The restaurant industry has been facing extremely tough challenges due to the ongoing economic turmoil. With a weak labor market, lower discretionary spending and continued credit-market access issues, it may be too early to predict any improvement in the restaurant industry, which is grappling with sluggish consumer demand.
Although current economic indicators show some signs of improvement, we believe that the weak labor market will continue to adversely impact the restaurant industry, even several months after the recovery is on track. The downturn has shattered consumer confidence, and it will take time before most people resume their former dining-out habits.
Restaurants are trying all means to lure cash-conscious guests. With consumers reluctant to shell out more — preferring to dine at home or spending less per meal — eateries are tweaking entrees, revamping promotions and focusing on value-for-meal menus.
The U.S. restaurant industry, which constitutes the fast food, casual dining and upscale chains, is facing its toughest stretch in three decades. A report by market research firm NPD Group asserted that recovery in the restaurant industry will not take place before the second half of 2010, although the firm believes that the rate of decline in traffic and sales will start to decelerate in the first half of 2010, and some improvement may be registered by the third quarter. U.S. restaurant guest traffic dropped 4% for the quarter ended Sept. 30, 2009.
A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index, measuring the health and outlook for the U.S. restaurant industry, showed some improvement in October (up 0.5% from September to 98.0), after posting a decline in the month of September (down 0.4% from August to 97.5), sending mixed signals to the restaurant industry. The index has remained below 100 for 24 consecutive months, indicating that the restaurant industry is scaling back its development plans.
The Current Situation Index, which measures comparable store sales, traffic counts, labor costs and capital expenditures in the restaurant industry, climbed 0.4% to 96.5. Approximately 61% of restaurant industry operators reported same-store sales decline in October, down from 65% reported in September. Moreover, 60% of the operators reported a traffic decline in October compared to 62% reported in September.
Although softness prevailed in sales and traffic in the restaurant industry, a slight uptick was noticed in capital spending activity in October.
The Expectations Index, which measures restaurant operators’ outlook on comparable sales, employees, capital expenditures and business environment, rose 0.6% to 99.6. Approximately 29% of the restaurant operators (up from 25% in September) now expect to have higher sales in 6 months compared to the same period in the last year, matching the percentage of restaurant operators who expect lower sales in 6 months.
In the midst of what is expected to be a tepid recovery, there are three potential drivers of net income growth for the restaurant industry: unit expansion, improved same-store sales and cost cuts.
There seems little chance that any upside will come from more aggressive unit expansion, as most of the companies have either scaled back or postponed further unit development. BJ’s Restaurants Inc. (BJRI) plans to grow the unit base by 12% in fiscal year 2009, much lower than 21% achieved in fiscal year 2008. Darden Restaurants Inc. (DRI) expects to open 50 to 55 net new restaurants in fiscal year 2010, drastically down from 71 restaurants opened in the last fiscal year.
The second driver, same-store sales, consists of menu price increases and traffic counts. Any price increases other than minimal ones would drive away value-conscious customers in this fiercely competitive environment. Moreover, to enhance the perception of value and to drive traffic, companies are remodeling restaurants to give them an up-market feel, and are rolling out new, smaller prototype restaurants that reduce construction and occupancy costs to boost returns on capital.
Finally, some of the cost cuts have been achieved through integrated information systems including point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems. Restaurant companies try to optimize their operations and achieve decent operating cash flow margins. Since the last five years, Darden has kept its restaurant operating cash flow margins stable at 22%−23% despite the current economic headwinds.
OPPORTUNITIES
Despite the restaurant industry facing the brunt of the economic downturn, there are defensive stocks in the restaurant industry promising long-term growth opportunities. Buffalo Wild Wings Inc. (BWLD) offers investors one of the strongest growth stories in this space with an annual growth target of 13% to 15% in units, 25% in revenue and 20% in net earnings. Buffalo Wild Wings has also been able to consistently deliver positive comps, while other restaurant operators are grappling with deteriorating same-store sales.
With consistent earnings and a healthy balance sheet, McDonald’s Corporation (MCD) provides relative safety and moderate growth in a turbulent environment and exposure to faster-growing international markets. Another stock, Chipotle Mexican Grill Inc. (CMG), which remains largely unruffled by the slowdown, plans to open 120−130 restaurants in fiscal year 2009 – a growth of 14.3%−15.5%.
WEAKNESSES
Offsetting these opportunities in the restaurant industry are the sagging same-stores sales and waning traffic count. The shares of Red Robin Gourmet Burgers Inc. (RRGB) are vulnerable to economic headwinds, and we believe that the stock will continue to underperform the restaurant industry. The chain expects guest count to remain negative, and expects restaurant-level operating margins to decline by 150 to 160 basis points in fiscal year 2009. The company’s third-quarter 2009 same-store sales fell 14.9%.
Another restaurant industry stock yet to recover is BJ’s Restaurants Inc. (BJRI), which has also been experiencing declining comps and guest traffic. In addition, more than two-thirds of BJ’s Restaurants are located in areas that have been hit hard by the housing downturn and economic slowdown. These include California, Arizona, Nevada, Colorado, Oregon and Washington state. This may dampen the company’s growth potential.
The financial distress has engulfed all the business sectors, and the restaurant industry has not been immune either. The tightening credit market, unemployment, and emolument freezes have adversely impacted the household budget of the economy class. The current global meltdown has rocked the restaurant industry and it will take time to come out of the woods.
