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Restaurant Industry to Grow Modestly on Diverse Strategies

Zacks Equity Research
Restaurant Industry to Grow Modestly on Diverse Strategies

The restaurant industry exhibited moderate growth in 2017. Per the National Restaurant Association (NRA), the industry generated $799 billion in revenues in the year, up 4.3% from 2016. However, this translates into a growth rate of just 1.7% when adjusted for inflation.

The industry remains on steady footing, thanks to the strategies adopted to counter headwinds currently hindering it. These include various sales building efforts, cost cuts, franchisee-based business models, loyalty programs and, most importantly, increased usage of technology.

Taking the past trends and long-term growth prospects of the industry into account, let’s explore the strategies in detail.

Current Economic Backdrop Favorable

A gradually improving U.S. economy as reflected in the rise in wages, record low jobless rate and upbeat consumer confidence should give restaurant stocks some push. In February, Consumer Confidence Index reached its highest level since 2000, after a modest increase in January. The index rose 6.5 points to 130.8. Notably, confidence remains high among consumers, and their expectations suggest that the economy will continue expanding at a solid pace in the near term.

We anticipate this positive sentiment to encourage consumers to dine out more and thereby arrest declining traffic. Moreover, it is to be noted that eating out is one of the items in the family budget that has grown manifold as households get a boost. This bodes well for the restaurant sector and is likely to keep investors’ appetite high for restaurants in the rest of 2018 and 2019.

Deploying Technology to Enhance Guest Experience

Technology at restaurants has become essential — more than ever before — given the troubles plaguing this space over the past few quarters. Hence, restaurant operators are going all guns blazing with their online and digital marketing activities. These will help them to cater to consumers’ increasing dependence on and penchant for online and mobile web technology and consequently lure them back.

While smartphone apps attract consumers, video menu boards in quick-service restaurants and tabletop devices speed up sales and ensure convenience. Further, restaurant operators rely on social media for promotions and incorporate Facebook (FB), online review sites, Twitter (TWTR) and blogs aggressively into their marketing mix.

In fact, mobile ordering in particular is fast becoming a crucial part of many restaurants' plans, given what it can bring in enhanced sales. This is because when using a phone to order their food, customers, on an average, tend to spend more and visit more often. Going forward, mobile ordering will form the crux of customers’ experience, rather than just being a point of differentiation.

Notably, pizza giants Domino's and Papa John's International (PZZA) have been the industry bellwethers in the digital ordering space. In 2017, Domino's AnyWare suite of ordering platforms that allow customers to order from various ordering apps and platforms such as Google Home, Facebook Messenger, Apple Watch, Amazon Echo, Twitter and via a Pizza emoji on text, grew significantly. Meanwhile, its digital loyalty program – Piece of the Pie Rewards – continues to contribute significantly to traffic gains.

Papa John’s aims to continue making investments in technology, focused on foundational improvements to its digital channels to increase order conversion rate, frequency and ticket average. Further, in 2018, Papa John’s aims to completely redesign its digital platform and solutions capabilities, leveraging enhanced data analytics and insights to ensure that its industry-leading platforms are sustainable, efficient and effective.

Though a few restaurants have managed to come along as far as the pizza chains, there are many who have advanced their own apps by leaps and bounds to attract more customers on the go.

The world’s largest coffee shop operator, Starbucks has secured a leading position in leveraging its mobile and digital assets and loyalty and e-commerce platforms to create more revenue streams. In fact, Starbucks’ mobile app is undoubtedly one of the most widely used mobile payment apps in the United States.

Dunkin' Brands Group (DNKN) is also growing in terms of its usage of digital technology through DD card, DD mobile app, DD Perks rewards program and On-the-Go ordering. While BJ's Restaurants has started getting positive results from its hand-held ordering tablets and slow-roasted menu, Brinker is seeing increased efficiency and speed from handheld devices across California.

Meanwhile, Chipotle is moving aggressively to make digital ordering more appealing to its customers. The company has witnessed consistently positive guest response since the launch of its mobile app. Additionally, since the rollout of its “Smarter Pickup Times” technology, there has been a significant increase in digital orders. Guest satisfaction has also improved.

As the company’s digital orders are made on a second make-line, it allows it to deliver excellent throughput and enhance the experience for customers moving to digital ordering. Though these are still early days, the company believes that it is positioned to be a leader in digital, given the momentum and customer reaction and results witnessed so far.

Burger giant McDonald's Corp. (MCD) continues to roll out mobile order and pay with a new curbside check-in option. It is on track to launch the option in nearly all 14,000 U.S. restaurants.Having witnessed continual traffic declines, the company considers mobile ordering a way to win back customers.

