By R. J. Hottovy
The domestic restaurant industry has been impacted by a number of secular headwinds over the past several years, including fewer meals eaten away from home, increased prepackaged meal offerings from grocers and warehouse clubs, elevated unemployment rates, and wage rate hikes. We see few signs of an immediate reversal in these trends, suggesting that restaurant operators will face a bumpy road to recovery. Collectively, we forecast marginally positive top-line growth for the restaurant industry in 2010, driven primarily by modestly improving restaurant traffic gains (but still well below historic norms). We anticipate a muted impact from menu price inflation, as restaurant operators have been reluctant to raise prices due to consumer spending constraints. This hypothesis is supported by the consumer price index for food away from home, which is up just 0.1% through July, according to the U.S. Bureau of Labor Statistics. We also expect menu mix to have a minimal impact on top-line results for 2010, as increased small plate offerings help to balance tepid sales for desserts and beverages.
Though there has been nominal improvement in restaurant traffic over the past several months, we believe the restaurant industry requires more meaningful economic catalysts before it will fully recover, including a significant reduction in unemployment. Still, there are several indications that consumers are not eating out as much as they would like, and we believe restaurants offer a relatively inexpensive form of entertainment for the average consumer. We also view many of the prevailing economic headwinds as cyclical in nature, and remain optimistic about the prospects for improving fundamentals over the long haul. Even with our cautious near-term outlook, we believe restaurant stocks could represent an attractive play on a late-cycle economic recovery, with our restaurant coverage universe presently trading at a median price-to-fair value ratio of 0.89 times.
There were indications of an early recovery among casual-dining restaurant chains through the first few months of 2010, evidenced by positive average comparable-restaurant sales trends across our casual-dining coverage universe the past two quarters. That said, we have concerns that comparable-restaurant sales trends could moderate over the next few quarters amid lingering economic uncertainty and the re-emergence of aggressive discounting. Although most of the casual-dining names on our coverage list are trading at a modest discount to our fair value estimate--the casual-dining restaurant group's median price/fair value ratio is 0.86 times--we would encourage investors to take a wait-and-see approach with many of these names, as more attractive entry points may present themselves. However, we consider Darden (DRI) to be the safest investment alternative in this category, given an everyday value menu approach (versus the deep discount strategies driving traffic at rival chains) and a dividend yield of 2.5%.
So far, 2010 has been an exceptionally brutal year for most domestic quick-service restaurant chains, with a median quarterly comp decline of 4% through the first half the year. While we continue to have concerns about the potential impact of pervasive industry discounting and the risk of elevated unemployment rates through the remainder of 2010 and likely into 2011, we have started to see a few glimmers of hope in recent results. In particular, Burger King's (BKC) fourth-quarter results (year-end June) were highlighted by a sequential uptick in the average check in the U.S., driven by the launch of fire-grilled ribs and other premium products. In our view, this trend demonstrates that consumers are willing to spend for items that stand out in the homogenous world of quick-service restaurant menus. The early success of new product platforms at Burger King and other quick-service restaurant chains gives us hope that comparable sales growth trends will continue to improve over the next few quarters.
McDonald's (MCD) has been the one notable exception to the sluggish trends plaguing quick-service restaurants, as its expanded beverage platform initiatives (including the nationwide rollout of frappes), the launch of a dollar breakfast menu, and successful marketing campaigns behind core menu classics have allowed the firm to outperform its peer group. That said, we believe shares have already priced in exceptionally lofty expectations (the shares are currently trading at a forward price/earnings of 16.0 times), even factoring in a premium valuation for McDonald's dominant position in the restaurant industry (13% of U.S. quick service restaurant sales and about 4% of global restaurant sales) and recent momentum. Our fair value estimate could prove moderately conservative if sales of margin-friendly smoothies prove sustainable over the next several months, but we believe greater upside potential lies elsewhere in the restaurant category.
Saddled between casual-dining and quick-service restaurants is the emergent $20 billion fast-casual restaurant category, which offers higher-quality ingredients than quick-service chains but at lower average prices than casual-dining chains. In particular, Chipotle Mexican Grill (CMG) and Panera (PNRA) have been standout stories in an otherwise lackluster environment for restaurant operators. We remain confident in these firms' ability to gain incremental market share through a mix of menu innovations, improved operations, more attractive real estate opportunities, and flexible balance sheets. That said, we believe current prices already reflect unrealistic long-term growth assumptions (representing a collective forward price/earnings ratio of 26 times), especially in light of new entrants with aggressive growth aspirations in this rapidly-growing category. We would encourage investors to take a cautious approach with these names given increasingly difficult comparisons in the back half of 2010 that could turn into a potential downside catalyst.
Where should investors turn to satisfy their investment hunger? Last year, we recommended several of our established-moat names in a June 2009 report--Which Restaurant Stocks Should Whet Investors' Appetites?--including McDonald's, Yum Brands (YUM), and Darden. We believed these restaurant companies were better positioned to weather recessionary pressures due to their considerable economies of scale, globally-recognized brand names, and healthy balance sheets. Since publishing that report, investments in these three names would have garnered returns of 25%, 22%, and 18%, respectively. While we continue to believe that these names will generate excess economic returns over an extended period of time, we believe more attractive investment opportunities can presently be found elsewhere in the restaurant industry.
In our view, greater share price potential currently exists for small- to midcap quick-service restaurant operators, including Burger King, Sonic (SONC), and Wendy's/Arby's Group (WEN), each of which is currently trading at a price/fair value under 0.75 times. We believe rivalry with larger restaurant chains has forced these competitors to raise their game, resulting in new traffic-driving initiatives, margin-friendly menu innovations, and cleaner expense structures. Although the market has either written off these names or regards them as value traps, we believe many of the pressures weighing on results to be cyclical in nature (unemployment in particular), and we expect improving fundamentals as the economic picture eventually improves.
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