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The U.S. restaurant industry has been under the weather over the past few quarters as continued soft consumer spending on dining out has strained sales.

Resultantly, same-store sales growth has been dull in this difficult sales environment. Foot traffic went into retreat, and profits at many chains followed suit. In fact, the third quarter of 2017 marked the seventh consecutive quarter of negative same-store sales (comps) for the restaurant industry as a whole, thereby stretching the somber mood.

This is further reflected in the industry’s stock-price performance. Over the past year, while the Zacks Restaurant Industry gained a mere 9.4%, the broader S&P 500 index added 18.5%.

After disappointing third-quarter numbers, the restaurant industry was hungry for some good news. Markedly, October delivered with comps turning positive for the first time since May 2016, per TDn2K’s Black Box Intelligence.

Additionally, recent strong gains in the labor market on the back of a steady rise in wages will likely encourage consumers to dine out more and stem the decline in traffic. Restaurateurs are undertaking various sales building and digital initiatives to enhance guest experience and, in turn, drive traffic and comps. Also, they are increasingly adapting to the changing tastes and preferences of consumers to entice them. Moving ahead, the restaurant industry should get its mojo back.

Challenges  

Restaurants have been witnessing solid sales growth ever since the Great Recession and 2016 was no exception, despite an industry-wide slowdown. Moreover, in its 2017 Restaurant Industry Forecast, the National Restaurant Association revealed that it expects sales in the industry to reach $799 billion, reflecting an increase of 4.3% over estimated sales of $766 billion in 2016. So, then what’s really spooking the restaurants?

It is to be noted that though this will mark the eighth consecutive year of real growth in restaurant sales, the rate of growth will remain dampened by historical standards. Considerable variances among geographic regions and industry segments are also likely to hamper restaurant sales.

Additionally, even though total sales are up, foot traffic at individual restaurants is waning fast. Same-store sales that account for traffic dropped in each of the four quarters of 2016 (0.2%, 0.7%, 1.1% and 2.4%, respectively), per TDn2K’s Black Box Intelligence. Moreover, comps have declined 2.2%, 1.6% and 1%, respectively, in the first three quarters of 2017, further attesting the difficult operating environment.

We note that the prime reason for such a drop in same-store sales is essentially the increased number of new restaurants amid restricted growth in eating-out budgets. Supply glut and limited demand are thus hampering traffic as well as stock prices for restaurants. Instead of generating added sales, each new restaurant is eating up share from others. This has resulted in bankruptcy for many public and private restaurants.

Another major challenge that restaurants are facing is an increase in menu prices at a much quicker rate than the prices for food at grocery stores. This is adding to the competitive pressure for restaurants, as preparing food at home has become much more attractive from a cost perspective, resulting in declining footfall.

Additionally, rising labor costs and a complex legislative and regulatory landscape on federal, state and local levels is thwarting business performance and bottom lines.

What Can Possibly Drive Growth?

Nevertheless, some of the big names like McDonald's Corp. (MCD - Free Report) , Yum! Brands, Inc. (YUM - Free Report) , Domino's Pizza, Inc. (DPZ - Free Report) , Darden Restaurants, Inc. (DRI - Free Report) and Restaurant Brands International, Inc. (QSR - Free Report) seem to be unperturbed by the plight and continue to do well on the back of strong fundamentals and innovative offerings. All these companies carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

This signifies that all is not lost for the U.S. restaurant space and investors should thus not shy away from putting money into this space and cash in on the bountiful opportunities. Moreover, the Restaurant Performance Index (RPI), which tracks the health and outlook of U.S. restaurants, was 100.7 in September, up 0.5% from August. According to the National Restaurant Association, a more optimistic outlook among restaurant operators for future business conditions drove the results.

