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The U.S. restaurant industry is facing a tough operating environment with factors like rising labor costs, increasing employee turnover, declining traffic and higher non-discretionary spending weighing on the sector. In fact, earlier this month, Moody's Investors Service revised its outlook for the U.S. restaurant industry from positive to stable. Industry operating income growth is now expected to increase 2% - 4% in the next 12-18 months instead of Moody's earlier forecast of 5% - 6%. Rising labor costs will become an even bigger issue once commodity prices start increasing.

Meanwhile, a TDn2K report published earlier this month indicates that Oct 2016 same-store sales growth was -0.9%, making this the eighth consecutive month of declining sales. Increasing costs are an issue with the use of promotions, discounts and similar inducements expected to remain high. According to Moody’s, it will be difficult to raise prices without impacting traffic.

Even though economic activity has been decent, more is being spent on non-discretionary items like healthcare than on eating out. Moreover, cheaper grocery bills and rising dining out costs are ensuring that people eat at home instead of in restaurants. As per data released last week, the food at home index has declined 2.3% over the last 12 months representing the largest 12-month decline since Dec 2009. In contrast, the index for food away from home rose 2.4% over the last 12 months.

While casual dining is expected to be the most impacted category within the restaurant industry, fast or quick casual restaurants are likely to outperform the restaurant industry as a whole. Meanwhile, the traditional QSR sector will remain affected by uncertain spending habits. According to Moody’s, the gap between the better players and those lagging the market will continue to grow.

Retail - Restaurants Industry Price Index

Stocks to Avoid

Given this backdrop, this may be the right time for investors to reshuffle their portfolio and consider avoiding restaurant stocks that currently hold an unfavorable Zacks Rank #5 (Strong Sell) or #4 (Sell) and are witnessing downward estimate revisions.

Noodles & Company (NDLS - Free Report) : NDLS, which develops and operates fast casual restaurants that serve noodle and pasta dishes, soups and salads, reported a higher-than-expected loss in the third quarter. The company also lowered its outlook for the year and is seeing major estimate revisions. While loss estimates for 2016 have gone up by 63.6% over the last 30 days, 2017 loss estimates have also gone up considerably.

NOODLES & CO Price, Consensus and EPS Surprise

Papa Murphy's Holdings, Inc. (FRSH - Free Report) : Papa Murphy's is a franchisor and operator of the largest Take 'n' Bake pizza brand in the U.S. The company missed both earnings and revenue estimates in the third quarter with aggressive competition in the pizza segment, increasing competition from the grocery category and significantly lower absolute levels of media hitting results. The company is witnessing downward estimate revisions - while 2016 earnings estimates are down 62.9% over the last 30 days, 2017 earnings estimates are down 73.3%.

PAPA MURPHYS HL Price, Consensus and EPS Surprise

El Pollo Loco Holdings, Inc. (LOCO - Free Report) : El Pollo Loco, which operates in the limited service restaurant (LSR) segment, specializes in fire-grilling citrus-marinated chicken. The company had a weak quarter missing both earnings and revenue estimates and lowering its outlook. The company said that it started experiencing a softening of sales during the second half of the third quarter, which continued into the fourth. El Pollo Loco is also seeing earnings estimates being revised downwards with 2016 estimates down 4.3% over the last 30 days and 2017 estimates down 9.3%.

EL POLLO LOCO Price, Consensus and EPS Surprise

BJ's Restaurants, Inc. (BJRI - Free Report) : BJRI’s restaurants are operated either as a BJ’s Restaurant & Brewhouse, a BJ’s Restaurant & Brewery, a BJ’s Pizza & Grill, or a BJ’s Grill restaurant. The company’s third quarter numbers were disappointing with results being hit by a soft operating environment. The company said that discretionary spending was hit by macro factors like the timing of the Summer Olympics as well as the economic uncertainty arising from the political elections. 2016 earnings estimates are down 2.8% over the last 30 days while 2017 estimates are down 5.3%.

BJ'S RESTAURANT Price, Consensus and EPS Surprise

While all of the above are Zacks Rank #4 stocks, you can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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