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Restaurant Industry Stock Outlook - January 2017

Zacks Equity Research

Where Are Restaurants Headed in 2017?

We can look back and say that the U.S. restaurant space was not too enticing to investors in 2016. In fact, same-store sales growth was rather dull in a difficult sales environment, which reflected in the industry’s stock-price performance. Over the past year, the stock-price performance of the Zacks Restaurants Industry lagged the broader S&P 500 index, with industry stocks up +0.1% vs. +17.6% for the broader index.

Despite economic growth, somewhat lower energy prices and higher income, consumers increased their spending only modestly on dining out, which resulted in low consumption over the last few quarters. The situation has turned worse, thanks to higher health care costs and tightened credit availability in the U.S. Moreover, an unfavorable currency, a cooling Chinese economy and a tightening labor market have compounded restaurateurs’ woes. Traffic has also been weak.

Nevertheless, restaurateurs are undertaking various sales building and digital initiatives to drive traffic and comps. Also, they are increasingly adapting to the changing tastes and preferences of their consumers to entice them once again. Further, increased focus on refranchising bodes well while remodeling efforts should enhance guest experience.

Pros & Cons

We note that same-store sales for the month of November declined 1.3%, marking the ninth consecutive month of negative same-store sales and representing the weakest performance since July, per TDn2K’s Black Box Intelligence.

Meanwhile, another report by TDn2K’s Black Box Intelligence stated that the third quarter of 2016 was the third consecutive quarter in which the restaurant industry failed to produce positive comps growth. Same-store sales during the quarter dipped 1% year over year, following a 0.2% and 0.7% decline in the first and second quarter of 2016, respectively.

Moreover, as per NPD Group, traffic at U.S. fast-food restaurants fell 1% in the third quarter, marking the sector’s first traffic decline in five years and continuing the somber mood at the restaurant industry.

Also, one of the main challenges that restaurants faced last year was menu prices increasing at a much quicker rate than the prices for food at grocery stores. This created added competitive pressure for restaurants, as preparing food at home became much more attractive from a cost perspective. As a result, the Zacks categorized Retail-Restaurants industry grew a mere 0.1% over the past one year. In fact, we note that 2016 turned out to be the worst year for the U.S. restaurant industry, since the end of recession.

Nevertheless, some of the big names like McDonald's Corp. (MCD), Domino's Pizza, Inc. (DPZ), Papa John's International Inc. (PZZA), The Cheesecake Factory Inc. (CAKE) and The Wendy's Company (WEN) seem to be unperturbed by the plight and continue to do well on the back of strong fundamentals. While McDonald’s and Domino's carry a Zacks Rank #3 (Hold), Papa John's, Cheesecake Factory and Wendy'scarry a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

This signifies that all is not lost for the U.S. restaurant space and there are still plenty of profitable investment opportunities.

In fact, long-term trends favoring eating out over eating at home are still in place. Moreover, operators willing to evolve and stand out in a competitive market will continue to reap profits. Thus, restaurants with strong fundamentals and sufficient capacity for innovation will continue to be strong bets.

More importantly, long-term factors supporting the sector remain firmly in place. According to the USDA, expenditure on food outside homes has increased from 10% to 50% of total food purchases from 1904 to 2013. Also, sales at food services and drinking places have increased faster than retail sales since 2014. This trend is also far more stable and will continue to lift the sector once the current weakness abates.

Meanwhile, as per National Restaurant Association data, though the rate of growth continues to be limited, 2016 marked the seventh consecutive year of real growth in restaurant sales.

The Trump Effect

It is to be noted that increased costs pertaining to the implementation of the Affordable Care Act were hurting restaurateurs’ margins and the bottom line for some time now.

However, President-elect Donald J. Trump recently nominated restaurant chain executive Andy Puzder as Labor Secretary. Puzder is the CEO of CKE Restaurants, the parent company of the fast-food burger chains Carl’s Jr. and Hardee’s.

The appointment of Andy Puzder could bring some relief in this regard. He is an outspoken critic of increasing the minimum wage. Also, Puzder is expected to not follow in the footsteps of the Obama administration and provide some relief to restaurateurs in the form of lower minimum wage levels and more lax regulations.

Meanwhile, Trump himself has announced plans to “repeal and replace” the Affordable Care Act. He is of the view that even though the act helps purchase insurance plans at a subsidized rate, it levies taxes on the industry which reduces profitability. Trump also plans to trim the business tax rate to 15% from 35%.

All of these moves by the new government body, though not effective in boosting the top line, can prove to be tailwinds to restaurateurs’ bottom lines as margins are expected to expand favorably. Trump’s tax and spending proposals should thus add to growth, but not until the second half of 2017.

Zacks Industry Rank – Positive Outlook

Within the Zacks Industry classification, we rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral,' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the Retail-Restaurants industry currently stands at #84. This puts the industry in the top third of all industries, corresponding to a positive outlook. Effective sales initiatives undertaken by most of the restaurateurs to counter sluggish comps and traffic growth over the past few quarters, justifies the industry rating.

Earnings Trends

The restaurant industry falls under the broader Retail-Wholesale sector.

If we look at the overall results of the sector, earnings grew 7.3% in the September quarter while total revenues rose 5.0%.

Meanwhile, for the December quarter, though revenues are expected to rise 4.9%, earnings are projected to decline 0.7%. However, for 2016, both earnings and revenues are expected to rise 2.1% and 5.7%, respectively.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

Bottom Line

Consumer behavior has been volatile and their willingness to spend on eating out has diminished due to higher costs as evident from 2016 results.

However, this may turn out to be only transitory as the economy remains robust on the back of growing income and solid employment numbers. Consumer spending has also been in fine fettle of late, although sluggish spending trends in the restaurant space and slowing comps growth make it hard to bank on a strong revival.

Nevertheless, despite the challenges, the restaurant industry is expected to sustain its general pace of recovery going forward, albeit at a slower rate, as it grapples with several global economic concerns. Moreover, as always, the restaurant industry is expected to remain hyper-competitive ahead as different names vie for attention from diners to capture market share.

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Wendy's Company (The) (WEN): Free Stock Analysis Report
 
Papa John's International, Inc. (PZZA): Free Stock Analysis Report
 
McDonald's Corporation (MCD): Free Stock Analysis Report
 
Domino's Pizza Inc (DPZ): Free Stock Analysis Report
 
The Cheesecake Factory Incorporated (CAKE): Free Stock Analysis Report
 
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