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After hitting highs in April-May of 2013, the restaurant industry has been struggling since June, with the Fed’s ‘taper talk’ adding to other issues. Despite this macro overhang, the underlying growth drivers of the restaurant industry remain intact. The outlook for the rest of the year has a positive bias given easy year-over-year comparisons and an easing in food cost inflation.

Restaurant sales witnessed a modest gain in August, as per the preliminary figures from the U.S. Census Bureau.  Eating and drinking place sales totaled $45.9 billion in August, up 0.3% sequentially. As per National Restaurant Association, pent-up demand in the sector is high, promising long-term earnings growth for the sector.

Statistics bear out this relatively favorable 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 100.7 in July, exceeding the 100 mark for the fifth successive month.

The Current Situation Index, which measures comparable store sales, traffic count, labor costs and capital expenditures in the restaurant industry, was 100.1 in July, also above 100 for last fourth months. The latest index is indicative of the underlying strength in the industry.

The Expectations Index, which measures the restaurant operators' six-month outlook on the above indicators, was 101.3 in July, staying above the 100 level for seven consecutive months.

While all three Indices managed to beat the safety threshold of 100, reaffirming operators' positive outlook on the industry for the near term, all indices were down 0.6% sequentially, reflecting the ‘taper concerns.’

The Conference Board came out with the slightly discouraging Consumer Confidence Index -- a barometer of the U.S. consumer health -- on Sep 24, 2013. After increasing 5 points in August, the index fell 2.1 points to 79.7 in September.

We believe, issues like trimmed GDP outlook for 2013 and 2014 for the U.S. by the Fed, new stipulations related to "Obamacare," volatility in housing data, higher fuel prices and excess supply may cloud the long-term picture. An extensive focus on value proposition along with moderate pricing power could also prove unfavorable to margins if exercised on a long-term basis.

Zacks Industry Rank

Within the Zacks Industry classification, the restaurant industry is grouped within the broader Retail sector. We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the restaurant industry is currently #120. This is in the mid 1/3rd of all industries ranked, highlighting the group’s near-term Neutral outlook.

Key Performers in Second-Quarter 2013

Not all companies performed equally well in the quarter. While some were laggards, others posted solid results mostly on their individual strength. While 31% of operators missed the Zacks Consensus earnings estimates this season, 60% surpassed theirs and about 9% met. Some operators blamed a softer economic trend for the insignificant growth in revenues.

Industry behemoth McDonald’s (MCD - Analyst Report) delivered weaker-than-expected earnings in the second quarter and in-line revenues hurt by comps deceleration, while another renowned operator, Yum! Brands (YUM - Analyst Report), topped its earnings estimate but fell shy of revenue expectations mainly due to issues in China. However, we believe that both the companies will rebound in the long run, once the global issues subside.

Earnings Trend

The restaurant industry falls under the broader Retail-Wholesale sector, which portrays a stable earnings trend in recent times. The second quarter 2013 results for the sector were impressive in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 51.2%, while the revenue "beat ratio" was 32.6%. Total earnings for this sector went up 7.2% in the second quarter from 5.6% growth in the first quarter of 2013. The improvement came from the upside in revenues. On the revenue front, the sector has seen an increase of 4.2% in the second quarter on the top of a 2.8% increase in the prior quarter.

Looking at the Consensus earnings expectations for the rest of the year, we are positive since earnings are expected to grow a modest 3.9% in the third quarter of 2013 and 7.1% in the fourth quarter thereby registering full-year growth of 7.6%. For the next year, the sector is poised to expand around 16.5% with 10.9% growth in the first quarter itself.  

While revenue surprises started off on the weak side, the sector is anticipated to gain momentum from the fourth quarter of this year. For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

OPPORTUNITIES

Cooling Commodity Inflation in the US

The food cost inflation seems to have eased as the nation emerged out of severe drought in the Midwest growing region last year. Food costs account for about one-third of restaurant sales, thus making the industry vulnerable to food cost inflation.

As suggested by the U.S. Department of Agriculture (USDA) report, price inflation for all food is expected at 1.5-2.5% in 2013 down from 2.5-3.5% estimated previously. Commodities like fish and seafood, dairy products, fats and oils, sugar sweets, non-alcoholic beverages, cereals and bakery products and other foods will likely witness a decline in prices.

Although USDA expects poultry costs to increase in 2013, feed prices will likely cool off with a favorable weather in the new harvest season, leading to lower poultry prices in 2014.

Domestic and International Unit Expansion

Emerging from a lackluster economy from more than three years back, most of the companies have accelerated their pace of restaurant openings. A relative recovery in consumer confidence has also encouraged companies to return to unit expansion.

Besides spreading their wings in the home country, the companies also aim to test waters in 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. McDonald's, Yum!, Krispy Kreme Doughnut Inc. (KKD - Snapshot Report), Dunkin' Brands Group Inc. (DNKN - Snapshot Report) and Darden Restaurants Inc. (DRI - Analyst Report) have been quite active on this front.

