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Restaurant Industry Outlook - April 2018

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The U.S. restaurant industry has been grappling with continued soft consumer spending on dining out over the past few quarters.

Resultantly, same-store sales growth has been dull in this difficult sales environment. Foot traffic declined, and profits at many chains followed suit. Although the fourth quarter witnessed same-store growth (first time in the last two years), growth dropped off in January and February, per TDn2K’s Black Box Intelligence.

This is further reflected in the industry’s stock price performance. Over the past year, while the Zacks Restaurant Industry has gained 10.2%, the S&P 500 added 10.8%.

The unfavorable environment is expected to persist for some time.

Traffic, Same-store Sales Remain Weak

The industry continues to struggle with weak same-store sales and traffic. Foot traffic declined 3.2% in 2017 and 3% and 3.1% in January and February, 2018 respectively. Same-store sales that account for traffic declined 2.2%, 1.6% and 1%, respectively, in the first three quarters of this year. Although the fourth quarter witnessed positive same-store growth of 0.4%, the metric declined thereafter, falling 0.3% in January and 0.8% in February, per TDn2K’s Black Box Intelligence.

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 of food items 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 lower footfall.

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

What Can Possibly Drive Growth?

Restaurants have been witnessing solid sales growth ever since the Great Recession and 2017 was no exception, despite an industry-wide slowdown. In fact, 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. This marks the eighth consecutive year of real growth in restaurant sales.

Some of the big names like Darden Restaurants (DRI - Free Report) , Domino's Pizza, Inc. (DPZ - Free Report) , McDonald's Corp. (MCD - Free Report) , Yum! Brands, Inc. (YUM - Free Report) and Restaurant Brands International, Inc. (QSR - Free Report) have remained unperturbed by the recent softness 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.

Recent strong gains in the labor market on the back of a steady rise in wages will likely encourage consumers to dine out more. Besides, restaurant operators 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 their guests to attract them once again. The restaurant industry should thus get its mojo back going forward.

Valuation Looks Bit Stretched

The restaurant industry has historically traded at a premium to the broader market, both on a trailing as well as forward basis.   

On a trailing 12-month P/E basis, the industry is currently trading at 25.4X, which compares to the 20.4X for the S&P 500 index. Over the last 5 years, the industry has traded as high as 29.3X and as low as 21.8X, with a median of 25.3X.

The industry is currently trading at 21X forward 12-month EPS estimates, which compares to the S&P 500 index’s 16.9X multiple. Over the last 5 years, the industry has traded as 25.3X and as low as 19.3X, with a 5-year median of 22.4X.

In other words, the industry is trading below the 5-year highs and close to the median for the period. Valuation isn’t cheap, but it isn’t nose-bleed expensive either.

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 their 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 #188 (bottom 27%).

The position 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. Nevertheless, operators willing to evolve and stand out in in a difficult environment and with strong fundamentals continue to exhibit strength.

Among the companies in our coverage universe, McDonald’s and Dine Brands (DIN - Free Report) Global posted robust results beating earnings and revenue estimates in the fourth quarter of 2017.

Restaurant Brands, Yum! Brands, Chipotle Mexican Grill (CMG - Free Report) and Brinker International (EAT - Free Report) posted mixed results. While their earnings surpassed the Zacks Consensus Estimate, revenues fell short of the same. Starbucks (SBUX - Free Report) reported better-than-expected earnings but failed to meet the Zacks Consensus Estimate for revenues in first-quarter fiscal 2018. The Wendy's Company (WEN - Free Report) lagged on both fronts.

Bottom Line

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. Restaurant operators continue to battle margin pressure, and lingering consumer uncertainties.

There might be light at the end of the tunnel, as a gradually improving economy on the back of growing income and solid employment numbers are likely to drive restaurant industry sales to continue in the balance of 2018 and 2019.

Meanwhile, as always, the restaurant industry is expected to remain hyper-competitive as different names vie for market share. Restaurant operators will thus need to differentiate themselves, keeping in mind price and convenience.  Being in the limelight, focus on innovative products, distinctive promotions and viable pricing will ensure steady footfall.

As the industry might not beef up its proverbial pie at a rate fast enough to satiate all its players, 2018 will see a "take share" environment in the industry.

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