) will likely beat the Zacks Consensus Estimate in the upcoming quarter.

Road Ahead

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 over 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 numbers.

OPPORTUNITIES

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 market.

Several food chains, including Denny's Corp. (DENN), Pollo Tropical (TAST), Starbucks Corp. (SBUX), 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 Common Trend

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. Companies like DineEquity Inc. (DIN) 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 (WEN), Darden Restaurants Inc. (DRI - Analyst Report) and Jamba (JMBA) 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 incorporating Facebook (FB), 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, owned by Pepsico Inc. (PEP).

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 McCafe line.

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. (BOBE) to LeDuff America.

Currently, one stock in the restaurant sector is carrying a Zacks Rank #1 (Strong Buy) and that is Krispy Kreme (KKD - Snapshot Report). Companies with a Zacks #2 Rank (short-term Buy rating) include AFC Enterprises (AFCE), Luby's Inc. (LUB), Burger King (BKW), Cheesecake Factory (CAKE - Analyst Report), Chuys Holdings (CHUY), Jack in the Box Inc. (JACK) and Dunkin Brands (DNKN - Snapshot Report). These companies have positive earnings estimate revision trends, highlighting the favorable momentum in their underlying businesses.

WEAKNESSES

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.

Eurozone Problems: 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 perfect example.

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 slowdown.

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 Texas Roadhouse (TXRH) 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 Menu

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, Cosi Inc. (COSI), Yum!,  McDonald's, Kona Grill Inc. (KONA), Domino's and BJ's Restaurants all of which retain the Zacks #3 Rank (Hold).

Texas Roadhouse (TXRH), Ruby Tuesday Inc. (RT) and DineEquity (DIN) still carry a Zacks Rank #4 (Sell). One of the industry's leading operators, Darden (DRI - Analyst Report), currently carries a Zacks Rank #5 (Strong Sell) due to persistent deceleration in some of its core brands.

In Conclusion

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.

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