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Restaurant Stocks Hurt by High Costs, Low Traffic

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The restaurant industry has been troubled by soft consumer spending environment over the past few quarters. Although the current economic backdrop is favorable with rise in in wages, jobless claims at a record low and upbeat consumer confidence, the benefits have not trickled down to the restaurant space yet.

The net result is an extended period of negative comps, sluggish traffic along with rising costs. Below we discuss some of the headwinds that restaurant stocks faced and will continue to face in the near and midterm.

These issues have been weighing on the industry’s stock market performance lately as well, which has been a tad below the S&P 500 index’s recent performance. Stocks in the Zacks Restaurants industry are currently down -3.5% this year, compared to the -3.2% decline for the S&P 500 index and the flat performance for the Zacks Retail sector of which the Restaurant industry is a part.

Expenses Continue to Climb

A difficult operating environment has forced restaurant operators to increase comps and sales initiatives, which has led to an increase in costs. Rising costs have been weighing on margins for companies like Domino's Pizza (DPZ - Free Report) , The Wendy's Company (WEN - Free Report) and Brinker International (EAT - Free Report) . Though these initiatives offer long-term advantages, related costs are expected to continue in the near term. Additionally, resorting to discounting and value bundling further puts pressure on casual dining operators’ already tight operating margins.

Moreover, restaurants like Dave & Buster's Entertainment (PLAY - Free Report) and Cracker Barrel Old Country Store (CBRL - Free Report) intend to make additional unit openings going forward. Thus, higher marketing and pre-opening costs 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 translated into substantial hike in their pay, resulting in strikes for wage hikes. These incidents significantly hurt the reputation of restaurants. As a result, the companies have been 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.

Meanwhile, increasing cost of turnover poses a serious 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. Restaurant management turnover is a critical headwind for operators as turnover rates continue to rise, 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.

Weak Comps and Low Traffic

In the past few quarters, consumer behavior has been volatile and their willingness to spend, especially on eating out, is showing signs of decline. Most of the restaurant companies are thus bearing the brunt of soft comps and traffic trends. Foot traffic declined 3.2% in 2017 and thereafter 3% and 3.1 % in January and February of 2018 respectively.

Same-store sales that account for traffic declined 2.2%, 1.6% and 1%, respectively, in the first three quarters of 2017. Although the fourth quarter witnessed a positive same-store growth of 0.4%, the metric fell 0.3% in January and 0.8% February, per TDn2K’s Black Box Intelligence.

The chief reason for the drop in same-store sales is an increase in the number of new restaurants amid limited growth in eating-out budgets as well as increased pressure from grocery stores. Supply glut and limited demand are 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.

Unit Openings to Go Down

As the operating environment has become increasingly challenging, the decline in sales volumes is impacting the returns on new restaurant openings. As a result, some of the restaurants are slowing down their development plan for 2018.

Notably, BJ's Restaurants, Inc. BJRI after reducing the number of restaurant openings to 10 in fiscal 2017 compared with 17 in fiscal 2016, 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.

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 till the beginning of 2019. This is likely to dent sales growth this year.

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, restaurant operators like McDonald's, Starbucks Corp. (SBUX - Free Report) , Dunkin' Brands Group, Inc.’s (DNKN - Free Report) , Papa John's International Inc. (PZZA - Free Report) , and others with exposure to some of these regions are facing the heat.

In fact, Dunkin' Brands’ international comps growth has suffered 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.

Although 2017 was expected to be a turnaround year for Chipotle Mexican Grill, Inc. (CMG - Free Report) after negative publicity linked with the food-borne illnesses, which surfaced toward 2015-end and continued through 2016, the company faced a fresh food safety scare. It closed a Washington area outlet due to an apparent norovirus alert. Evidence of rodents was found at a Dallas outlet, and some of its workers at a Los Angeles outlet complained of nausea, vomiting and diarrhea to local health officials, further adding to the woes.

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.

The Impacts of 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.

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. Some others have limited their hiring, which may push up the unemployment rate.

Stocks to Avoid

Some of the players in the space that induce our cautious-to-bearish outlook are Chipotle Mexican Grill, Dave & Buster's, Good Times Restaurants (GTIM - Free Report) and Papa John's International, each carrying a Zacks Rank #4 (Sell).

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

To Conclude

Rising costs, weak comps, consumer spending uncertainty on dining out, higher restaurant prices, decline in at-home food costs, market saturation and the changing preference of consumers has been weighing on sales and hampering 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 remains to be seen how these companies overcome the hurdles and get back their groove in the coming days. In “Restaurant Industry to Grow Modestly on Diverse Strategies,” we focused on the conditions that are expected to drive the industry in spite of the headwinds.

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