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Which Restaurant Turnarounds Will Taste Success?

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According to the National Restaurant Association, 2017 could well be the eighth consecutive year of real sales growth in the industry. Amidst all the talk of a restaurant recession, strong sales and digital initiatives undertaken by restaurateurs to counter sluggish comps and traffic issues, along with improving economic indicators in the U.S., should bring some relief.

Taking the past trends and long-term growth prospects of the industry into account, we highlight a few positives of investing in the restaurant space:

Various Sales Building Strategies: In order to navigate in the challenging sales environment, restaurant operators are continually striving to add new items to their menu to cater to the ever-changing palates of customers while enhancing food presentation. Endeavors to augment sales by targeting higher footfall and improvising on the menu are thus bearing fruit. Some of the notable restaurateurs playing this card are Chipotle Mexican Grill, Inc. CMG, Buffalo Wild Wings Inc. BWLD, The Wendy's Company (WEN - Free Report) , and Jack in the Box Inc. (JACK - Free Report) .

Another initiative undertaken by the food chains is re-imaging of stores, which has been received favorably by guests. Wendy's, Domino's Pizza, Inc. DPZ, Brinker International, Inc. EAT, Ruby Tuesday, Inc. RT and Red Robin Gourmet Burgers Inc. (RRGB - Free Report) have been working on these lines. Notably, reimaging of stores helps to create an appealing and differentiated concept that helps the brand connect better with guests, especially millennials.

Meanwhile, restaurant companies like BJ's Restaurants, Inc. BJRI, Buffalo Wild Wings, Brinker International, Red Robin and Panera Bread Company PNRA offer loyalty programs at their outlets to enhance value dining. The companies engage guests through these programs with offers designed to increase frequency of visits. Loyalty programs thus help retain old diners while bringing in new ones, thereby driving traffic.

On the other hand, industry players like Brinker International and BJ's Restaurants are rolling out prototypes and smaller restaurant chains to augment value and drive traffic. This in turn will lower construction and occupancy costs but boost return on invested capital. Notably, smaller prototypes also accelerate growth in non-traditional locations.

Modern Technology, Digital Ordering & Other Channels Gain Precedence: The digital wave has hit the U.S. restaurant space as an increasing number of restaurateurs are deploying technology to enhance their guests’ collective experience. The companies’ online and digital marketing activities have thus increased significantly over the past several years in response to increasing use of online and mobile web technology.

While smartphone apps attract consumers, video menu boards in quick-service restaurants and tabletop devices speed up sales and ensure convenience. Further, restaurant operators rely on social media for promotions and incorporate Facebook, Inc. FB, online review sites, Twitter, Inc. (TWTR - Free Report) and blogs aggressively into their marketing mix.

Domino's continues with its digital capabilities with the launch of various ordering apps and platforms. Particularly, its world-class digital ordering platforms like Facebook Messenger, Apple Watch and Amazon Echo should boost digital orders. The extended ways to order a pizza has in fact kept Domino’s in the forefront of digital ordering and customer convenience. Papa John's International Inc. (PZZA - Free Report) also aims to continue investing in technology focused on foundational improvements to its digital channels to increase order conversion rate, frequency and ticket average.

Additionally, the world’s largest coffee shop operator, Starbucks Corporation (SBUX - Free Report) has secured a leading position in leveraging its mobile and digital assets and loyalty and e-Commerce platforms to create more revenue streams. Dunkin' Brands Group, Inc. DNKN is also growing in terms of its usage of digital technology through DD card, DD mobile app, DD Perks rewards program, On-the-Go ordering and delivering.

Meanwhile, Chipotle is moving aggressively to make digital ordering more appealing to its customers in order to drive digital sales and lure customers. Notably, it recently completed the rollout of its “Smarter Pickup Times” technology at all its restaurants that offer digital ordering. McDonald's Corp. (MCD - Free Report) has also finally begun testing mobile order-and-pay capabilities on its app in the U.S. Having witnessed four straight years of traffic declines, the company considers mobile ordering a way to win back customers.

