Restaurant Industry

The Restaurant Industry has been facing extremely tough challenges due to the ongoing economic turmoil. With rising unemployment and lower discretionary spending, we believe it will be too early to predict improvement in the industry, which is grappling with sluggish consumer demand.

Although the current economic indicators show some signs of improvement, we believe that job losses will continue to adversely impact the restaurant industry even several months after the recovery is on track.

The U.S. restaurant industry, which constitutes fast food, casual dining and upscale chains, is facing its toughest times in three decades. A report by market research firm, NPD Group asserted that U.S. restaurant guest traffic plunged 2.6% for the quarter ended May 31, the steepest fall in 28 years. However, the quick-service restaurants (traffic down 2%), which are generally less susceptible to an economic downturn, are faring better than casual dining restaurant chains (down 4%) and mid-scale segment (down 6%).

A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index that measures the health and outlook for the U.S. Restaurant Industry softened in August (down 0.2% to 97.9 from July), after posting a marginal improvement in the month of July (up 0.3% to 98.1 from June), sending mixed signals in the industry. The index has remained below 100 for 22 consecutive months indicating that the industry is scaling back its development plans and is in contraction.

The Current Situation Index, which measures comparable store sales, traffic counts, labor costs and capital expenditures fell 0.9% to 96.0 due to sharp declines in sales and traffic in August. Approximately 68% of restaurant operators reported same-store sales decline in August, up from 58% reported in July. Moreover, 65% of operators reported a traffic decline in August compared to 59% reported in July.

The Expectations Index, which measures restaurant operators’ outlook on comparable sales, employees, capital expenditures and business environment, rose 0.5% to 99.9. Approximately 32% of restaurant operators (up from 31% in July) now expect to have higher sales in 6 months compared to the same period in the last year. Thirty percent of restaurant operators (down from 33% in July) now expect their sales volume to be lower in 6 months compared to the same period in the last year.

In the midst of what is expected to be a tepid recovery, there are three potential drivers of net income growth: Unit Expansion, Improved Same-Store Sales and Cost Cuts.

There seems little chance that upside will come from more aggressive unit expansion, as most of the companies have either scaled back or postponed further unit development. BJ’s Restaurants Inc. (BJRI - Analyst Report) plans to grow the unit base by 12% in fiscal year 2009, much lower than 21% achieved in fiscal year 2008. Darden Restaurants Inc. (DRI - Analyst Report) expects to open 50 to 55 net new restaurants in fiscal year 2010, drastically down from 71 restaurants opened in the last fiscal year.

The second driver, same-store sales, consists of menu price increases and traffic counts. Any price increases other than minimal ones would drive away value-conscious customers in this fiercely competitive environment. Moreover, to enhance the perception of value and to drive traffic, companies are remodeling restaurants, with an up-market feel, and are rolling out new, smaller prototype restaurants that reduce construction and occupancy costs, and in turn boost returns on capital.

Finally, some of the cost cuts have been achieved through integrated information systems including point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems. Restaurant companies try to optimize their restaurant operations and achieve decent restaurant operating cash flow margins.

OPPORTUNITIES

Despite the restaurant industry facing the brunt of the economic downturn, there are defensive stocks in the industry promising long-term growth opportunities. Buffalo Wild Wings Inc. (BWLD - Analyst Report) offers investors one of the strongest growth stories in this space with growth target of 15% in units, 25% in revenue, and 20% to 25% in net earnings. The company has also been able to deliver positive comps consistently, when other restaurant operators are grappling with deteriorating same-store sales.

McDonald’s Corporation (MCD - Analyst Report) with consistent earnings and healthy balance sheet provides relative safety and moderate growth in a turbulent environment and exposure to faster-growing international markets. Another stock, Chipotle Mexican Grill Inc. (CMG - Analyst Report), which remains largely unruffled by the slowdown, plans to open 120-130 restaurants in fiscal year 2009 -- a growth of 14.3%-15.5%.

WEAKNESSES

Offsetting these opportunities are the sagging same-stores sales and waning traffic counts. The shares of Red Robin Gourmet Burgers Inc. (RRGB - Analyst Report) are vulnerable to economic headwinds, and we believe that the stock will continue to underperform the restaurant industry. The chain expects guest counts to remain negative, and expects restaurant-level operating margins to decline by 50 to 80 basis points in fiscal year 2009. The company’s second-quarter 2009 same-store sales fell 11.5%.

Another stock obstructing the recovery is BJ’s Restaurants Inc. (BJRI - Analyst Report), which has also been experiencing declining comps and guest traffic. In addition, more than two-thirds of BJ’s Restaurants are located in areas that have been hit hard by the housing downturn and economic slowdown. These include California, Arizona, Nevada, Colorado, Oregon and Washington. This may dampen the company’s growth potential.

Read the full analyst report on BJRI

Read the full analyst report on DRI

Read the full analyst report on BWLD

Read the full analyst report on MCD

Read the full analyst report on CMG

Read the full analyst report on RRGB