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Industry Outlook

The U.S. restaurant industry has been a little under the weather since the beginning of 2014. Increasing food costs, weak consumer spending environment and a few political and general issues have kept the industry under pressure so far. Restaurant Performance Index (RPI) -- a health and outlook measure for the industry -- was 101.0 in July, marking the second consecutive monthly decline.

Despite positive same-store sales and traffic trends, RPI declined on a mixed outlook for the rest of the year as provided by the restaurant operators. Also, the continuous rise in food costs poses a threat to the industry. According to the Bureau of Labor Statistics, average wholesale food prices were up 7.1% in Jul 2014 and registered sharp gains in six of the first seven months of 2014. In fact, food prices are set to register their highest annual increase in three years.

However, despite the challenges, the underlying fundamentals point toward an improving business environment in the months ahead. Restaurant industry sales trended in a positive direction during the first half of 2014. Per the U.S. Census Bureau data, total eating and drinking place sales were up 6.2% in July on a seasonally-adjusted basis. However, consumers are relatively less optimistic about the outlook in the near-term.

Nevertheless, per National Restaurant Association, restaurant-and-foodservice sales will be $683.4 billion in 2014, up 3.6% year over year driven by innate fundamental strengths, which reflects an improving economic backdrop. Moreover, consumer confidence index has reached its highest level in around seven years.

OPPORTUNITIES

Domestic and International Unit Expansion: Amid a sluggish economy, most of the companies have stepped up their pace of restaurant openings. Not content with domestic expansion alone, the companies are looking to test waters as well as developing taste buds 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 these companies to shift their spotlight from the somewhat saturated domestic market. Burger King Worldwide, Inc. (BKW), Jamba, Inc. (JMBA - Snapshot Report) and Domino's Pizza, Inc. (DPZ) have been quite active on this front.

Refranchising, Revamping & Innovating Menus to Impress Guests – A Common Trend: Though refranchising was common in the restaurant sector, it has received a boost lately given the benefits of this business model even in an anemic economy. The franchise-centric model helps to reduce volatility in earnings and enhances cash flow generation. Companies like Yum! Brands, Inc. (YUM - Analyst Report) and The Wendy's Company (WEN - Analyst Report) are examples of highly franchised brands.

Additionally, restaurants are responding in different ways to address heightened competition in a somewhat over-supplied domestic market. One of the initiatives taken by these food chains is re-imaging of stores, which has received an overwhelming response from guests. The Wendy's Company, Denny's Corporation (DENN), Fiesta Restaurant Group, Inc. (FRGI) have been working along these lines.

Some of the industry players like BJ's Restaurants, Inc. (BJRI), Buffalo Wild Wings Inc. (BWLD) and Chipotle Mexican Grill, Inc. (CMG) are rolling out prototypes and smaller restaurant chains to augment value and drive traffic, thereby reducing construction and occupancy costs but enhancing returns on capital. Also, these smaller prototype restaurants help to accelerate growth in non-traditional locations. Companies such as Darden Restaurants, Inc. (DRI), Panera Bread Company (PNRA - Analyst Report) and BJ's Restaurants are busy investing in kitchen equipments to improve capacity and speed.

Having stabilized their financial positions, the operators are constantly striving to add new offerings to their menu card in order to cater to the ever-changing palates of customers while making food presentation better.  Chipotle Mexican Grill, Buffalo Wild Wings and Jamba are focusing on this strategy. Restaurateurs like, BJ's Restaurants, and Panera Bread are offering loyalty programs at their units to enhance value dining. This is a ploy to encourage sales at a time when customers are spending less on dining and need added incentives.

Modern Technology, Digital Ordering, & Delivery Gaining Precedence: The digital wave has hit the U.S. fast casual restaurant sector as more and more restaurants are deploying technology to enable a better guest experience. The National Restaurant Association notes that technology will make pervasive inroads into the restaurant sector. Smartphone apps will lure consumers to the restaurants while video menu boards in quick-service restaurants and the growing application of tabletop devices in casual dining give operators some of the latest tools to push sales.

A few restaurants chains that are aggressively moving on this track are Panera Bread, Buffalo Wild Wings and Krispy Kreme Doughnuts, Inc. (KKD) that use tablets and kiosks to drive traffic. Meanwhile, the world’s largest coffee-shop operator, Starbucks Corporation (SBUX) is also reportedly planning to release an app that will let customers order and pay even before they reach the store.

