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Opportunities in Restaurant Stocks

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An outlook and overview of the restaurant industry from an investor's perspective.

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The US restaurant industry has ended the first half of 2012 on a positive note despite nagging sovereign debt issues in Europe and faltering domestic consumer confidence. The strength was backed by modest traffic improvement and the consequent rise in comparable store sales. Easy comparisons from 2011 will likely place forthcoming performance of 2012 in a brighter light.

Statistics bear out this relatively favorable environment. A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index (or RPI), measuring the present condition and outlook on the U.S. restaurant industry, was 101.6 in April, slightly down from the extremely strong level of 102.2 in March. Despite the decline, January characterized the sixth consecutive month in which RPI stood above 100. This RPI run-rate in the last six months connotes improvement in comparable store sales and customer traffic.

Most of the restaurant operators reported positive same-store sales and a majority of them expect business to gain momentum in the months ahead.

The Current Situation Index, which measures comparable store sales, traffic count, labor costs and capital expenditures in the restaurant industry, was 101.0 in April, down 1.0% sequentially. The Expectations Index, which measures restaurant operators' six-month outlook on the above indicators, was 102.2, slightly down from 102.4 in March. This was the eighth 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.

All these culminate to the general optimism in the sector. We are hopeful that restaurant companies will continue to deliver better numbers in the upcoming quarter despite macroeconomic weaknesses. An improving outlook can be validated by the NPD foodservice market research report, which stated that annual visits to restaurants will increase by 8% in the next decade.

Road Ahead

We see modest top- and bottom-line trends in 2012. According to a research conducted by National Restaurant Association, the restaurant industry is projected to expand in 2012 despite the sluggish US 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 research firm estimates total restaurant industry sales to increase 3.5% year over year to $632 billion in 2012, thus marking the second consecutive year of total industry sales of more than $600 billion.

Most of the restaurant operators are passing on higher costs to consumers in order to mitigate commodity pressures. The companies that are well positioned are likely to enjoy pricing power and in turn same-store sales increase. The improvement in the US economy is slow but palpable. But a sluggish labor market, over-supply of restaurants in the industry, a still-hot food cost environment, a still elevated unemployment level, credit unavailability, and weak income growth may weigh on industry profitability.

Restaurants have been trying to win back cash-conscious guests by revamping promotions and focusing on value-for-meal menus. However, the tendency to offer discounts has been moderating. We remain cautiously optimistic over the near-to-medium term.

OPPORTUNITIES

Improved Californian Market

The core California market, which was badly hit by the recession resulting in a high rate of unemployment and weak consumer confidence, has turned around. We see plenty of growth opportunities in the California and Texas markets. BJ's Restaurants (BJRI) and Red Robin Gourmet Burgers Inc. (RRGB) are expanding rapidly in California.

Job Growth in the Sector

The restaurant industry is one of the major contributors to job growth in the US. In 2011, total US 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 US employment is believed to grow 1.3%. Among all markets, Texas and Florida are envisioned to see maximum job growth, among all other markets in the restaurant industry over the next 10 years.

Domestic and International Unit Expansion

Emerging from a lackluster economy from more than two years back, most of the companies have accelerated their pace of restaurant openings. A relative recovery in consumer confidence has also encouraged companies to return to unit expansion.

In fact, the companies are also exploring international markets. Restaurateurs are primarily concentrating on emerging markets that provide ample opportunities for expansion. Several food chains, including Denny's Corp. (DENN), Pollo Tropical of Carrols Restaurant (TAST) and Starbucks Corporation (SBUX) intend to tap the fast-growing Indian market. McDonald's Corp. (MCD) and Yum Brands Inc. (YUM) already have considerable coverage in India. They are aggressively expanding in China to capitalize on the fast-paced economic growth over there. Some European countries including UK, Germany and France are also not far behind.

Remodels and Menu Innovations Remain Key to Success

Additionally, restaurants are accessing different means to plug the problems of heightened competition in a somewhat over-supplied domestic market. Companies continue to reduce their energy consumption and are remodeling their restaurants to give an upmarket feel. They are rolling out new, smaller prototypes to augment the perception of value and drive traffic, thereby reducing construction and occupancy costs to enhance returns on capital. McDonald's is continuously benefiting from its reimaging. This year, the company expects to see a comps gain of 5-6% from its "facelifts."

This is not the end. Having stabilized their financial positions, the operators are well poised to bring newer offerings to their menu card in 2012 in order to cater to the ever-changing demands of customers. Limited Time Offers are also gaining attention.

Marketing Tools

Social media as a marketing tool has taken the industry by storm. Most of the operators rely on social media for promotion. Hence, we believe they are likely to incorporate Facebook, online review sites, Twitter and blogs aggressively into their marketing mix going forward. National Television advertising is also an important tool for promotion. A company like Panera Bread Co. (PNRA), successful even during the recession, increased its advertising spending by 26% for 2012 over an above 32% increment in 2011.

Loyalty Program

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 the trend. For example, Panera Bread rolled out "My Panera" loyalty program in November 2010. Since its inception, the program has developed a database of over 10.4 million registered users in March 2012 (up from 9.5 million in the prior quarter).

Pricing Power

We have seen most of the companies take pricing action in last few months. The faster-rising inflation of food at home compared to food away from home might allow the US eateries some room to take additional pricing actions in the near term.

Growing Fast-Casual Segment

According to a recent NPD foodservice market research report, fast casual is the only restaurant segment growing at a steady pace in the last five years. The segment quintessentially offers healthier options with respect to menu with a premium setting and rational pricing. The highlight of this segment is the counter service, which considerably saves on labor costs. Panera Bread, Noodles & Company, Five Guys and Pei Wei are some restaurateurs enjoying their positioning in this category. The segment comprises a small part of the industry sales, leaving further scope for growth.