Digital Ordering & Delivery Gaining Precedence

Digital ordering is in fashion now and restaurateurs are leaving no stone unturned to capitalize. So far, Domino's Pizza Inc. (DPZ - Analyst Report) has been a huge beneficiary of this trend, generating over $2 billion in digital sales globally in 2012. As a matter of fact, the company’s mobile ordering system together with traditional online ordering accounts for more than 30% of its revenues globally, and is likely to account for more than 50% of total sales over the long term.
 
Industry bellwether McDonald’s also looks to tap into the opportunity as it recently announced various digital schemes like self-ordering kiosks in Europe, mobile ordering, mobile payments and other smartphone tie-ins.

Though delivery was common in the restaurant sector, especially among pizza chains, it got a boost of late thanks to the busy lifestyle of consumers. The world’s second largest hamburger chain Burger King Worldwide Inc. (BKW) is the latest to join this bandwagon. Apart from this, catering initiatives are also doing the trick for companies like Panera Bread Co. (PNRA - Analyst Report) and Jack in the Box Inc.'s (JACK) Qdoba Mexican Grill chain.

Some other initiatives that have been undertaken to boost sales across the wide spectrum of operators are renovation of restaurants and continued reinvigoration of menu options.

Currently, Red Robin Gourmet Burgers Inc. (RRGB - Analyst Report) carries a Zacks Rank #1 (Strong Buy). Companies with a Zacks #2 Rank (short-term Buy rating) include CEC Entertainment Inc. (CEC), AFC Enterprises Inc. (AFCE), Burger King, The Cheesecake Factory Inc. (CAKE), Chuys Holdings (CHUY), Domino’s Pizza Inc., Dunkin’ Brands and Sonic Corp. (SONC). These companies have positive earnings estimate revision trends, highlighting the favorable momentum in their underlying businesses.

WEAKNESSES

Global Economic Backdrop Yet to Recover at Full-Swing: Strengths aside, companies are caught up with macroeconomic tensions like implementation of austerity measures in Europe owing to the sovereign debt crisis and decelerating growth in Asia.

The big chains have considerable exposure in European nations like France and Germany and in Asian countries like China. Although debt-ridden European regions have started witnessing improvements, they have yet to reach pre-crisis levels. Despite improving economic data, German customers remain extremely value-sensitive. Among the emerging nations, China and Brazil have their own share of problems. Japan also continues to be a dampener as it is still on the way to recovery from last year's earthquake.

Affordable Care Act to Hurt Margins: Since the sector plays a key role in the nation's employment picture, the recent Affordable Care Act by President 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 companies are trying out different labor models like involving more part-timers and cutting work hours ahead of the implementation of the healthcare reform.

Limited Pricing Power: As per USDA, the food-away-from-home inflation index in the U.S. is expected to grow in the range of 2–3% while food-at-home inflation will likely go up by 1.0% to 2.0%. The scenario leaves less room for operators to exercise pricing action as the pocket pinch will be more upon eating away from home. This, coupled with the slight decline in projected IEO traffic for 2013, might restrict eateries' pricing in the U.S.

Change in Consumer Preference: The latest trend in U.S. eateries is to serve a healthy menu, owing to consumer preference for fresh, organic, nutritious and low calorie food. Rising health concerns and increasing awareness to obesity and related diseases have led to the shift in consumer preference toward healthy and “good for you” products. Focus on child nutrition is also a priority. However, the fuss about nutrition poses challenges.

There are some names that induce our cautious outlook. These include Bloomin' Brands Inc. (BLMN), Cracker Barrel Old Country Store Inc. (CBRL), Darden Restaurants, Buffalo Wild Wings Inc. (BWLD), Chipotle Mexican Grill, Jamba Inc. (JMBA - Snapshot Report), Kona Grill Inc. (KONA), Brinker International Inc. (EAT - Analyst Report), Panera Bread Co., Krispy Kreme, McDonalds and Yum!, all of which retain the Zacks #3 Rank (Hold). Cosi Inc. (COSI) and BJ’s Restaurants Inc. (BJRI) carry a Zacks Rank #4 (Sell) due to their prolonged struggle on the earnings front.

Bottom Line

In hindsight, the performance of the restaurant sector was more-or-less satisfactory in the recent times. Cautious consumer spending in the light of “Taper Hold” along with a reduced growth outlook for the nation will likely result in sector stagnation for a short while. The upcoming quarter does not enthuse much optimism, and faster upward revisions in estimates should be seen fourth quarter onward.

Overall, the restaurant industry is expected to sustain recovery in the rest of 2013 but at a slower clip as it is at the receiving end of several global economic concerns. Our proprietary Zacks Ranks indicates the movement of the stocks over the short term (1 to 3 months). At present, respectively 27% and 51% stocks sport a positive and neutral outlook and the rest is negative.

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