Menu Innovation, Re-imaging, Loyalty Programs for Increasing Sales

In order to navigate a challenging sales environment, restaurant operators are continually striving to innovate on the menu front to cater to the ever-changing palate of customers. Some of the notable restaurant operators playing this card are Chipotle Mexican Grill (CMG), Buffalo Wild Wings (BWLD), Dunkin' Brands Group and Jack in the Box (JACK).

Another initiative undertaken by the food chains is re-imaging of stores, which has received overwhelming response from guests. The Wendy's Company (WEN), Domino's Pizza (DPZ), Brinker International (EAT) and Red Robin Gourmet Burgers (RRGB) have been working on these lines. Notably, reimaging of stores helps to create an appealing and differentiated concept that helps to boost the brand as well as improve client experience.

Restaurant companies like Starbucks (SBUX), BJ's Restaurants (BJRI), Buffalo Wild Wings, Brinker International, Red Robin and Dunkin' Brands offer loyalty programs at their outlets to enhance value dining. The companies engage their guests through these programs with offers designed to increase frequency of visits. Loyalty programs thus help retain old diners while bringing in new ones, thereby driving traffic.

Other industry players like Buffalo Wild Wings and BJ's Restaurants are rolling out prototypes and smaller restaurant chains to augment value and drive traffic. These lower construction and occupancy costs but boost return on invested capital. Notably, smaller prototypes also accelerate growth in non-traditional locations.

Cost-Cutting Efforts & Franchise-Based Business Driving the Bottom Line

Given the exponential rise in costs, companies are striving to keep expenses under control. Along with several conscious attempts, commodity cost deflation is helping Cracker Barrel to make solid progress in reaching its cost reduction targets. Additionally, these initiatives are expected to aid the company in combating wage inflation pressure. Darden Restaurants (DRI) is also focusing on an aggressive cost management plan, under which it has been able to significantly cut operating costs.

Of late, various companies in the restaurants space like Yum! Brands (YUM), Restaurant Brands, McDonald’s, Domino's, Wendy's, Papa John's and Jack in the Box have adopted a de-risking strategy by reducing their ownership of restaurants through refranchising. Notably, refranchising a large portion of the system reduces the company’s capital requirements and facilitates earnings per share growth and ROE expansion.

In addition, free cash flow continues to grow, thus allowing reinvestment for increasing brand recognition and shareholder returns. Moreover, since a major portion of their business is re-franchised, these companies are less affected by food inflation than their peers.

Delivery Gains Precedence

In order to capitalize on increasing demand for their products, quite a few players in the industry are focusing on growing their off-premise, online-ordering business via carry-out, delivery and catering.

Particularly, restaurant operators are increasingly focusing on the delivery channel, which is a growing area for the industry driven by ease of access. By driving incremental sales at the companies, delivery services should turn out to be a strong revenue growth driver in the long term, given the huge demand.

Meanwhile, many restaurants are seeing an increase in their take-out business as customers are more willing to relax at home while enjoying their meal. Notably, both take-out and delivery increase a restaurant’s business without significantly raising its operational expenses or demanding an expansion of facility.

Starbucks has initiated a food and beverage delivery service while Yum! Brands is pursuing a delivery-centric strategy at all its brands. Meanwhile, The Cheesecake Factory (CAKE) has rolled out third-party delivery service in 90% of its restaurants as it is leading to incremental sales. In fact, to provide greater convenience to its customers, McDonald’s is increasingly focusing on delivery.

It has already scaled this initiative by introducing delivery at more than 3,700 restaurants in the United States via its partnership with UberEATS. The company also remains on track to reach 5,000 restaurants by this year-end.

Red Robin is another such company that is moving smartly on new revenue streams. It expects off-premise orders to become a growth engine in the long run as it begins to actively promote new offerings and reach more guests, thereby driving profitability.

Meanwhile, the likes of Red Robin along with BJ’s Restaurants, Dunkin' Brands, Jack in the Box and Wendy's have entered into a partnership with DoorDash – which connects customers with their favorite local and national businesses in more than 500 cities across the United States and Canada through door-to-door delivery – to meet the delivery needs of their new and existing guests and cash in on its tremendously growing popularity.

On an average, off-premise sales represent about 10-11% of the industry’s total sales. Therefore, there lies a tremendous opportunity in the segment and investors can earn good returns from it.

Continuous Efforts to Expand Internationally

A number of restaurant operators are committed to boost their presence in high-growth international markets. Pizza chains Domino’s and Papa John’s are leading the race for international expansion.

