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The restaurant industry is showing improvements and seems poised for long-term growth, but concerns about the health of the U.S. economy and the nagging sovereign debt issues in Europe pose some risks to this outlook. However, if we look back at the last few months, restaurant operators managed to post improved results riding on the back of modest traffic improvement and the consequent rise in comparable-store sales.

A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index (RPI), measuring the health and outlook on the U.S. restaurant industry, was 100.1 in September, up 0.7% from August. It was the highest level since June. The RPI run-rate in the last three months connotes improvements in same-store sales and customer traffic.

The Current Situation Index, which measures comparable-store sales, traffic counts, labor costs and capital expenditures in the restaurant industry, was 100.1 in September, up 0.8% from August. The Expectations Index, which measures restaurant operators’ six-month outlook on the above indicators, stood at 100.2, up 0.7% from the prior month. Restaurant operators’ capital spending plans are also on the rise, reaffirming their positive outlook on the industry.

All these culminate to the general optimism in the sector. We are hopeful that restaurant companies will continue to deliver better numbers in the upcoming quarter as opposed to the year-earlier period. An improving outlook can be validated by the NPD foodservice market research report, which stated that annual visits to restaurants will increase by 8% over the next ten years.

Road Ahead

Looking ahead, we see modest top-line trends. Most of the restaurant operators are passing on higher costs to consumers in order to mitigate commodity pressure this year, and we expect this trend to continue in 2012. The companies that are well positioned are likely to enjoy pricing power and thus same-store sales increases.

However, we expect guest count to remain subdued in the first half of 2012. The U.S. economy is improving, albeit at a lower rate, but a sluggish labor market, over-supply of restaurants in the industry, higher gasoline prices, food cost inflation, a still-elevated unemployment level and weak income growth may weigh on industry profitability.

Restaurants have been trying to win back cash-conscious guests by revamping promotions, offering discounts and focusing on value-for-meal menus. However, the tendency to offer discounts has been moderating. We remain cautiously optimistic over the near-to-medium term, with consumers continuing to look for value, distinct dining experiences, as well as convenient and enhanced menu deals in a gradually improving economic backdrop.

Drivers of the Restaurant Industry

The U.S. restaurant industry consists of Quick Service Restaurants (QSR), Midscale Restaurants, Casual Dining, Non-Commercial and Fine Dining/Upscale restaurants.

In the midst of what might be called a lukewarm recovery, these are the potential drivers of net income growth for the restaurant industry: unit expansion, same-store sales, cost-containment efforts and marketing tools.

Unit Expansion: Emerging from a lackluster economy in 2008-2009, most of the companies have accelerated their pace of restaurant openings, though not aggressively. A relative recovery in consumer confidence has also encouraged companies to return to unit expansion.

In fact, the companies are also exploring international markets. While Chipotle is primarily concentrating on European countries including U.K., Germany and France, Buffalo Wild Wings Inc. (NASDAQ:BWLD) will expand its overseas footprint by opening more than 50 company-owned and franchised restaurants in Canada over the next 5 years. Additionally, the company is also looking for expansion opportunities in other international markets like the United Kingdom and Middle East. Another restaurant, P.F. Chang's China Bistro Inc. (NASDAQ:PFCB) is also eying the Canadian market.

Darden Restaurants Inc. (NYSE:DRI) will also spread its operations in the Middle East. Several food chains, including Denny's Corp. (NASDAQ:DENN), Pollo Tropical of Carrols Restaurant (NASDAQ:TAST) and Starbucks Corporation (NASDAQ:SBUX) intend to tap the fast-growing Indian market. McDonald’s Corp. (NYSE:MCD) and Yum! Brands Inc. (NYSE:YUM) already have considerable coverage in India. Companies like Yum! Brands and McDonald’s are aggressively expanding in China to capitalize on the fast-paced economic growth in Asia. The companies are also targeting South-East Asia for expansion.

Same-Store Sales: The second driver consists of menu price increases and traffic counts. Most of the restaurant operators reported positive same-store sales and customer traffic growth in the recent months. Growth in menu price has accelerated, as per figures from the Bureau of Labor Statistics.

Cost-Containment Efforts: Some cost cuts have been achieved through integrated information systems, including point-of-sale, automated kitchen display, labor-scheduling and theoretical food cost systems.

Marketing Tools: Social media as a marketing tool has taken the industry by storm. Most of the operators rely on social media for promotion. Hence, we believe they are likely to incorporate Facebook, online review sites, Twitter and blogs increasingly into their marketing mix over the next two years.

