Restaurant Industry

Restaurant stocks have rebounded sharply from their November 20th lows, rocketing an average of 60% in the five weeks ended December 26, compared with a rise of 18% for both the S&P 500 and the Nasdaq Composite. Our restaurant index’s rebound has been sharper than the broader market, in part because its fall was greater. Year-to-date, our restaurant index is down 35%; the S&P 500 & Nasdaq have both lost nearly 42%.

Restaurants are typically early-cycle stocks, bottoming six-to-nine months before a turn in the economy. With that in mind, it appears that investors expect restaurant traffic to bottom in the June-to-September time frame. Bolstering that investment case are falling gas prices and the likelihood of aggressive stimulus packages from President-elect Obama, both of which should provide some relief for consumer spending pressures.

Meanwhile, restaurants are beginning to enjoy decelerating food costs, lower overhead through cost cuts and kitchen improvements, industry-wide capacity rationalization as restaurants close under-performing units and slow expansion, and improved credit markets, which make franchise financing more available.

There is also abundant evidence, however, that the consumer may not be as resilient as recent stock price increases suggest. Rising unemployment (it’s currently at 6.7% nationally and 8.4% in California), falling home values, negative personal savings, and diminished retirement portfolios all suggest that an upturn in consumer spending may be father away and the recession longer than past recessions. As a result, we think same-store sales at casual dining and upscale restaurants will continue to decline well into 2009 at average rates in the mid-to-high single digits, with flat to low-single digit average declines in the quick service sector as it benefits from a consumer trade-down.

Given the past month’s multiple expansion, we expect that any earnings disappointments would be met with sharp stock price corrections and valuation multiple contractions. Earnings estimates have been revised significantly downward, however, lessening the potential for severe disappointments, as much of the near-term bad news appears baked into estimates. The severity and longevity of the recession will determine whether future downward estimate revisions are necessary, and currently there is no visibility to the economy in 2009.

With these uncertainties in mind, we recommend investing in companies that have solid balance sheets, are fully funded for the next 12 months, pay attractive dividends in no danger of being cut, and have catalysts for top-line growth.

OPPORTUNITIES

In the restaurant sector, we recommend companies that are actually benefiting from the recession as consumers "trade down" to cheaper eats. McDonald’s (MCD - Analyst Report) and Yum! Brands (YUM - Analyst Report) are at the top of our Buy-rated recommendations that we expect to outperform the overall market and the restaurant sector over the next 6-12 months. MCD and YUM pay healthy dividends, currently yielding 3.3% and 2.5%, respectively, and we expect continued revenue and free cash growth, both domestically and overseas as the trade down phenomenon picks up Europe and rapid unit growth continues in Asia.

WEAKNESSES

Conversely, we expect restaurant companies with poor balance sheets and waning customer traffic to under-perform the overall market. Jamba (JMBA - Snapshot Report) is our strongest Sell recommendation. In the midst declining sales, rising food costs and heavy capital expenditures, Jamba faces a severe cash flow shortage that poses a risk of bankruptcy, in our opinion.  To secure badly needed cash, in September the company borrowed $25 million in a two-year note that pays interest in cash and shares equivalent to 18.5%!