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Yum! Brands, Inc.’s (YUM - Analyst Report) second quarter 2014 results, reported on Jul 16, fell short of analysts’ expectations. Same-store sales at its Pizza Hut restaurants fell 3.0% while same-store sales at its Taco Bell restaurants increased only 2.0%, thereby missing consensus expectations.

Since then, share price of this leading restaurant has declined 6.0%. Moreover, the stock has gained just about 4.6% year-to-date compared with the S&P 500’s gain of 9.1%. Why hasn’t Yum!, once the industry darling, been able to keep pace with the broader index?

It is not about industry weakness as is evident from the performance of the National Restaurant Association's Restaurant Performance Index (RPI), which rose to its highest level since Mar 2012. The RPI – which tracks the health of and outlook for the U.S. restaurant industry – stood at 102.1 in May, up 0.4% from its April reading.

This points to a fundamental weakness in Yum!. Though the company’s adjusted second-quarter 2014 earnings came in line with the Zacks Consensus Estimate, it followed a streak of negative earnings surprises since the first quarter of 2013.

Its China division had been facing allegations concerning the quality of chicken supplied to its KFC restaurants since Dec 2012. Therefore, the division that accounts for more than double of its U.S. revenues, had to face adverse publicity that affected its performance. To add to its woes, the outbreak of avian flu in China in Apr 2013 also hurt segment sales.

Industry Challenges Persist

We note that overall U.S. restaurant industry sales continued to remain sluggish in the second quarter, after a dismal first quarter, when results were hurt by inclement weather. Per Black Box Intelligence and People Report, U.S. restaurant same-store sales rose just 0.3% in the second quarter, a marginal improvement from the 0.2% decline in the first quarter. Moreover, traffic declined 1.4% in the second quarter.

The weak data reflects a sluggish labor market, changing consumer preferences beyond traditional restaurant chains, higher gasoline prices and lower disposable incomes that do not allow much spending on restaurants. However, the same-store sales data in the second half of the year is expected to be higher due to easier year-over-year comparisons.

The industry faces other challenges, too -- the most concerning being the rise in food costs. According to the U.S. Department of Agriculture, food price inflation is expected to be 2.5% to 3.5% in 2014. Moreover, retail prices for certain meats – one of the most important ingredients for restaurant stocks – are already at record highs and are expected to increase further.

3 Restaurant Stocks to Buy Now

Though the current macro environment should impact other restaurant stocks as well, we believe some of these are better off given their solid fundamentals and strong initiatives undertaken to boost sales. Here we have handpicked three stocks that are likely to outperform despite the hiccups.

Red Robin Gourmet Burgers Inc. (RRGB - Analyst Report), an operator of casual dining restaurants, has been posting positive comps growth over the past three years, amid a sluggish economic environment, thereby validating its strong fundamentals. Red Robin has undertaken several brand revitalization initiatives such as menu innovation, improving food presentation and introducing an improved customer service platform to significantly drive revenues. Red Robin’s unit expansion remains unruffled amid an uncertain economy. With the resurgence of consumer confidence, management has accelerated unit openings.

This Zacks Rank #1 (Strong Buy) company has beaten the Zacks Consensus Estimate in the trailing four quarters. Estimates for this company have largely moved up for second quarter, full year 2014 and 2015 over the last 60 days. Long-term growth rate for the company is pegged at 11.3%.

Domino's Pizza, Inc. (DPZ - Analyst Report) is the second largest pizza chain in the U.S. and the market leader in the delivery segment in the U.S. The company has been posting impressive results for the past few quarters on the back of higher traffic at its restaurants and unit growth. Domino’s Pizza has delivered positive earnings surprises in three out of the four trailing quarters.

This Zacks Rank #2 (Buy) company has undertaken several brand revitalization initiatives such as menu innovation, store expansion and re-imaging of existing stores to drive its revenues. Moreover, the company has been posting strong domestic as well international comps over the past few quarters. The company has witnessed 81 consecutive quarters of positive same-store sales in its international business.

Domino’s is investing heavily in technology-driven initiatives like digital ordering in order to capitalize on the digital wave that has hit the U.S. fast casual restaurant sector. The company is on track to improve its online ordering platform that was launched in 2006. 

The enhanced system will enable customers to save information and place orders in as little as five clicks or about 30 seconds. These efforts appear to be paying off strongly as Domino’s generated over $3 billion in digital sales globally in 2013, thus becoming one of the top technology-driven brands across the globe.

Also, the company has made menu innovations quite often to cater to changing consumer preferences. The company recently launched a new item, Specialty Chicken, a boneless chicken item with a pizza twist to cater to the growing demand for boneless chicken. Demand for boneless chicken has increased 11.0% over the past three years. Long-term growth rate for the company is 14.9%.

Buffalo Wild Wings Inc. (BWLD - Analyst Report), owner and operator of restaurants, has been posting positive comps growth over the past two years. The company remains better positioned than many of its peers on the back of menu innovation, promotional offers, better food presentation and operational efficiency. Apart from this, the company also stresses on advertising initiatives, installation of new point-of-sales programs, improvement in supply chain management, remodeling initiatives and its loyalty program to augment sales.

Buffalo Wild Wings offers dozens of projectors and televisions for its guests to view their favorite sporting events while dining at its restaurants. It is open seven days a week for up to 13 hours, providing high-quality entertainment and good food at the same time.

This Zacks Rank #3 (Hold) has beaten the Zacks Consensus Estimate in the past four quarters. In fact, the company is expected to continue the trend in the soon-to-be reported quarter driven by the FIFA World Cup that ended on Jul 13. Long-term growth rate for the company is currently pegged at 19.5%.

Other Steady Restaurant Players

There are some other stocks that are likely to perform well amid the difficult operating environment given their innate strength and fundamentals. For instance, through its ‘Food with Integrity’ initiative, Chipotle Mexican Grill, Inc. (CMG - Analyst Report) seeks to provide better food quality by not only using fresh ingredients but also sustainably-grown and naturally-raised products such as pork, chicken and beef.

Chipotle has eliminated all the GMO ingredients from its food menu. The company has been witnessing a fairly stable traffic trend over the past few years. As per the National Restaurant Association, 72.0% of the consumers would prefer to visit a restaurant that offers healthful options, thereby driving traffic and revenues.

Other stocks like Burger King Worldwide, Inc. (BKW - Analyst Report), Starbucks Corp. (SBUX - Analyst Report), Jack in the Box Inc. (JACK - Snapshot Report) are also on the same track and are making consistent efforts to withstand the current tough environment.

Bottom Line

The overall economic environment is improving, albeit at a slower pace. However, the year-over-year decline in guest count remains a concern. As per media reports, the industry is yet to achieve improved same-store guest count since the end of the recession.

It's 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 may as well help these restaurateurs stay afloat.

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