OPPORTUNITIES

With the economic outlook improving, the fortunes of a number industry players have turned around. These companies promise long-term growth opportunities.

  • Buffalo Wild Wings offers investors one of the strongest growth stories in this space. It had also been able to consistently deliver positive comps during the height of market turmoil.
  • With steady earnings and a healthy balance sheet, McDonald’s provides relative safety and moderate growth opportunities in the current scenario, as well as exposure to faster-growing international markets. McDonald’s U.S. comparable-store sales have been showing a continued uptrend since the last few months on strong sales of beverage as well as core menu products.
  • Boasting of a unique position in the hyper-competitive bar and grill segment, yet another stock, BJ’s Restaurants offers investors a strong growth story with a viable business strategy and debt-free balance sheet. The company delivered impressive second quarter results in terms of earnings per share and same-store sales growth.

Improved Californian Market

The core California market, which was badly hit by the recession resulted in a high rate of unemployment and weak consumer confidence, has turned around. We see plenty of growth opportunities in the California and Texas markets. BJ’s Restaurants and Red Robin Gourmet Burgers Inc. (NASDAQ:RRGB) are expanding rapidly in California.

Job Growth in the Sector

The restaurant industry is one of the major contributors to job growth in the U.S. In the 12 months ended October 2011, restaurant employment increased 1.7% from 1.1% for the same period a year earlier. According to the National Restaurant Association, Texas and Florida will likely show the strongest job growth over the next 10 years.

Remodels and Menu Innovations Remain Key to Success

Additionally, restaurants are accessing different means to plug the problems of heightened competition in a somewhat over-supplied domestic market. Companies continue to reduce their energy consumption and are remodeling their restaurants to give an upmarket feel. They are rolling out new, smaller prototypes to augment the perception of value and drive traffic thereby reducing construction and occupancy costs to enhance returns on capital.

While Darden has embarked on an extensive remodeling plan for its core brands like Olive Garden and Red Lobster to spur its same-store sales, Chipotle Mexican Grill is introducing typical Southeast Asian cuisine along with the naturally raised food, for which it is well known.

Having stabilized their financial positions, the operators are well positioned to bring newer offerings to their menu card in 2012 in order to cater to the ever-changing demands of customers. The introduction of small plates or individual appetizers by several chains such as California Pizza Kitchen (NASDAQ:CPKI), BJ's Restaurants and Buffalo Wild Wings have already tasted success. Limited Time Offers are also on the rise.

Franchise-Driven Business Model

Most of the companies are transforming to more a franchise-centric model to reduce the volatility in earnings and increase cash flow generation. However, Panera Bread Co. (NASDAQ:PNRA) bread is more inclined toward company-owned unit openings, which speak well of its fundamental strength and make us optimistic on the stock.

Breakfast Menus a Key Driver

Breakfast has accounted for nearly 60% of the U.S. restaurant industry and remains a key driver of traffic growth in recent years. Over the past five years, morning meal traffic has increased at an average rate of 2% per year, while lunch visits were flat, and supper traffic declined 2% per year on average.

We can thereby conclude that growth potential remains mainly in the QSR markets. Leveraging the trend, The Wendy's Company (NASDAQ:WEN) has expedited its breakfast menu in different markets. The company targets to have about 1,000 restaurants serving its new breakfast by the end of this year. The comps of Jamba Inc. (NASDAQ:JMBA) also gained traction in the recent quarters through its breakfast wraps. The company expanded this product line to 270 company stores in May and will spread further in 2012. McDonald’s is yet another beneficiary of the increasingly popular breakfast menu.

According to an analysis by NPD, which has a ten-year projection of foodservice trends based on aging, population growth and trend momentum, servings of breakfast sandwiches are projected to outpace the industry’s growth forecast. Annual servings per capita of breakfast sandwiches at foodservice are expected to jump from 11 in 2004 to 14 in 2019.

M&A Activity

Merger and acquisition activity is also gaining momentum in the sector. The companies are looking at potential business partners to foray into different zones and unlock value. While Starbucks has stepped beyond coffee and ventured into the $50 billion category of healthy juices, Yum! Brands is also on the verge of acquiring China-based restaurant chain Little Ship. Recently, the Minneapolis-based Granite City Food & Brewery agreed to acquire the assets of seven Cadillac Ranch All American Bar & Grill restaurants. Darden has also inked a deal to purchase two Eddie V's restaurant brands –– Eddie V's Prime Seafood and Wildfish Seafood Grille.