Meanwhile, long-term trends favoring eating out over eating at home are still in place. Notably, sales at food services and drinking places have increased more rapidly than retail sales since 2014. This trend is also far more stable and will continue to lift the sector once the current weakness subsides. Moreover, operators willing to evolve and stand out in a competitive market will continue to reap profits. Thus, restaurants with solid fundamentals and sufficient capacity for innovation will remain compelling bets.

Traffic declined 1.5% in the month of October, further highlighting the fact that falling guest counts remain the biggest challenge for chain restaurants since the recession. However, comps grew 0.9% in the month, marking the industry’s best results in over two years.

Valuation Looks Fair

Going by the P/E (price to earnings per share) valuation metric, which is one of the most commonly used ratio and best suited for evaluating restaurants, the industry looks a bit expensive and investors might not want to pay any further premium.

The industry currently is currently trading at a trailing 12-month P/E ratio of 26.5X, which compares to a 5-year high of 29.4X, low of 19.2X and median of 24.3X. As recently May 2017, the Zacks Restaurant Industry was trading at 27.1X trailing 12-month EPS estimates.

At the current trailing P/E multiple, the industry is trading at a 27.4% premium to the S&P 500 index, which is below the May 2017 premium of 34.2%.

On a forward 12-month P/E basis, the industry’s valuation picture mirrors what we saw above.

All in all, the industry’s valuation metrics don’t appear stretched or expensive.

Zacks Industry Rank

Within the Zacks Industry classification, restaurant companies are grouped under the broader Retail-Wholesale sector (one of the 16 Zacks sectors).

We rank 265 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by more than twice as much. The Zacks Industry Rank for the Retail-Restaurants industry is currently at #232 (bottom 9%).

The location of the industry suggests that the general outlook for the restaurant space as a whole is leaning toward Negative.

The ranking is available on the Zacks Industry Rank page.

Earnings Trends

The restaurant industry belongs to the broader Retail-Wholesale sector.

A soft consumer spending environment in the U.S. restaurant space, along with rising costs, continues to haunt restaurant chains. Also, the recent hurricanes seem to have impacted results for a number of restaurant companies that have significant exposure to the affected areas. Nevertheless, innovative operators with strong fundamentals are continuing to exhibit strength even in a not-so-favorable environment.

Among the companies in our coverage universe, behemoths like Yum! Brands, Domino’s and Restaurant Brands posted robust results beating earnings and revenue estimates in the third quarter of 2017.

Meanwhile, McDonald’s and Buffalo Wild Wings, Inc. (BWLD - Free Report) posted mixed results. While their earnings surpassed the Zacks Consensus Estimate, revenues fell short of the same. Starbucks Corp. (SBUX - Free Report) reported in-line earnings but failed to meet the Zacks Consensus Estimate for revenues in fourth-quarter fiscal 2017. However, Chipotle Mexican Grill, Inc. (CMG - Free Report) , The Cheesecake Factory Inc. (CAKE - Free Report) and BJ’s Restaurants, Inc. (BJRI - Free Report) lagged on both fronts.

Bottom Line

Restaurant operators continue to battle margin pressure, a tightening labor market and lingering consumer uncertainties. There might be light at the end of the tunnel, though, as a gradually improving economy on the back of growing income and solid employment numbers are likely to help restaurant-industry sales to continue advancing in the balance of 2017 and 2018.

In fact, signs of improvement emerge despite weak performance. Thus, the restaurant industry is expected to sustain its general pace of recovery going forward, albeit at a slower rate, as it grapples with several global economic concerns.

Meanwhile, as always, the restaurant industry is expected to remain hyper-competitive as different names vie for attention from diners to capture market share. Restaurant operators will thus need to differentiate themselves from the competition, keeping in mind price and convenience.  Moving ahead, it will be critical to stay in consumers’ minds, focus on innovative products, distinctive promotions and viable pricing, validate the benefits of eating at restaurants instead of home, and at the same time deliver a congenial experience.

As the industry might not beef up its proverbial pie at a rate fast enough to satiate all of its players — it means 2018 will be another "take share" environment for the industry.

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