Restaurateurs are also fast catching up on the growing trend of digital ordering. So far, Domino's Pizza, Inc. (DPZ) has been a huge beneficiary of this trend. A few others following the footsteps of this leading pizza brand are Papa John's International Inc. (PZZA - Snapshot Report) and Cracker Barrel Old Country Store, Inc. (CBRL).

Though delivery was common in the restaurant sector, especially among pizza chains, increasingly busy lifestyles have given it a boost. However, in order to capitalize on the increasing demand for their products, a few players in the industry like BJ's Restaurants, Chipotle Mexican Grill and Panera Bread have begun providing off-premise catering programs. These programs are especially designed to serve a large number of customers at their homes, offices or at any other venue.

These operators also rely on social media for promotions and incorporate Facebook (FB), online review sites, Twitter (TWTR - Analyst Report) and blogs aggressively into their marketing mix.

Change in Consumer Preference: The latest trend at 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 about 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. A few companies like Chipotle Mexican Grill and Kellogg Company (K - Analyst Report) are coming up with low-calorie offerings to improve revenues and profits.

Currently, Chipotle Mexican Grill and Jamba, Inc. sport a Zacks Rank #1 (Strong Buy). A few companies with a Zacks Rank #2 (Buy) include DineEquity, Inc. (DIN), Fiesta Restaurant, Jack in the Box Inc. (JACK - Snapshot Report) and Papa Murphy's Holdings, Inc. (FRSH). Despite having a Zacks Rank #3 (Hold), we are optimistic about Brinker International, Inc. (EAT), Tim Hortons Inc. (THI), Buffalo Wild Wings and Burger King, owing to strong fundamentals and future outlook.

WEAKNESSES

Commodity Cost Inflation: Food costs account for about one-third of restaurant sales, thus making the industry excessively vulnerable to food cost inflation. Increase in demand for a commodity is always good news for producers. However, it is only when there is inadequate supply of a particular commodity that prices start to rise.

Products like cheese, beef, bacon, avocado, pork and coffee are some of the key ingredients whose prices have increased significantly. While a drought in California raised the prices of cheese, beef and avocado, a virus infection in pigs raised bacon costs. The drought in Brazil has resulted in coffee price increases. In fact, prices of beef, bacon and pork have hit record highs in the last 2-3 months.

The situation is not expected to improve in the near-term. Wholesale pork prices are expected to jump 10% to 11% while beef prices are expected to increase 8% to 9% in 2014, per the U.S. Department of Agriculture. Also, the food-at-home inflation as well as the food-away-from-home inflation index in the U.S. is expected to grow year over year in the range of 2.5–3.5% in 2014.

Rising costs hurt the margins of the company who try to pass on the costs to customers by increasing menu prices, thereby resulting in a decline in traffic. We would like to remind investors that The Hershey Company (HSY), Starbucks Corporation, Kraft Foods Group, Inc. (KRFT) and The J. M. Smucker Company (SJM) have already announced price increases for their products in response to rising input costs of their key ingredients. (Read: Hershey Ups Prices to Counter Input Cost Rise; Cuts '14 View)

In addition to commodity costs, pre-opening and re-imaging expenses and costs incurred to boost sales also dampen margins.

Bleak Economy/Political and Macro Issues: The industry is caught up in difficulties like heightened competition in the U.S. and decelerating growth in Asia.  Though the debt-laden Eurozone emerged out of recession in mid-2013, challenges still remain. The restaurants have little pricing power in the region due to a slowdown in consumer discretionary spending, which has constricted the European informal-eating-out (IEO) industry. Among the emerging nations, China and Brazil have their own share of problems. Japan also continues to be a dampener as it is still recovering from the 2012 earthquake.

Moreover, the brunt of government budget cuts, higher gasoline prices, payroll tax increases and delayed tax refund checks leave less room for companies to pass on the rising food costs to customers, thus putting profits under pressure.

Other Challenges: Restaurants operating overseas are vulnerable to political and other issues in the regions in which they operate. The temporary closing of McDonald's Corp. (MCD - Analyst Report) restaurants amid allegations of violation of sanitary rules in Russia is a case in point. This was likely the result of the ongoing tension between Russia and the West on the Ukraine issue.