Notably, Domino’s earns a chunk of its revenues from outside the United States with many international franchisees continuing to generate robust returns. In fact, the fourth quarter of 2017 marked the 96th consecutive quarter of positive same-store sales in its international business. Many of Papa John’s restaurants are located in international markets like Europe, the Middle East, Latin America and China and continue to perform strongly. Notably, the fourth quarter of 2017 marked the 31th consecutive quarter of positive comps in Papa John’s international segment.

Meanwhile, Cheesecake Factorycontinues to foray into lucrative markets like the Middle East, North Africa, Central and Eastern Europe, Russia, Turkey, Mexico, China, Kuwait, Lebanon and Chile. Also, Brinker is one of the few fast-casual restaurant chains that have been expanding, especially in the faster growing emerging markets despite sluggish economic development.

Moreover, given its growing popularity, Dunkin Brands is expanding its footprint in the emerging markets of Asia and the Middle East. The company also believes that the untapped market of South Africa holds great potential. Restaurant Brands International, Inc. (QSR) also believes that there is an attractive opportunity to grow all its brands around the world by expanding its presence in existing markets as well as entering new markets.

Catering to Changing Tastes and Preferences

U.S. eateries’ focus on serving customers a healthy menu has increased manifold as consumers are increasingly showing their preference for fresh, organic, nutritious and low-calorie food.

Chipotle has fulfilled its pledge of not using added colors, flavors or preservatives of any kind in any of its ingredients. In fact, the company’s deeper focus on making better food accessible to everyone may aid in bringing back health-conscious customers. Papa John’s is also committed to provide quality food and serve better ingredients to its customers.

Burger giant, McDonald's has discontinued the use of chicken raised with antibiotics, started using real butter and not margarine in breakfast sandwiches, and has removed the high-fructose corn syrup from buns. The company is also set to discard the use of frozen patties in favor of fresh beef in all its popular “Quarter Pounder” burgers across the majority of its U.S. restaurants by mid-2018. Yum! Brands’ KFC has also pledged todiscard the use of chicken raised with antibiotics — commonly used to treat humans— at more than 4,000 of its restaurants in the United States by the end of 2018.

Meanwhile, companies like McDonalds, Dunkin' Brands and Wendy's are shifting to cage-free eggs to appease health-conscious guests.

Moving to the consumer side, it seems that Americans are keener on having breakfast at restaurants as exclusive breakfast offerings have been driving traffic at most U.S. restaurants, outpacing conventional lunch and dinner items. The breakfast segment is also gaining popularity because of lower rates than other meals and lesser waiting time. In fact, the consumption of breakfasts and morning snacks, at and away from home, is projected to grow 5% through 2019, according to research firm NPD Group.

Fast food giant, McDonald's has its own all-day breakfast platform in the United States, which has proven to be a remarkable success. In fact, Denny's Corp. (DENN) and Jack in the Box have been offering all-day breakfast for quite some time now, highlighting how the trend has been successfully driving sales. Dunkin' Brands also sells breakfast sandwiches all day, which is a major contributor to sales.

Other players in the industry like Yum! Brands’ Taco Bell is also capitalizing on rising demand for breakfast. With breakfast foods playing a key role in the daily eating habits of restaurant-goers, the fast food industry has been able to turn around and drive growth even as non-healthy items on their menus are falling out of favor.

Stocks That Warrant a Look

We are bullish onDine Brands Global, Inc. (DIN) and Arcos Dorados Holdings (ARCO), holding a Zacks Rank #1 (Strong Buy) and Zacks Rank #2 (Buy), respectively. You can see the complete list of today’s Zacks #1 Rank stocks here.

Despite being Zacks Ranked #3 (Hold) stocks, we also find McDonald’s, BJ's Restaurants, Brinker International and Cracker Barrel Old Country Store solid plays, given the momentum in their underlying businesses.

Bottom Line

There are plenty of reasons to be optimistic about the restaurant industry’s near to medium-term outlook. Effective sales and digital initiatives undertaken by the restaurant companies, particularly their enhanced focus on technology and delivery, to cater to the ever-changing wants and needs of customers, are likely to aid them in defying industry-wide headwinds.

We thus expect the industry to grow at a modest pace. Predominantly, innovative operators with strong fundamentals are likely to continue exhibiting strength even in a not-so-favorable environment. Hence, investing in some sound restaurant companies to satisfy your appetite should not be a bad proposition.

Check out our latest “Restaurant Industry Outlook” here for more on the current state of affairs from an earnings perspective and the trend for this important sector.

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