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Restaurant Industry Stock Outlook - Oct. 2012

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Despite beginning the year on a relatively positive note, sales momentum in the U.S. restaurant industry appears to have slackened in the second quarter of 2012, mostly reflecting macroeconomic issues. The industry has been at the receiving end of the global economic concerns, a stronger dollar, the uncertainty around upcoming presidential election in the U.S., a more expensive food cost environment in the U.S., a sluggish labor market and over-supply of restaurants in the industry.

Despite these hurdles, the restaurant sector is expected to sustain its pace of recovery this year, albeit at a slower clip.

We remain cautiously optimistic over the medium term, though same-store sales growth in the coming months will likely be subdued. According to the National Restaurant Association, the restaurant industry is projected to expand in 2012 despite the sluggish U.S. recovery. Focus on cost containment, extra value-for-price and international expansion are on most restaurateurs' wish-list to tide over the macro difficulties.

The industry association noticing “substantial pent-up demand” in the market estimates total restaurant sales to increase 3.5% year over year to $632 billion in 2012. If realized, this would mark the second straight year of total industry sales exceeding the $600 billion mark.

Yearly hikes in dividend on a regular basis for some industry leaders like McDonald's Corp. ([url=]MCD[/url]), Yum! Brands Inc. ([url=]YUM[/url]) and Brinker International Inc. ([url=]EAT[/url]) underscores their concerted efforts to consistently return shareholder and franchisee value irrespective of the economic peaks and valleys. Yet another improving outlook was dished out by the NPD foodservice market research report, which stated that annual visits to restaurants will increase by 8% in the next decade.

Statistics bear out this relatively favorable environment. A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index (RPI), measuring the present condition and outlook on the U.S. restaurant industry, was 100.6 in August, up 0.4% sequentially, the tenth consecutive month in which the RPI scored above 100. This RPI run-rate in the last ten months connotes improvement in comparable store sales and customer traffic.

The Current Situation Index, which measures comparable store sales, traffic count, labor costs and capital expenditures in the restaurant industry, was 100.6 in August, up 0.8% sequentially. The Expectations Index, which measures the restaurant operators' six-month outlook on the above indicators, was 100.7, at par with the July level.

This was the twelfth consecutive month that the Expectations Index remained above 100. Restaurant operators' capital spending plans are also riding uphill, reaffirming their positive outlook on the industry longer term.


Job Growth in the Sector

The restaurant industry is one of the major contributors to job growth in the U.S. In 2011, total U.S. employment grew 1.0% while restaurant employment increased 1.9%. According to the National Restaurant Association, overall restaurant industry employment will reach 12.9 million in 2012, accounting for 10% of the total U.S. workforce.

This projected employment figure represents year-over-year growth of 2.3%, while total U.S. employment is believed to grow 1.3%. Texas and Florida are envisioned to see maximum job growth, among all other markets in the restaurant industry, over the next 10 years.

Global Unit Expansion

Putting behind the economic downturn that paralyzed the U.S. economy a couple of years back, most companies in the sector are accelerating their pace of restaurant openings. A relative recovery in consumer spending has also encouraged companies to return to unit expansion.

Besides spreading their wings in the home country, the companies also aim to test waters in foreign shores. Restaurateurs are primarily concentrating on emerging markets that provide ample opportunities for expansion. The burgeoning middle income population in emerging countries encourages the companies to shift their spotlight from the somewhat saturated domestic market.

Several food chains, including Denny's Corp. ([url=]DENN[/url]), Pollo Tropical of Carrols Restaurant ([url=]TAST[/url]) and Starbucks Corporation ([url=]SBUX[/url]) are eyeing to tap the fast-growing Indian market. McDonald's Corp. and Yum! already have considerable coverage in India . They are aggressively expanding in China to capitalize on the fast-paced economic growth there. Latin American countries are also not far behind.

Refranchising, Revamp & Menu Innovations – a Common Trend

Though refranchising was common in the restaurant sector, it has got a boost of late given the benefits of this business model amid an anemic economy. The franchise-centric model helps to reduce volatility in earnings and enhances cash flow generation. Companies like DineEquity Inc. ([url=]DIN[/url]) and Burger King Worldwide Inc. ([url=]BKW[/url]) are some examples of highly franchised brands, with DineEquity offloading 99% of its Applebees stake.