Furthermore, in order to capitalize on increasing demand for their products, a few players in the industry are focusing on growing their off-premise, online-ordering business via carry-out, delivery and catering.

Companies like Panera Bread, BJ's Restaurants, Chipotle and Noodles & Company (NDLS - Free Report) are offering off-premise catering programs. These programs are especially designed to serve a large number of customers at their homes, offices or any other venue.

Also, restaurateurs are increasingly focusing on the delivery channel, which is a growing area for the industry driven by ease of access. By driving incremental sales at the companies, delivery services should turn out to be a strong revenue growth driver in the long term, given the huge demand for the same.

Starbucks has initiated a food and beverage delivery service through its employees at New York’s Empire State building. Meanwhile, fan following has been extremely positive and Buffalo Wild Wings thus aims to aggressively pursue third-party delivery to more restaurants throughout 2017. The Cheesecake Factory Inc. CAKE has also rolled out the service in nearly half of its restaurants with plans in place to continue introducing delivery to additional locations in 2017 as it is leading to incremental sales. Based on Panera Bread’s initial success with delivery, it now plans to have delivery in 35% to 40% of its total system by year-end 2017.

International Expansion: A number of restaurateurs are committed to expedite their presence in high-growth international markets to boost their business. Pizza chains Domino’s and Papa John’s are leading the race for international expansion.

Notably, Domino’s earns a growing part of its revenues from outside the U.S. with many international franchisees continuing to generate robust returns. In fact, the fourth quarter of 2016 marked the 92nd consecutive quarter of positive same-store sales in its international business. Many of Papa John’s restaurants are also located in international markets like United Kingdom, Mexico and China. The fourth quarter of 2016 marked the 28th consecutive quarter of positive comps in the international segment.

Meanwhile, Cheesecake Factorycontinues to foray into lucrative markets like the Middle East, North Africa, Central and Eastern Europe, Russia, Turkey, Mexico, Kuwait and Lebanon and Chile. Also, Brinker International is one of the few fast casual restaurant chains that have been expanding despite sluggish economic development. Management is gearing up for international expansion, especially in the faster growing emerging markets.

Cost-Cutting Effort & Shift to Franchise-Based Business Model: Given the exponential rise in costs, companies are striving to keep expenses under control. Through its Project Q initiatives, BJ's Restaurants is striving to reduce kitchen hours and enhance labor efficiencies. Cheesecake Factoryand Darden Restaurants, Inc. DRI are also working on techniques to aggressively cut costs. Meanwhile, Panera Bread has also rolled out its Panera 2.0 program to drive sales as well as earnings while lowering costs.

Of late, various companies in the restaurants space like Yum! Brands, Inc. (YUM - Free Report) , McDonald’s, Domino's, Wendy's, Papa John's and Jack in the Box have adopted a de-risking strategy by reducing their ownership of restaurants through refranchising. Notably, refranchising a large portion of the system reduces the company’s capital requirements and facilitates earnings per share growth and ROE expansion.

In addition, free cash flow continues to grow, thus allowing reinvestment for increasing brand recognition and shareholder return. Moreover, since a major portion of their business is re-franchised, these companies are less affected by food inflation than their peers.

Adapting to Changing Consumer Preference: U.S. eateries’ focus on serving customers a healthy menu has increased manifold as consumers are increasingly showing their preference for fresh, organic, nutritious and low-calorie food. Rising health concerns and growing awareness about obesity and related diseases have led to the shift in consumer preference toward healthy and “good for you” products and restaurant operators are quickly adapting.

Starbucks is working on replacing all artificial flavors and colors used in their food items with natural alternatives. Chipotle is also well known for using genetically modified organism-free ingredients in its food items and has also finally fulfilled its pledge of using no added colors, flavors or preservatives of any kind in any of its ingredients. Panera too has made its menu 100% clean by prohibiting an extensive list of additives.