Also, issues like food safety have hurt the comps of a couple of restaurants. In Jul 2014, McDonald’s and Yum! Brands faced serious allegations over food safety in China. The charge was related to their supplier Shanghai Husi Food Co Ltd, a unit of U.S.-based OSI Group LLC, which sold expired meat to the two quick-food chains. Other restaurant chains like Papa John's International and Burger King who also received meat from this supplier suffered as well.

Also, there has been considerable debate in the recent past over the wages of restaurant workers. Workers at fast food joints claim that their employer’s profits have not trickled down to their pay, thereby forcing them to go on strikes demanding a wage hike. These movements significantly hurt the reputation of the companies. Besides, we believe that a wage hike would lead to an increase in prices at many fast-food chains, thereby lowering traffic. For the U.S. restaurant sector, which is already battling increased commodity prices, a raise in wages will further stifle margins.

Affordable Care Act to Hurt Margins: Since the sector plays a key role in the nation's employment picture, the Affordable Care Act by President Obama, commonly known as Obamacare, is expected to have an adverse impact on the operators, once fully implemented. The law entails companies to provide coverage for workers or face government penalties, though it is not applicable for employees who log less than 40 hours per week on an average. To avoid these austerities, most companies are trying out different labor models like involving more part-timers and cutting work hours, which would hurt margins at the restaurant chains.

Once the act is fully implemented, companies with 50 or more workers will be required to offer a generous health insurance package or pay an annual penalty of $2,000 for each full-time worker. Some companies are already limiting their hiring, which will eventually increase the unemployment rate. There are also several other clauses which would adversely impact the restaurant industry.

There are some companies that induce our cautious to bearish outlook. These include The Cheesecake Factory Inc. (CAKE), Bloomin' Brands, Inc. (BLMN), Ignite Restaurant Group, Inc. (IRG) and Noodles & Company (NDLS), all with a Zacks Rank #4 (Sell).  Meanwhile, McDonald's Corp., Panera Bread and Red Robin Gourmet Burgers Inc. (RRGB - Analyst Report), currently hold a Zacks Rank #5 (Strong Sell).

Zacks Industry Rank – Negative Outlook

Within the Zacks Industry classification, the restaurant industry is grouped within the broader Retail sector. We rank all 260+ 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 at #193. This is in the bottom 1/3rd of all industries ranked, highlighting the group’s near-term Negative outlook. We believe that the Negative outlook reflects the near-term concerns such as food cost inflation and a bleak economy that are minimizing consumer spending.

Earnings Trends

The restaurant industry falls under the broader Retail-Wholesale sector, which has an earnings beat ratio of 47.6% and revenue beat ratio of 50%.

Earnings grew 2.6% in the second quarter, up from 0.4% growth in the first quarter of 2014. On the revenue front, the sector recorded an increase of 5.5% in the second quarter, up from 3.8% in the first quarter of the year. The upside on both the fronts reflects initiatives taken by the companies to boost traffic trends.

Looking at the consensus expectations for the third quarter of 2014, earnings are expected to decline 1.7%. However, for 2014, earnings are expected to increase around 6.9% with significant growth coming in the fourth quarter of the year. Revenues are expected to grow 3% in the third quarter of 2014. For 2014, revenues are expected to increase 6.3%, primarily on the back of top line increase of 7.2% in the fourth quarter.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

Performance of Some Restaurateurs

Among the companies in our coverage, companies like Buffalo Wild Wings, Chipotle Mexican Grill, Domino's Pizza posted solid second quarter results with earnings and revenues beating the Zacks Consensus Estimate on strong fundamentals. However, McDonald's Corp., Red Robin Gourmet, The Cheesecake Factory and Panera Bread missed the consensus mark on both the fronts, primarily due to a sluggish economy that resulted in lower traffic.

A look at the Earnings ESP in the table below shows that McDonald’s Corp. and Yum! Brands could miss the Zacks Consensus Estimate in their upcoming quarterly results (third quarter 2014).



Bottom Line

While traffic trends are improving, food costs are likely to erode margins in the back end of the year. It is high time that these food chains focus on strategies that will help them alleviate the impact of increased costs. Implementing the right pricing strategy, increasing global presence and focusing on supply chain revenues hold the key to growth. Overall, the restaurant industry is expected to sustain its general pace of recovery in the second half of 2014, albeit a bit slower as it contends with several global economic concerns.

Our proprietary Zacks Rank indicates the movement of the stocks over the short term (1 to 3 months). At present, 23% stocks hold a positive while 38.5% of the stocks hold a neutral and negative outlook each.

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