Additionally, restaurants are responding in a variety of ways to address the issue of heightened competition in a somewhat over-supplied domestic market. They are remodeling their restaurants to give an up-market feel, rolling out new and smaller prototypes to augment the perception of value and drive traffic, thereby reducing construction and occupancy costs and enhancing returns on capital. Operators like McDonald's, The Wendy's Company ([url=]WEN[/url]) and Darden Restaurants Inc. ([url=]DRI[/url]) are continuously benefiting from unit-refurbishment strategy.

This is not the end. Having stabilized their financial positions, the operators are constantly striving to bring newer offerings to their menu card in order to cater to the ever-changing palates of customers. As per the research conducted by Technomic, within the fast casual segments, Mexican menus are presently ruling the consumers’ taste buds with a solid 20% share. Limited Time Offers are also gaining attention.

Marketing Tools & Loyalty Program Gaining Precedence

Social media as a marketing tool has taken the industry by storm. Most of the operators rely on social media for promotions by incorporating Facebook ([url=]FB[/url]), online review sites, Twitter and blogs aggressively into their marketing mix. National Television advertising is also an important tool for promotion.

As per research conducted by National Restaurant Association, restaurateurs are offering loyalty programs at their units to enhance value dining. Amid the prevailing environment where customers spend less enthusiastically on dining and seek incentives for doing so, approximately 30% of restaurant operators are frequently coming up with diner programs to hone sales further. The operators have now started to leverage this trend. Panera Bread ([url=]PNRA[/url]) has proved to be a beneficiary from both these tactics.

Breakfast & Beverage: A Breakout

Breakfast has accounted for nearly 60% of the U.S. restaurant industry and remains a key driver of traffic growth in recent years. Leveraging the trend, Jamba Inc. ([url=]JMBA[/url]), Wendy’s and Yum! all have expedited their breakfast menus. According to an analysis by NPD, which has a ten-year projection of foodservice trends, annual servings per capita of breakfast sandwiches at foodservice are expected to jump from 11 in 2004 to 14 in 2019.

Non-alcoholic beverages remain a sweet spot in the U.S. eateries. The market also has the ability to grow further through innovation, especially in healthier solutions. We see juicing giant Jamba geared up to leverage the trend by adding all-fruits to its line-up. There are other players like sector behemoths Starbucks venturing into the $50 billion category of healthy juices and McDonald's specializing in both frozen as well as hot beverages through its McCafe line.

M&A Activity

Merger and acquisition activity is also gaining momentum in the sector. The companies are looking at potential business partners to foray into different zones and unlock value. Private equity firms are citing potential in the restaurant industry and accordingly making buyout deals. Apart from acquisitions, the companies are also divesting their slow-moving brands in order to spur growth.

Currently, Krispy Kreme Doughnut Inc. ([url=]KKD[/url]) is the only stock in the restaurant sector that carries a Zacks #1 Rank (short-term Strong Buy rating).

Companies with a Zacks #2 Rank (short-term Buy rating) include Brinker International Inc. ([url=]EAT[/url]), Kona Grill Inc. ([url=]KONA[/url]) and Panera Bread Co. Companies with Zacks #1 Rank and Zacks #2 Rank have positive earnings estimate revision trends, highlighting the favorable momentum in their underlying businesses.


Bleak Economic Backdrop

The strengths aside, the companies are caught up with macroeconomic tensions like implementation of austerity measures in Europe owing to the sovereign debt crisis, decelerating growth in Asia and increasing commodity costs in the U.S. Further, a stronger dollar will likely threaten the companies with substantial operations abroad.

Eurozone problems: The overcast European financial atmosphere has slowed down the overall growth rate in the region since the second half of 2011. Some food companies that have hitherto endured the economic turmoil fairly well are finally straining under the implementation of austerity measures in Europe. The pressure is now beginning to be felt on their top and bottom lines.

Decelerating Growth in Asia: Growth has been moderating in Asia, especially in two major countries -- China and India -- where major eateries are exploring expansion opportunities in response to the saturation in the U.S market. Steep decline in export to developed economies, lack of foreign capital inflows, and changes in internal fiscal and monetary policies led to the decline in the estimated growth rate in China and India. The recent same-store sales performance of McDonald’s is indicative of this slowdown.

The growth prospects for China remain dull, as in the second quarter of 2012, the country recorded growth of 7.6% -- its slowest three-month annual growth in three years. As per IMF’s July forecast, China is expected to grow by 8.0% in 2012, down from its April forecast of 8.2%.

