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Fast-Casual Food For Thought

Winter storms, higher payroll taxes, tax refund delays and China's bird flu scare were just a few of the factors working against restaurants in the first three months of 2013.

But you wouldn't have known it from the customers crowding into chains like Chipotle Mexican Grill (CMG), Starbucks (SBUX) and Panera Bread (PNRA). The same holds true for investors, who crowded into restaurant stocks, despite a slew of reports out in the past week showing generally disappointing sales and profit growth.

Some 44 of 53 stocks in IBD's Retail - Restaurant industry group advanced for the week, despite recent earnings misses by McDonald's (MCD) and Panera, and a profit decline for Yum Brands (YUM).

"Investors were willing to look through to the easier comparisons that are now upon us and to the potential for better news as we move through this year," said analyst Andy Barish of Jefferies & Co.

Starbucks, for example, reported a 20% EPS gain that met analysts' estimates, but its 11% sales growth came up short. Still, U.S. same-store sales bested forecasts. Management lifted its full-year earnings guidance, and Robert W. Baird raised its price target on the stock to 70 from 65. Shares fell less than 1% Friday, but still ended the week with a gain of nearly 3%.

Shares of highflying bakery-cafe operator Panera Bread, which typically posts same-store sales gains in the high single digits, fell 2% Wednesday after a weak first-quarter report. Panera lost 4% for the week.

Panera's February store sales showed virtually no growth. Management at the fast-casual chain blamed winter storms.

Last year, an early spring sent consumers flocking to their favorite dining spots.

That made for tough comparisons among restaurant operators this year, as fiercer weather kept consumers home.

The payroll tax kicked in at the start of the year and made matters worse, dampening consumers' spending plans.

"January and February got off to a difficult start," Barish said.

But the quarter ended on a positive note, with same-store sales and traffic picking up in March, according to data from analyst Larry Miller of RBC Capital Markets.

The outlook for the year is still hazy, but it seems some of the earlier head winds are weakening.

"We're starting to see people getting accustomed to the payroll tax. And gas prices are off their peak from a month ago," Miller said.

Based on his MillerPulse proprietary research, he says consumers plan to spend more on dining out in coming months.

Meanwhile, food costs have been backing down after worrying increases last year. Coffee prices have cooled. Chicken wings have folded almost 40% from peak levels in mid-January, which is good news for Buffalo Wild Wings (BWLD). Cheese prices remain a concern, driven up by a drought in New Zealand, a top dairy exporter.

Labor rates are moving up only slightly, says Miller. And employees deciding to stay put in the normally high-turnover restaurant industry "have led to better efficiencies," he said. "The longer store managers are in their jobs, the better service and operations.

Also, Miller says it appears that health care costs under the Affordable Care Act won't rise next year as much as restaurant operators originally feared.

"We initially thought restaurant margins would be impacted by 1% to 3%, which would have caused a 10% to 30% drop in earnings," he said.

Instead, the impact will likely be under 0.5%, he says.

Survival Of The Fittest The economy and employment remain key issues.

"We don't see the environment as strong enough to lift all the boats," Barish said. "You have to be on your game. The macros are still choppy and the competitive environment is still very fierce.

That's especially true in the mature casual dining segment. It's been struggling to remain relevant amid newer or faster-growing concepts such as Tex-Mex-themed Chuy's (CHUY), Buffalo Wild Wings and fast-casual players Panera and Chipotle Mexican Grill.

"Consumers have found that the experience at most of the older, traditional casual dining places don't have the appeal they used to have," said Ron Paul, president of restaurant research firm Technomic Inc.

"And their audience has gotten older and many are in locations that have changed significantly over the last 20 years," he added.

Paul counts DineEquity's (DIN) Applebee's, Brinker International's (EAT) flagship Chili's chain and Ruby Tuesday (RT) among those older concepts fighting to stay vibrant.

"And to some extent you can say the same thing about Red Lobster and Olive Garden," Paul said, adding that Red Lobster "usually figures a way to get their customers back" through aggressive marketing and value pricing.

Red Lobster and Olive Garden are part of Orlando, Fla.-based Darden Restaurants (DRI). Its shares have lagged behind the restaurant group over the past 12 months.

Darden shares did climb more than 4% in the latest week.

After several years of stale sales growth, casual dining outfits have begun to post modestly better results. But they still can't keep pace with fast-casual players.

"It's a very tough market in general in casual dining. There are too many seats," Paul said. "The chains that are doing well have a point of differentiation and they're also executing well. Think Chipotle, Panera, Buffalo Wild Wings.

Subway Snags Market Share Barish sees some warning signals at Chipotle, where same-store sales growth slowed to 1% in the first quarter vs. 12% a year ago.

Earnings leapt 19% to $2.35 a share and topped Wall Street views. But the beat was mostly on lower expenses and a lower tax rate, Barish says.

"We really don't see any drivers moving forward other than taking menu pricing (higher) later this year," he said of Chipotle. "That's always a little risky in terms of traffic. You run the risk you might drive off some traffic.

On the fast-food side, big veterans such as McDonald's and Yum Brands, which oversees KFC, Taco Bell and Pizza Hut, face tough competition from sandwich chains such as the fast-growing Subway, Paul says.

Pizza Hut is taking heat from a host of small, emerging pizza players. Papa John's (PZZA) and Domino's (DPZ) are so far beating that challenge. Papa John's earnings are forecast to rise 20% this year. Analysts see Domino's earnings up 15%.

McDonald's profit grew only 2% in the first quarter, with a 7% forecast for the year.

"McDonald's did not have a good quarter or March," Paul said, despite continuing to innovate with new wraps and expanding their coffee drink offerings.

But he contends that privately held Subway, which opened 1,000 stores in the U.S. last year, has stolen some of McDonald's burger business, as well as that of Burger King (BKW) and Wendy's (WEN).

"While burger chains are not growing their stores dramatically, they're fighting for customers at lunch and they have not found a good answer on how to get a good dinner business," Paul said.

Haves Vs. Have-Nots Most fast-food unit expansion is happening overseas. Yum Brands garnered about 40% of its operating profit from China before bird flu scares choked sales at chicken chain KFC.

Yum's same-store sales at its 5,300 China restaurants, most of them KFC, were down 20% in the first quarter. Overall company profit fell 8% to 70 cents a share. But it was better than investors expected. At midday Friday, shares were tracking toward a 2.7% gain for the week, but were up less than 1% so far this year.

Barish thinks coffee and snack giants Starbucks and Dunkin' Brands (DNKN) continue to resonate with customers on new products and sharp marketing.

"Both brands are executing very well," he said.

Krispy Kreme Doughnuts (KKD), which scores high in IBD metrics, has slimmed down its store base and is apparently healthier for it. "It closed a lot of underperforming stores and it's shown good results on a smaller store base," Paul said.

With inflation easing and signs consumers may be willing to step out to restaurants more could mean better days ahead for operators.

"We're setting the table for earnings increases in the second half of the year, maybe even in the June quarter," said Miller.

"The thing that drives this business higher is more people going out to eat across the board," he said. "We think there's a good chance of that happening. We'll know whether or not that happens in the next few months.

Even if the tide does rise, Barish still prefers to stick with companies that have growing sales, margins and unit openings, all of which he says will drive earnings higher.

Barish's top picks are Starbucks, Dunkin' Brands and Panera.

"We think all three have noticeable drivers to continue to move their business forward in both same-store sales growth, unit growth and margins and that will flow through to earnings," he said.

"You definitely have the haves and have nots right now," he said.