Restaurants ‘fairly well positioned’ due to strong consumer, analyst says

Citi Restaurant Analyst Jon Tower joins Yahoo Finance Live to discuss restaurant earnings and how inflation could affect consumer spending on dining and food.

Video Transcript

BRIAN SOZZI: Investors are keeping a close eye on the fast food space this week as Chipotle, McDonald's, and Domino's are all set to report earnings this week. Joining us now to break down what to expect is Citi restaurant analyst Jon Tower. Jon, always great to see you here.

I've been looking at some restaurant traffic data. And I've been surprised, just given all the inflation we are seeing in the consumer goods space, fast food appears to be holding up well. Do you think consumers are trading down from eating at home to eating at fast food?

JON TOWER: Well, hey, Brian. Thanks for having me today first. And good to see you.

In terms of the space and demand specifically, we actually think the consumer is in pretty good shape. And some of the work that we did when we launched on April 11, we dug into that key debate. How is inflation impacting consumer consumption and specifically their wallets and discretionary income?

And what we think is often lost in the discussion is the backdrop around jobs and wages. And when we dug into the different income cohorts, specifically four to five different cohorts, sub-30,000 at the low end and then greater than 200,000 at the high end. And when you take a look at inflation's impact against their spend over time, it's certainly a drag but.

When they then add in some of the wage growth as well as some of the job growth as well, that's a nice netting positive effect for the consumer. So generally speaking, they're in good shape even though inflation numbers have picked up pretty nicely, and there are some pressures on the consumer that hadn't been there say, six to nine months ago.

But yeah, in terms of thinking about how this is going to impact demand over time, we think that restaurants are fairly well-positioned. They offer convenience that, say, the grocery channel can't provide with respect to speed and availability. And we think that given the consumer being in a relatively strong spot with low unemployment and jobs plentiful and wage rates moving higher, restaurant demand should be pretty strong into the future.

JULIE HYMAN: Hey, Jon, it's Julie here. The stocks are not trading as though the demand is going to be strong going into the future, right? If you look at most of these stocks, they are down pretty sharply year to date. I mean, you're looking at a drop of 34% for Starbucks. Domino's is down about the same amount.

And it's hard to find any that are, in fact, green year to date when you look across the restaurant space. So what do you think would be a catalyst for the thesis that you're talking about, the market to sort of come to that place?

JON TOWER: Yeah, I think, look, this earnings season in particular will help be a bit of a watershed moment. If you take a look back when many of these companies offered fourth quarter earnings, which was really starting in late January and into early February, it was before the Ukraine crisis took off and, frankly, before a lot of the input prices took off as well. I think mid-single-digit, high single-digit inflation since that point in time for many of the core inputs for the restaurant industry.

So I think the investor community is a little concerned that you're going to see a negative revision to earnings for the back half of the year because of higher inflation across the restaurant space. Couple that with concerns about the demand environment, which we just went through in terms of our expectation versus the Street, and I can understand why the stocks are seeing some pressure.

But I do think this earnings season, when numbers do get reset, likely lower, for many of the brands, that'll give investors at least some reasonable confidence on where numbers can go for the balance of the year. And then they got to buy the multiples that they want to pay for these stocks. But I think it is this moment coming up, especially when companies give a bit of guidance around their expectations for food costs in the back half.

And I think to what Brian mentioned earlier, the data that we're looking at from a demand standpoint is held in very well, meaning the consumer is still going to restaurants, even in the face of all this inflation.

So to the extent companies can come out and say, demand is still healthy, we've quantified what the impact is going to be from a P&L standpoint from inflation, there's likely a bit in the market that forms from investors from this point forward.

BRIAN SOZZI: Jon, the way I'm segmenting this, pizza, burgers, chicken sandwiches. So pizza, of course, you have Domino's, Papa John's. Burgers, you have McDonald's. And chicken sandwiches, I'll say Popeyes, which is owned by Restaurant Brands, and Wendy's. Out of all those names, which company or companies do you think will have success pushing through higher prices of its products, could see profits hang up or hold up pretty well, and their stock prices might do well?

JON TOWER: Yeah, so I think generally speaking across the board, restaurants have pricing power, given the convenience that they offer to customers as well as just the value on the plate. Thinking more specifically into different brands, we like to think of it as companies that are consistently investing back into their brand, into the product quality, into the experience, and those that, frankly, have been running with a good amount of momentum in their business, meaning traffic but also sales growth coming into this, what we dub as, a more noisy period than what we had seen probably six months ago or so.

Those brands themselves are likely going to be the ones that are able to take a little bit more pricing to help offset some of the inflationary pressures in the business going forward. So outside of that, there's also businesses that haven't historically taken much price. Domino's Pizza is towards the top of that list. And they've recently flexed their everyday value menu and segmented the delivery from the carryout channel on that everyday value. We think that's a signal that they're likely open to take more price in the balance of this year and going forward or at least recommend that for franchisees to the extent they can.

JULIE HYMAN: Jon, would that be your top pick going into this earning season, Domino's?

JON TOWER: Yeah, it's probably the most controversial name that we've got right now, certainly the most pushback from investors these days. There's an expectation in the market that they're going to have a fairly significant miss on first quarter earnings and that some of that weakness is carried forward into the second quarter to date. We think there's many different factors going on.

And some of the underlying shifts in the business, specifically the company's own push to try and ease pressures on the delivery side of the business, which accounts for about 60% or so of their transactions, what they've done intentionally is moved customers toward the carryout channel. And they've done that in two manners.

One, they've advertised quite a bit around carryout. Two, obviously, they've done this promotion where they've raised the price on the delivery side of the everyday value piece. And then the third is they've done the $3 tip that you may be seeing in some of the traditional advertisements these days.

That channel shift is likely providing a negative mix headwind on their same store sales. So while traffic might actually be improving underlying, you've got this negative sales headwind as customers pivot from delivery, which is traditionally a higher checkout option for the company, and towards carryout, plus you weave in this $3 tip that's essentially a discount the company's going to take in order to keep that traffic going.

This is probably making some noise in the near term on same store sales. But we like the longer-term algorithm. We think that the company still has plenty of room to grow domestically and internationally from a new store growth standpoint as well as same-store standpoint. And frankly, we think that--

We put out a note today, actually, on the topic regarding third party delivery. It's something that the brand has really not wanted to pursue in the past. And we think that platform, specifically as an advertising medium, might make a ton of sense for Domino's Pizza to kind of capture a set of eyeballs that are missing the brand today.

JULIE HYMAN: Very interesting stuff. And Domino's report is due to report before the open on Thursday. So people will get more information on everything you're talking about. Jon, thank you so much. Jon Tower, Citi restaurant analyst. Good to catch up with you today. Really appreciate it.