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The restaurant industry had some good news earlier this summer, when restaurant traffic seemed to stabilize and stock prices increased. We chatted with Zacks senior restaurant industry analyst Ann Northrop, CFA to see if some positive sentiment remains in the group, or perhaps just for a few stocks.

It's been about a year since the U.S. economy began softening under fears of a mortgage-led credit crisis. In what ways has the restaurant industry been dealing with this issue?

Restaurant operators are being squeezed by declining customer traffic and rising food and labor costs. To stem the traffic drain, most operators are running value promotions and have stepped up advertising while raising prices. Restaurants at all ends of the spectrum are running value promotions, from the $1 value menu at many quick service operators to Morton’s (MRT) “steak and seafood for two” promotion at $99.

Because lunch has generally been the hardest-hit day-part, many casual dining chains have added lunch specials to the menu in an effort to reinvigorate sales. At the same time, these operators are rolling out price increases, often in their premium items, such as smoothies or premium beef items. This “barbell” pricing strategy is designed to retain the more price-sensitive customer, while increasing average price and supporting margins.

Are other quick-service restaurant [QSR] chains able to reinvent themselves the way McDonald's (MCD) has recently, or is that company a special case?

If by reinvent, you mean change the public perception of fast food being unhealthy, then the answer is yes. Most quick service operators have switched to trans-fat free oil in recent years and offer a range of salads and non-beef options. Yum! Brands’ (YUM) Taco Bell recently added its Fresco menu, which consists of nine items with less than nine grams of fat. KFC’s (also a Yum! Brand) U.S. business is hurting because it didn’t respond to consumers’ long-running shift away from fried foods. It’s now test-marketing a line of grilled sandwiches and salads and expects to launch them nationally in the first half of 2009.

But McDonald’s has done the best job of marketing to mothers. The company has managed to defuse an avalanche of negative publicity from popular books and documentaries linking fast food with childhood obesity. It not only added healthier options to its Happy Meals, but ran an inspired PR campaign to change its image. Its “Mom's Quality Correspondents” program consists of several mothers from varying backgrounds that tour behind the scenes at McDonald’s and report back about their findings.

Judging by the company’s recent financial results, their marketing programs to have been successful. Burger King (BKC) has lagged behind many of its rivals on the health, children and value fronts but is moving quickly to catch up. It’s switching to trans-fat free oil this year, has added a value menu, and recently new, healthier kids meals and launched a marketing campaign targeted at moms.

What is your outlook for the casual dining industry? Is now a good time to invest?

Despite recent downward estimate revisions, I think 2009 Street consensus estimates are still too high in many cases. It appears that investors are expecting improved traffic and in my opinion that is not likely to happen, unless gas prices decline substantially. Remember, rising gas prices was the initial catalyst for declining casual dining traffic.

The housing crisis isn’t likely to correct soon either. There were some signs in second quarter results that traffic declines may be stabilizing. But with unemployment ticking up, I wouldn’t be surprised to see further deterioration in the third quarter. Barring significant deterioration in the economy, I think traffic could bottom in the fourth quarter and remain flat next year, as more consumers have had time to adjust to their higher cost of living by eating out less frequently among other cutbacks.

That said, I think July’s stock price run-up could reverse itself as estimates are revised downwards. A reversal in the recent decline in gas prices would also likely deflate restaurant stock prices. We saw brief spurts of this effect early last week as oil prices rose.

At either time, I would look to buy the better, more profitable concepts, such as Buffalo Wild Wings (BWLD), BJ’s Restaurants (BJRI) and Famous Dave’s (DAVE). Restaurant stocks are early-cycle investments, and we anticipate lasting multiple expansion nine months before industry traffic and profitability begin improving meaningfully.

Which are your top Buy recommendations on restaurant stocks these days?

I think three of the quick service operators will outperform the market - McDonald’s, Yum! Brands, and Burger King. Yum! and McDonald’s generate a significant portion of the revenue in faster-growing developing markets and are sustaining traffic here in the U.S. as casual dining customers trade down. Burger King has just started to expand internationally and has enormous growth potential. It’s also in the midst of a turnaround that I think will likely expand margins.

Ann Northrop, CFA is a senior analyst covering the restaurant industry for Zacks Equity Research.

Source: Restaurants Add New Low-Price Promotions