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High Costs, Low Traffic Take a Bite Out of Restaurant Stocks

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The restaurant industry’s sales trends in recent quarters have been very challenging, as the Thursday report from Starbucks (SBUX - Free Report) shows. This makes it prudent for investors to take a closer look at the dampeners threatening growth in the restaurant industry. Particularly, negative comps growth, given sluggish traffic trends along with rising costs, are taking the sheen out of restaurateurs.

Below we discuss some of the downsides plaguing the restaurant industry:

High Expenses: Costs related to various sales and comps boosting initiatives along with restaurant re-imaging expenses 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) . Though these initiatives offer long-term advantages, the costs related to them are expected to continue to dampen margins in the near term.

Moreover, restaurants like The Cheesecake Factory Inc. CAKE and Panera Bread Company (PNRA) 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. Moreover, higher labor costs due to a 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, again at the cost of margins, to retain or attract employees. Industry giants like McDonald's Corp. (MCD - Free Report) and Domino's are working on these lines.

Soft Comps & Traffic Trends: Over the past few quarters, consumer behavior has been volatile and their willingness to spend on most goods, especially eating out, is showing signs of decline. Most of the restaurateurs are thus bearing the brunt of soft comps and traffic trends. In fact, the first quarter of 2017 marked the fifth consecutive quarter of negative comparable sales for the restaurant industry as a whole, per a report by TDn2K’s Black Box Intelligence. Given the negative same-store sales, there has been a lot of buzz about the restaurant industry hitting recession.

But it is to be noted that the chief reason for the drop in same-store sales is an increased number of new restaurants amid limited growth in eating-out budgets. Moreover, per market analysts, diners are spending more per visit instead of visiting chain restaurants more often, 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.

Slowdown in New Restaurant Openings: As the operating environment has become increasingly challenging, the decline in sales volumes have begun to impact the returns on new restaurant openings. As a result, some of the restaurants are slowing down their development plan significantly for 2017.

Red Robin is one such company that has slowed down its unit growth plan and expects the first half of 2017 to be challenging. BJ's Restaurants, Inc. BJRI has also reduced the number of planned restaurant openings to 10 in 2017 compared with 17 restaurant openings in 2016. The reduction is due to the company’s continued belief that the sales headwinds in the industry call for greater focus on traffic and sales building initiatives.

Such slowdown in their development plan in 2017 is likely to dent sales growth in the year.

Macro & Political Issues/Company-Specific 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, where economic/political conditions are expected to be challenging after U.K.’s exit from the 28-member economic bloc. Naturally, restaurateurs like McDonald's, Papa John's International Inc. (PZZA - Free Report) , Starbucks Corporation (SBUX - Free Report) and others with exposure to some of these regions are facing the heat.

Back in the U.S., Chipotle Mexican Grill, Inc.’s CMG results for the past few quarters bore the brunt of negative publicity linked with food-borne illnesses that surfaced toward 2015-end. The company’s earnings and revenues have been under tremendous pressure since then. In fact, comps witnessed a decline of 20.4% in full-year 2016. Despite various strategic initiatives, we believe, it will take some time for the company to completely restore its economic model as well as customers’ trust and return to its former glory.

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, Yum! Brands, Inc.’s (YUM - Free Report) China business − which accounted for more than half of the company’s total revenue − played a pivotal role in its solid performance, over the last few years. Thus, the slight uncertainty surrounding the company’s business post spin-off of the China division has been weighing on its stock performance in the near term.

Currency Headwinds: Negative currency translation is a concern for companies like Domino's, Yum! Brands, Papa John’s and McDonald's as these have considerable overseas presence. As the U.S. dollar continues to show strength against various other currencies, the negative currency impact is likely to hurt the international sales of these companies.

Moreover, Papa John’s and Domino's revenues are also being affected by the British Pound’s plunge in value since the Brexit vote. In fact, Domino's anticipates foreign currency to have an $8 million to $12 million year-over-year impact on royalty revenues in 2017.

Affordable Care Act: The Affordable Care Act, commonly known as Obamacare, is having 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 and Brinkerwhich have numerous company-owned units and laborers and are already reeling under the pressure of higher costs.

To combat 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 push up the unemployment rate.

Nevertheless, the collapse of the Republican-led bill which would have replaced Obamacare means that the Affordable Care Act is here to stay. Naturally, restaurateurs are worried since they will have to continue shouldering increased labor costs.

Stocks to Avoid

Some of the players in the space that induce our cautious-to-bearish outlook are Brinker,Dunkin' Brands Group, Inc. (DNKN - Free Report) , Shake Shack Inc. (SHAK - Free Report) , DineEquity, Inc. (DIN - Free Report) and Zoe’s kitchen, Inc. . All these companies carry a Zacks Rank #4 (Sell).

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

To Conclude

The combination of rising costs, weak comps, economic uncertainty, higher restaurant prices, decline in at-home food costs, market saturation and the changing tastes of consumers has been straining sales and weighing on restaurant stocks’ performance. Nonetheless, implementing the right pricing strategy, providing unique offerings, increasing global presence and focusing on supply chain revenues can offset these negatives to some extent.

It is to be seen how these companies overcome the hurdles and get back their shine in the coming days. In “Which Restaurant Turnarounds Will Taste Success?” we focused on the conditions which are expected to drive the industry forward despite the headwinds.

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