Franchise-Driven Business Model

Most of the companies are transforming to more a franchise-centric model to reduce the volatility in earnings and increase cash flow generation. Franchising is also an important factor for international development. However, Panera Bread is more inclined toward company-owned unit openings, which speak well of its fundamental strength and make us optimistic on the stock.

Breakfast & Beverage: A Breakout

Breakfast has accounted for nearly 60% of the US restaurant industry and remains a key driver of traffic growth in recent years. Leveraging the trend, Jamba Inc. (JMBA), The Wendy's Company (WEN), and Yum Brands all have expedited their breakfast menu. McDonald's is yet another beneficiary of the increasingly popular breakfast menu.

According to an analysis by NPD, which has a ten-year projection of foodservice trends based on aging, population growth and trend momentum, servings of breakfast sandwiches are projected to outpace the industry's growth forecast. 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 US eateries. According to Mintel Global Market Navigator, the US fruit juice drinks market expanded by 1% in 2011. This was a steady gain on the 1.7% fall recorded in 2009 and breakeven in 2010. 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. McDonald's has been delivering strong comparable sales in the US, buoyed by its McCafe line.

We see continued sales recovery in the next few months as cold beverages provide a higher run in comps against hot beverages in winter.

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 restaurant industry and accordingly plunging into the buyout deals. Some recent deals include the proposed sale of Benihana by a private equity group Angelo, Gordon & Co., PF Chang's China Bistro's (PFCB) takeover by Centerbridge Partners, Fidelity National Financial's acquisition of O'Charley's.

Apart from acquisitions, the companies are also divesting their slow-moving brands in order to spur growth. For example, Yum Brands disposed two of its brands Long John Silver's and A&W, Wendy's broke up with Arby's and Frisch's Restaurants Inc. (FRS) divested all its Golden Corral operations.

Currently, there are a number of stocks in the restaurant with a Zacks #1 Rank (short-term Strong Buy rating). These include Brinker International Inc. (EAT), Einstein Noah Restaurant Group Inc. (BAGL) and Jamba. Companies with Zacks #2 Ranks (short-term Buy rating) include Benihana Inc. (BNHN), Cosi Inc. (COSI), Texas Roadhouse Inc. (TXRH), and Kona Grill Inc. (KONA).

WEAKNESSES

Higher Cost Structure

We remain wary of the rising commodity costs of the restaurant industry. Food costs account for about one-third of restaurant sales. Wholesale food prices increased in 2011. Beef prices continue to rise in 2012 on a year-over-year basis. Companies like Red Robin Burger, McDonald's and Texas Roadhouse, 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 in 2012.

Seafood prices are also creeping up, putting companies like Darden's margin at stake. However, some softening is being noticed in dairy as well as produce prices. A few companies are expecting food cost inflation to moderate, especially in the latter half of 2012.

According to the Green Restaurant Association, restaurants account for one-third of all the US energy used by the retail sector. Hence, rise in energy costs remain another risk to the restaurateurs.

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.

Steep Competition and Promotional Offers

The restaurant industry is still value-sensitive. High discount rates applied to menu prices in order to battle difficult economic conditions are resulting in price wars among competitor companies. Hence, the failure of any promotional offer will put pressure on the company's same-restaurant sales growth.

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 inflow, changes in internal fiscal and monetary policies led to the decline in the estimated growth rate in China and India.

According to the IMF, the Chinese economy is projected to grow 8.2% and 8.8% in 2012 and 2013, respectively, while India is expected to post 6.9% growth in 2012 and 7.3% in 2013. Japan also continues to be a dampener as it is still on the way to recovery from the last year's earthquake. The trend can be validated from the May comparable sales trend in McDonald's where comps dropped 1.7% in Asia Pacific Middle East and Africa versus a growth of 4.3% in the year-ago month.

Eurozone Debacle

To add to this, there is the overcast European financial atmosphere which has slowed down the overall growth rate in the region since the second half of 2011. Some food companies, which have so far endured the recent economic turmoil in Europe, began to believe that the implementation of austerity measures will now put pressure on its top and bottom lines. With the focus on value proposition along with less pricing power, margins will likely be hassled there, at least in the near term until any concrete solution crops up.

Stringent Food Standards

Consumer's 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. While these criteria are giving a competitive advantage to companies like Chipotle, many others are sometimes finding the standard tough.

Restaurant and beverage companies' momentum will likely be hitched in New York area in the near term as Mayor Bloomberg is trying to forbid the sale of large sodas and sugar drinks. This ban, if implemented, 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 Domino's Pizza Inc. (DPZ), DRI Restaurants Inc. (DRI), The Cheesecake Factory (CAKE), Panera Bread, and Yum Brands, all of which retain the Zacks #3 Rank (short-term Hold). McDonald's, Carrols Restaurant and Krispy Kreme Doughnuts, Inc. (KKD) still carry a Zacks #4 Rank (short-term Sell).

Conclusion

The restaurant industry is still not immune to uncertainties in the macro-economy. Industry behemoths like McDonald's are caught up with difficulties like implementation of austerity measures in Europe, increasing commodity costs in the US and sluggish growth in Asia. On the domestic front, although the economy has been improving, full-fledged consumer response has yet to be seen. They are slowly regaining confidence and cautiously dining out. We believe the companies with strong cash flow generation will survive the market volatility.

Editor's Note: For more from Zacks.com, click here.
No positions in stocks mentioned.
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