Apart from acquisitions, the companies are also divesting their slow-moving brands in order to spur growth. The recent sale of Long John Silver’s and A&W of Yum! Brands as well as the departure of Arby’s from Wendy’s confirm the trend.

Currently, there are a number of stocks in the restaurant with a Zacks #1 Rank (short-term Strong Buy rating). These include Domino's Pizza Inc. (NYSE:DPZ). Companies with Zacks #2 Rank (short-term Buy rating) include Benihana Inc. (NASDAQ:BNHN), Panera Bread Co. and Papa John International.

WEAKNESSES

Higher Food and Gasoline Prices

Food costs account for about one-third of restaurant sales. Wholesale food prices have been on the rise this year. Prices of corn, wheat, coffee and other commodities have also trended up, compelling many restaurants to raise prices on some of their products. The companies are expecting industry-wide increases in commodity and energy costs to continue in 2012. Dairy and beef prices witnessed a steep rise on a year-over-year basis.

Companies like Red Robin Burger, McDonald’s and Texas Roadhouse, which are exposed to the beef market, or CEC Entertainment Inc. (CEC) and The Cheesecake Factory Inc. (NASDAQ:CAKE), which are regular buyers of cheese, often feel the brunt of price inflation. Chicken wing prices, which have been favorable in third quarter 2011, are rising now. A continued rise in traditional wing prices is expected for 2012.

With food being more expensive and gasoline prices always on the rise, people have less disposable income and prefer to dine at home. In our opinion, most of the restaurants will try to safeguard their margins by passing the cost hikes onto consumers. While big and established chains like McDonald's, Yum! Brands and Starbucks will survive the price increases due to their broad customer base and larger economies of scale, smaller chains will feel the cost pressure. Some restaurants also expect labor expense to rise in 2012, due to a hike in minimum wages across a number of states, particularly in the West.

Steep Competition and Promotional Offers

Competition among casual dining restaurants is expected to remain fierce with respect to price, service, location and concept in order to drive traffic. The environment is still value-sensitive. High discount rates applied to menu prices in order to battle difficult economic conditions are resulting in price wars among competitor companies. Hence, the failure of any promotional offer will put pressure on the company’s same-restaurant sales growth.

Shut Down of Regional Restaurant Chains

The majority of independent U.S. restaurant units are closing, while restaurant chains remained steady. Large national chains, which attract mainly higher-income visitors are performing better than regional restaurants as upscale-customers are recovering faster than the lower-income group.

Lag in Traffic Growth Barring Fast Casual Restaurants

According to a recent NPD foodservice market research report, visits to the leading fast casual restaurant chains grew more than 15% over the last three years while the rest of the industry experienced its sharpest traffic declines. However, fast casual unit availability increased 12% since 2007. Visits to the leading fast casual restaurant chains, like Chipotle (NYSE:CMG) and Panera, were up 6% for the year ending December 2010 versus a year ago. This compares with a 1% decline in total industry visits for the same time period.

Given the lack of overall earnings catalysts, it’s hard to be upbeat about a number of restaurant stocks. There are quite a few names on which we have a cautious outlook. These include Brinker International Inc. (NYSE:EAT), Yum! Brands, The Cheesecake Factory, Einstein Noah Restaurant Group Inc. (NASDAQ:BAGL) and McDonald’s, all of which retain the Zacks #3 Rank (short-term Hold). Ruby Tuesday Inc. (NYSE:RT) and Jack in the Box Inc. (NASDAQ:JACK) still hold the Zacks #4 Rank (short-term Sell).

Conclusion

The restaurant industry is still not immune to uncertainties in the macro economy. We believe the companies with strong cash flow generation will survive the market volatility. However, there are companies with huge capital budgets that look to be in good shape financially. Easy comparisons from the prior year will likely place this year's performance in a brighter light.

On the consumer front, while they were previously struggling to survive in a recessionary environment, they are now grappling with steeply rising commodity costs, a still-high unemployment rate and dreary wage gains. These factors are still compelling consumers to tighten their belts. In our opinion, a set of focused efforts will help restaurant companies operate with a cautiously optimistic outlook in 2012.

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PF CHANGS CHINA: Free Stock Analysis Report

PANERA BREAD CO: Free Stock Analysis Report

RED ROBIN GOURM: Free Stock Analysis Report

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WENDYS CO/THE: Free Stock Analysis Report

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Source: Restaurant Industry Stock Review