Meanwhile, as part of its clean label commitment, Papa John was the first national pizza delivery chain to announce the removal of preservatives such as BHA and BHT, flavor enhancer, MSG, cellulose, partially hydrogenated oils and high fructose corn syrup. All these efforts reinforce these companies commitment to provide quality food and serve better ingredients.

McDonald's has discontinued the use of chicken raised with antibiotics, started using real butter (not margarine) in breakfast sandwiches, and has removed the high-fructose corn syrup from buns. Yum! Brands’ KFC has also pledged todiscard the use of chicken raised with antibiotics – commonly used to treat humans– at more than 4,000 of its restaurants in the U.S., by the end of 2018.

Meanwhile, McDonald's has also pledged to shift completely to cage-free eggs for roughly 16,000 restaurants in the U.S. and Canada over the next 10 years, in order to meet consumer preference for quality food. Further, companies like Dunkin' Brands, Wendy's and Panera Bread are shifting to cage-free eggs to appease health-conscious guests.

Moving to the consumer side, it seems that Americans are keener on having breakfast at restaurants. Exclusive breakfast offerings such as coffee, sandwiches, pancakes and doughnuts have been driving traffic at most U.S. restaurants, outpacing conventional lunch and dinner items. The breakfast segment is also gaining popularity because of lower rates than other meals and lesser waiting time. In fact, the consumption of breakfasts and morning snacks, in and away from home, is projected to grow 5% through 2019, according to research firm NPD Group.

Fast food giant, McDonald's started its own all-day breakfast platform in the U.S., which has proven to be a remarkable success. In fact, Denny's Corporation DENN and Jack in the Box have been offering all-day breakfast for quite some time now, highlighting how the trend has been successfully driving sales. Dunkin' Brands also sells breakfast sandwiches all day, which is a major contributor to sales. Other players in the industry like Yum! Brands’ Taco Bell is also capitalizing on rising demand for breakfast.

With breakfast foods playing a key role in the daily eating habits of restaurant-goers, the fast food industry (Quick-Service Restaurants, or QSR) has been able to turn around and drive growth even as non-healthy items in their menus are falling out of favor.

Favorable Macro Factors: Though the U.S. economy has got off to a slow start in 2017, the employment picture -- rising wages along with mounting consumer confidence -- are expected to encourage consumers to dine out more and thereby put a check on declining traffic.

Meanwhile, in Mar 2017, U.S. consumer confidence jumped to the highest level since Dec 2000 amid growing labor market optimism. This record consumer sentiment is noteworthy since it has been, historically, good at envisaging potential consumer spending for the next three to six months. 

Itis to be noted that eating out is one of the items in the family budget that has grown many folds as households get a boost. This bodes well for the restaurant sector and should aid in keeping investors’ appetites high for restaurants in 2017.

Stocks that Warrant a Look

Some of the restaurant stocks we are bullish on include Restaurant Brands International, Inc. (QSR - Free Report) and Yum China Holdings, Inc. (YUMC - Free Report) sporting a Zacks Rank #1 (Strong Buy). We are also optimistic on Darden, Jack in the Box and Bob Evans Farms, Inc. BOBE holding a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Despite being Zacks Ranked #3 (Hold) stocks, we also find McDonalds’s, Domino's, Cheesecake Factory, Red Robin and Dave & Buster's Entertainment, Inc. (PLAY - Free Report) worth considering given the momentum in their underlying businesses.

Bottom Line

There are plenty of reasons to be optimistic about the restaurant industry’s near- to medium-term outlook. Though the industry has its share of headwinds, effective sales and digital initiatives undertaken by the companies to cater to ever-changing wants and needs of customers should keep it going. We thus expect the industry to grow at a modest pace ahead.

Particularly, innovative operators with strong fundamentals are likely to continue exhibiting strength even in a not-so-favorable environment. Hence, investing in some sound restaurant companies to satisfy your appetite should not be a bad proposition.

Check out our latest “Restaurant Industry Outlook” here for more on the current state of affairs from an earnings perspective and the trend for this important sector.

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