The IMF has warned that the worsening debt crisis in the Eurozone will pose a "key risk" to China's growth. For 2013, growth in China is now expected to be 8.5% as compared to the earlier projection of 8.8%. Japan also continues to be a dampener as it is still on the way to recovery from last year's earthquake.

The agency estimates weakening growth for India in 2012 and 2013. In its July projection, the agency cut down its growth forecast for India from 6.8% and 7.2% to 6.1% and 6.5%, respectively. For Brazil, the agency reduced its growth forecast from 3.1% to 2.5% for 2012.

According to a German newspaper, IMF will go for a further reduction in its 2013 growth estimates. China and India are expected to record 8.2% and 6.0% growth in 2013, respectively. Growth estimate for Brazil is also expected to be slashed to 4.0% from the earlier projection of 4.7%, according to the said source.

Commodity inflation in US: We remain wary of the rising commodity costs of the restaurant industry. Food costs account for about one-third of restaurant sales. Beef prices continue to rise in 2012 on a year-over-year basis. Companies like Red Robin Burger ([url=]RRGB[/url]), McDonald's ([url=]MCD[/url]) and Texas Roadhouse ([url=]TZRH[/url]), which are exposed to the beef market, often feel the brunt of price inflation. A continued rise in traditional wing prices, which had been favorable earlier, is another weak pocket for the rest of the year. We believe the threat for more inflation lurks in 2013.

Meanwhile, the drought in the Midwest growing region has caused a spike in grain costs, which is likely to push up chicken costs ahead. Further, the drought led to a sooner-than-expected supply of cattle in the market leading to augmented near-term supply. However, this might create a medium-term supply crunch. Some softening is nonetheless being noticed in dairy and sea food prices.

Rising energy cost is another risk faced by restaurateurs. The restaurant industry accounts for one-third of the energy used by the retail sector in the U.S., as per the Green Restaurant Association.

Most of the restaurants safeguard their margins by passing the cost hike onto consumers. While big and established chains like McDonalds, Yum! Brands and Starbucks will survive the price increases due to their broad customer base and larger economies of scale, smaller chains will feel the cost pressure.

Decreasing Pricing Power

Menu pricing has been restaurateurs’ remedy to counter cost pressures. While some eateries had believed that food-at-home inflation was rising faster than food-away-from-home, allowing them room for additional pricing, their conviction has taken a beating of late. According to the U.S. Department of Labor, food-at-home inflation was up 1.5% in August while food-away-from-home inflation was up 2.8% in the month under review. This inflationary environment leaves lesser room to exercise pricing action in the latter half of 2012.

Shrinking Margins on Value-Orientation

Restaurants have been trying to win back cash-conscious guests by revamping promotions and focusing on value-for-meal menus. An extensive focus on value proposition in the major markets domestically and internationally along with less pricing power could prove detrimental to margins if exercised on a long-term basis. Although management at McDonald’s noted that most of its value-oriented sales measures are short-term in nature, we expect the trend to be predominant, at least for the near future until any concrete solution crops up.

Stringent Food Standards

Consumers’ inclination toward fresh organic menu as well as the fuss about nutrition is considered to be a tough benchmark in the restaurant industry. Consumers generally tend to visit restaurants offering locally produced food. Focus on children’s nutrition has also become a priority. While these criteria are giving a competitive advantage to companies like Chipotle ([url=]CMG[/url]), many others are sometimes finding the standard difficult.

In the near term, restaurant and beverage companies, in the New York area, will find the going difficult with Mayor Bloomberg trying to forbid the sale of large sodas and sugar drinks. This ban, which is likely to be implemented in March 2013, could prove pricey for the fast-food industry as soft drinks carry a high margin.

Given the lack of overall earnings catalysts, it's hard to be upbeat about a number of restaurant stocks. There are quite a few names on which we have a cautious outlook. These include Texas Roadhouse Inc., DRI Restaurants Inc. ([url=]DRI[/url]) and Domino's Pizza Inc. ([url=]DPZ[/url]), all of which retain the Zacks #3 Rank (short-term Hold). The Cheesecake Factory ([url=]CAKE[/url]) and Cosi Inc. ([url=]COSI[/url]) still carry a Zacks #4 Rank (short-term Sell).

In Conclusion

The restaurant industry is still not immune to uncertainties in the macro-economy. On the domestic front, although the economy has been improving, full-fledged consumer response has yet to be seen. Given the soft international backdrop we expect this doldrums to persist in the near term.  Only the cash-rich companies will likely survive this volatility smoothly.

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