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Restaurant Stocks Challenged by Low Traffic, High Costs

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Troubles simmering in the U.S. restaurant industry over the past few quarters are known to all. This is reflected in the industry’s recent stock-market performance as well, which has lagged the broader market in the year-to-date period.

Stocks in the Zacks Restaurant industry are up +12.1% this year, which compares to a +17.7% gain for the S&P 500 index in the year-to-date period. Negative comps as a result of sluggish traffic, along with rising costs, are the contributing factors to this underperformance.

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

High Expenses: Higher payroll expenses and costs related to various comps and sales 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. Additionally, resorting to more discounting and value bundling might further put pressure on casual dining operators’ already tight operating margins.

Moreover, restaurants like Brinker, Cracker Barrel Old Country Store, Inc. CBRL and Dave & Buster's Entertainment, Inc. (PLAY - Free Report) 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.

Additionally, recruitment and retention of employees has emerged as a top challenge for restaurant operators. As the economy keeps improving and employment levels rise, there is more competition for qualified employees to fill vacant restaurant positions. Meanwhile, restaurant management turnover is a critical headwind for operators as turnover rates continue to rise, as per a report by TDn2K’s. This is further compelling restaurants to either hike wages or provide benefits, at the cost of margins, to retain or attract employees.

Comps Under Pressure: 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, which is resulting in low consumption. This is because, along with wage growth, inflation is also on the rise, which translates into lower real income and thus less disposable income. The situation has taken a turn for the worse, thanks to higher health care costs and tightened credit availability in the United States.

Moreover, as consumers demand high-quality products at lower prices, grocery stores are being forced to decrease their food prices to remain competitive. This is resulting in a bigger gap between food-at-home and food-away-from-home indices.

Most of the restaurateurs are thus bearing the brunt of soft comps trends. In fact, the third quarter of 2017 marked the seventh consecutive quarter of negative comparable sales for the restaurant industry as a whole, per a report by TDn2K’s Black Box Intelligence. Given the persistent negative comps trend, there has been a lot of buzz over the restaurant industry hitting recession.

But it is to be noted that the chief reason for the drop in same-store sales is a significant decline in traffic. In fact, per market analysts, diners are spending more per visit instead of visiting chain restaurants more often, which is hurting traffic. An increased number of new restaurants amid limited growth in eating-out budgets as well as increased pressure from grocery stores add to the woes. Also, increases in menu prices are at times preventing people 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 plans.

Notably, after slowing down its development plan significantly for 2017 and 2018, Red Robin Gourmet Burgers Inc. (RRGB - Free Report) now plans to pause new unit development after 2018. The company is thus choosing to take an 18-to-24 month pause on unit development as it assesses the shifting desires of customers and the most profitable way of addressing them.

Meanwhile, after reducing the number of planned restaurant openings to 10 in fiscal 2017 from 17 in fiscal 2016, BJ's Restaurants, Inc. BJRI now plans to open just four to six restaurants in fiscal 2018. 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 is likely to dent sales growth.

Macro & Political Issues/Company-Specific Challenges: The restaurant industry is grappling with difficulties like intense competition in the United States, decelerating growth in Asia, concerns in Latin America 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) , Dunkin' Brands Group, Inc.’s (DNKN - Free Report) , Starbucks Corp. (SBUX - Free Report) and others with exposure to some of these regions are facing the heat.

In fact, Dunkin' Brands’international comps growth has been suffering over the past few years at both its Dunkin’ Donuts and Baskin Robbins divisions. Discretionary spending is under pressure due to a number of factors including sluggish local economies, currency devaluation and oil prices. Even in the third quarter of 2017, Baskin Robbins witnessed negative international comps as performance remained bleak in Korea, Japan and the Middle East.

Meanwhile, it is to be noted that 2017 has been a challenging year for Chipotle Mexican Grill, Inc. CMG. Though initially sales somewhat recovered from the massive food safety scandal, which surfaced toward 2015-end, a fresh round of food-safety scare this summer once again raised questions.

Also, the company now expects sales to rise 6.5% (earlier high single digits) at established locations in 2017. Thus, we believe it will take time for the company to completely restore its economic model as well as customers’ trust and return to its former glory.

Notably, 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.

Additionally, we note that traffic has been one of the major reasons for the recent decline in comps at Cracker Barrel. For Cracker Barrel, the problem of declining traffic affects the company in more than one way. Firstly, traffic declines in restaurants cause sales to fall, which can only be combated through a significant increase in prices.

Secondly, fewer guests at restaurants results in a decline in guests for the retail segment of the company, as most shoppers at Cracker Barrel are the restaurants’ guests. Thus, the high correlation between the two segments weighs heavily on the company.

Currency Headwinds: Negative currency translation is a concern for companies like Domino's, Yum! Brands, Papa John’s, Restaurant Brands International, Inc. (QSR - Free Report) and McDonald's as these have considerable overseas presence. Strengthening of the U.S. dollar against various other currencies is likely to hurt 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. Meanwhile, Restaurant Brands’Tim Hortons brand realizes much of its business from Canada. Thus, any fluctuation in the Canadian dollar with respect to the U.S. dollar impacts the company’s revenues greatly.

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 the costs for restaurant operators like Darden Restaurants, Inc. (DRI - Free Report) , Red Robin, Dave & Buster's and Brinker,which 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.

However, the collapse of the Republican-led bill which would have replaced Obamacare means that the Affordable Care Act is likely 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 Wendy’s, Red Robin, Noodles & Company (NDLS - Free Report) , DineEquity, Inc. (DIN - Free Report) and The Cheesecake Factory Inc. CAKE. While Wendy’s and Noodles & Company carry a Zacks Rank #4 (Sell), Red Robin, DineEquity and Cheesecake Factory have a Zacks Rank #5 (Strong Sell).

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

To Conclude

The amalgamation of rising costs, weak comps, consumer spending uncertainty on dining out, higher restaurant prices, decline in at-home food costs, market saturation and shifting preference of consumers have been weighing on restaurant stocks’ performance. Nonetheless, by increasing global presence, implementing the right pricing strategy and providing unique offerings, restaurant operators can offset these negatives to some extent.

It is to be seen how these companies overcome the hurdles and get back their groove in the coming days. In “Will Digital Efforts, Delivery Aid a Recovery in Restaurants?” we focused on the conditions which are expected to drive the industry forward despite the headwinds.

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