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Will High Costs, Low Traffic Hit Restaurant Stocks in 2017?

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Though an improving U.S. economy and slightly lower energy costs are driving consumer spending, it would be prudent for investors to take a closer look at the dampeners threatening growth in the restaurant industry. Particularly, sluggish comps growth and traffic trends along with rising costs are dulling the sparkle and could continue to spoil the party for restaurateurs.

Below, we discuss some of the headwinds that are plaguing the restaurant industry:

High Expenses: Costs related to various sales and comps boosting initiatives along with restaurant re-imaging expenses and higher minimum wage stipulations are hurting margins for companies like Domino's Pizza, Inc. (DPZ - Free Report) , The Wendy's Company (WEN - Free Report) and Brinker International, Inc. (EAT - Free Report) .

Moreover, restaurants like The Cheesecake Factory Inc. (CAKE - Free Report) and Panera Bread Company intend to make additional unit openings going forward. Thus, higher marketing and pre-opening costs associated with the same are expected to hurt profits.

Also, there has been considerable debate in the recent past over restaurant workers’ wages. Workers at quick-service restaurants claim that their employers' profits have not trickled down to them proportionately, which is leading to strikes for wage hikes. These incidents significantly hurt the reputation of restaurants. As a result, the companies are compelled to make minimum wage increases, which again lead to narrower margins. Higher labor costs due to the competitive labor market are expected to continue to keep profits under pressure.

Restaurant management turnover is another critical headwind for operators as turnover rates are now at the highest level since the recession, according to a report by Black Box Intelligence. This is further compelling restaurants to either hike wages or provide benefits, at the cost of margins, to retain or attract employees. Companies like Chipotle Mexican Grill, Inc. (CMG - Free Report) , Cheesecake Factory, McDonald's Corp. (MCD - Free Report) and Domino's Pizza are working on these lines. While Cheesecake Factory carries a Zacks Rank #2 (Buy), McDonald's andDomino's Pizza carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Soft Comps & Traffic Trends: Throughout 2016, consumer behavior was volatile and willingness to spend on most goods, especially eating out, showed signs of decline. Most of the restaurateurs thus bore the brunt of soft comps and traffic trends in 2016, with the year turning out to be the worst for the industry since the end of recession. In fact, the third quarter of 2016 marked the third consecutive quarter of negative comps growth in the restaurant industry, per a report by TDn2K’s Black Box Intelligence.

Per market analysts, diners are visiting chain restaurants less often and instead spending more per visit, which is hurting traffic. Also, increase in menu prices is at times preventing them from dining out. This unwillingness of Americans to dine out is thus pulling down restaurateurs’ sales.

Macro & Political Issues/Other Challenges: The restaurant industry is grappling with difficulties like intense competition in the U.S., decelerating growth in Asia along with weakness in some parts of Europe, wherethe economic/political conditions are expected to be challenging after U.K.’s exit from the 28-member economic bloc. Naturally, some restaurateurs like McDonald's and Papa John's International Inc. (PZZA - Free Report) with exposure to some of these regions are facing the heat.

Back in the U.S., Chipotle continues to reel under the negative publicity associated with the E. coli and norovirus outbreaks in several states, which surfaced toward the end of 2015, which has impeded sales of the fast-casual restaurant.

Meanwhile, Brinker International has substantial exposure to the energy-exposed markets. Though it expects these markets to improve over the long term, with the current volatility in energy prices, revenues in these markets would remain under pressure in the coming quarters.

On the other hand, BJ's Restaurants, Inc. (BJRI - Free Report) expects sales headwinds in the near term because of social and political issues, increasing global uncertainty and weakening consumer confidence which is resulting in continued decline in traffic.

Currency Headwinds: Negative currency translation is a concern for companies like Domino's Pizza, Yum! Brands, Inc. (YUM - Free Report) , Papa John’s and McDonald's as these have considerable overseas presence. Thus, fluctuating currency exchange rates might hurt the international sales of these companies.

Affordable Care Act: The Affordable Care Act, commonly known as Obamacare, had an adverse impact on restaurant operators. The Affordable Care Act requires employers to extend health benefits. The law entails restaurants with 100 or more full-time equivalent employees to offer health care coverage to substantially all full-time employees and their dependents beginning this year. Meanwhile, from the beginning of 2016, the Affordable Care Act was implemented for organizations with 50 to 99 full-time-equivalent employees. Employers will have to suffer penalties if they do not follow these rules.

This has increased costs for restaurant operators like Darden Restaurants, Inc. (DRI - Free Report) , Panera Bread, Papa John's and Wendy's, which have numerous company-owned units and laborers and are already reeling under the pressure of higher costs.

To avoid this, most companies are trying out different labor models like involving more part-timers and cutting work hours. Meanwhile, some companies have limited their hiring, which will eventually increase unemployment rate.

The incoming administration to repeal this legislation will be a big help, as will be its plans to cut taxes and spend extra on infrastructure projects.

To Conclude

While the restaurant industry has its share of pitfalls in the form of high costs along with slowing comps and traffic growth, implementing the right pricing strategy, undertaking initiatives, increasing global presence and focusing on supply chain revenues can offset these negatives to an extent.

It is to be seen how these companies fare and register profits in the coming days. In Are Restaurateurs’ Initiatives Enough to Attract Investors?” we focused on the conditions which are expected to drive the industry forward despite the headwinds.

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