After five straight years of underperformance vs. restaurant equities, food & drug and convenience store stocks are now poised to outperform restaurant stocks. The main reasons for this underperformance, discussed below, have either been addressed or are now beginning to work in favor of these food retailers.
Relative Improvements in the Retail Channel
The three largest grocery store operators, Kroger (KR), Safeway (SWY) and Supervalu (SVU), have reduced their store counts over the past five years. Headcount has fallen even faster at each grocer. These trends will continue, helping rebuild margins.
Meanwhile, grocery industry over-capacity has been further lessened by the bankruptcy of A&P, once the largest grocer in the country. Similarly, more than 3,000 C-stores operated by oil companies have been closed since 2004, according to Convenience Store News.
With few distinguishing characteristics, grocers have, over the past several years, had to resort to price competition to retain existing customers. But during the past several years, grocers have stepped-up private label offerings and expanded fresh food and prepared meals.
Wal-Mart's (WMT) recent October quarter was the first since early 2009 in which comparable store sales rose. No small thing. With $165 billion in annual grocery sales (including Sam's Club), WMT is larger than the three largest traditional grocers combined. Less price cutting from a healthier Wal-Mart should provide cover for food retailers to lift their own prices.
Overseas growth, which had boosted profitability within the restaurants, especially the larger operators, like MCD (Europe), YUM (China) is well discounted at Papa John's (PZZA) and Starbucks (SBUX), and could become a drag on future growth.
Favorable Organic Growth
Each of the past five years the average Food & Drug/C-store has grown its identical or comparable sales faster than the typical restaurant operator.
I recommend buying the following five stocks:
Ruddick (RDK) : Decline from October peak, following announced divestiture of A&E thread business. Cash from the sale ($180 million) will support reinvigorated store growth - after slowing in 2011. Buy RDK.
Casey's General Store (CASY) : The company is emphasizing gross profits ($s) over gross margins (%), using gas sales to drive more profitable in-store traffic. Profits are rising from gas sales where CASY is pricing itself above competitors with narrower in-store choices. Likewise, grocery and prepared foods comparable sales are growing 5-7% and 12-15%, respectively, taking share in most markets. I remain bullish on CASY since my report last spring ("Casey's General Store: Buy the Best in Class", April 13, 2011).
Safeway: Comparable growth began to turn corner in 2011, with profit margins now beginning to follow. Asset sales, including stores (Genuardi in Philadelphia, potentially Dominick's in Chicago) and possibly Blackhawk, combined with over $1 billion in operating cash flows, will help SWY return significant amounts of cash to shareholders, via dividends and buybacks. I have been bullish on SWY since my report in late 2010 ("A Turn for the Better at Safeway", Nov. 12, 2010), and I remain a buyer.
Kroger: Will be biggest beneficiary of less price-competitive Wal-Mart. KR management has spent last few years focused on market share. Reduced price-pressure industry-wide will help it leverage mid-single digit ID sales I see for 2012 into a 20% profit boost in 2012. Buy KR.
Walgreens (WAG): Weakness from loss of Express-Scripts business is a buying opportunity. Given the market shares in their respective industries, both sides are incentivized to make this deal work. Buy WAG.
I recommend funding these purchases through the sale of the following:
Red Robin Gourmet Burgers (RRGB): Declining customer counts, low single digit comps, negligible unit growth do not merit a 21x P/E (on my 2012 estimate of $1.47). Since I moved to buy last Spring ("Ranking the Restaurant Stocks", April 12, 2011), the company has done a fine job cutting costs. But its ~3.5% operating margin is still well below any of the 13 restaurants I follow. The only area left to meaningfully cut is corporate overhead. To do that it must either do much better than the 2-3% run rate comp sales growth, which seems unlikely given declining customer counts. Alternatively, it could jump start its franchising program, except that new franchise partners aren't exactly coming out of the woodwork.
McDonald's (MCD) : I have been negative on MCD since last spring, and wrong. But now anecdotal evidence among franchisees suggests pricing in the US looks overly aggressive (+5%) and its European growth machine likely to show softer comparisons in 2012, I still hold to my investment thesis: Sell MCD short.
Cracker Barrel (CBRL): the company continues to push price, at the expense of unit volumes, and the stock's 10% higher since my negative view on CBRL since last spring ("Sell Cracker Barrel Ahead of Weak Quarterly Results", May 18, 2011). Sell CBRL short.
Buffalo Wild Wings (BWLD): With among the best unit growth rates in the industry, and solid organic growth, I'm still a believer. But after a 35% jump since my late'10 buy recommendation ("It's Heating Up at Buffalo Wild Wings", Nov. 12, 2010) and with wing costs likely to head higher, I'm moving to the sidelines. Sell BWLD but only if you already own it (this is not a short call).