John Gordon's  Instablog

The restaurant space will be interesting in 2013. Sales issues, cost issues, expansion issues, franchisee issues. There are still too many restaurants in the US and x-US markets sales increases have slowed. The two industry leaders, McDonald's (MCD) and Darden (DRI), are both somewhat in the penalty box and under pressure. Here are our thoughts on 2013 issues and opportunities.

Comps Cliff Coming: In looking at 2013, its likely restaurants will get off to a bad start. In Q4 and Q1 2013, the restaurant space will fall off a cliff of sorts: the comps generated last winter. Driven then both by warmer weather, price increases, a bit lower sales of discounted items and the peak of the 2010-2011 restaurant recovery, the January-March 2012 number will be hard to beat.

The following chains will likely have the hardest sales comp comparisons in Q1. Every single chain had lower comps most recently reported than the Q1 peak:

More sales news. In the QSR space generally, traffic now is very marginally positive and average check app. 2-3% favorable, but in the overall casual dining space, traffic is negative and totally offsets about a 2.5% check increase. There were a few standouts, however: TXRH, PNRA, SBUX, and AFCE.

One question is why was investor disclose so poor at YUM? The China same store sales trend is so stunningly negative-large sequential decreases from +19% in FY-11 to -6% just noted this week for Q4 2012, perhaps the largest decline anywhere over such a short time.

Extreme discounting is the newest news but is really old news. The current price spectrum of restaurant TV ads runs from $.99 grillers at Taco bell to $11.99 30 piece shrimp at Red Lobster. Doesn't portend well for average check. The comps cliff has affected marketing strategies everywhere.

Earnings standouts: Texas Roadhouse (TXRH), Panera (PNRA), Starbucks (SBUX) and Popeye's (AFCE) were Q3 (and Q2) positive standouts: positive sales and traffic, sales beat and earnings beat $.01 or more over estimate. Does prior performance guarantee future results?

Dividends as the goal: Dividends will be important in a low growth, low return world. The US restaurant market is way overdeveloped and worldwide development takes time and proper store level economics.

We'll be glad to see companies like DNKN (1.80% yield), BKW (.90% yield), and BLMN (0%) finally work their way out of private equity positions so that more substantial dividends can be paid.

THI, another pure play 100% "capital light" franchisor, is also low at 1.70%. That there are two coffee sector players in this group is interesting. Lower coffee commodity costs advantage will accrue to the franchisees not the corporate entities.

IPOs and M&A Pending: we still wonder when Noodles will be ready for their IPO. Fast casual is "hot". Another fast casual brand, Pei Wei could be a candidate once its lower newer unit open sales problem is fixed.

It was clear from the 2012 SBUX and DRI transactions that the path to a rich valuation is to develop a unique but mainstream product that well-heeled restaurant majors can buy for entry at rich multiples.

There will continued private equity churn, they always have fresh powder to deploy. The wave of 2006-2008 PE acquisitions will soon come due to sell.

Turnarounds to watch: Interesting that the two worldwide restaurant leaders, MCD and DRI are both challenged. No surprise that MCD went into a new news decline as it changed CEOs in 2012. When will it change?

It will be fascinating to watch Darden (DRI) work out of its current tight cash position caused by lagging big brands and resulting profit shortfall, big remodeling CAPEX requirements and now debt service for its 2012 acquisitions. Of necessity, they will look for another acquisition in 2014, once its free cash flow position improves.

We wonder if BKW has the worldwide AUV sales base potential except Latin America for franchisees to expand profitably.

Restaurants must more creatively test revenue and expense solutions: Restaurants can offset negative cost pressure and difficult comps pressure by looking at revenue increases beyond price increases and cost reductions beyond food portion cuts and labor hour savings.

Unique store level pricing tiers and dual wage tiers to offset Obamacare are but two examples. The industry needs to test aggressively new ideas. I've published more details on my website, pacificmanagementconsultinggroup.com.

Defrancising v. Refranchising divergence will continue. Those who can operate restaurants well will continue to do so, those who can't, refranchise. Panera (PNRA), Texas Roadhouse (TXRH) and Qdoba (JACK) are building new units /converting franchisees to company operation.

Franchisors still need to improve investor reporting and franchisee disclosure if they hope the franchising "capital light" business model will be sustained. How can DineEquity (DIN), now 100% franchised, be properly analyzed if there is no franchisee profitability reporting?

Reasons for optimism: always. Commodity costs thus far are coming in at the light end of what was feared some months earlier. Some companies have finally fixed their marketing focus, example Sonic (SONC). The revenue and cost challenges so often noted can be offset. And finally, this is a very adaptive industry. It just needs to get more creative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Note to McDonald's: Fix the Reporting Calendar

It's happened again: McDonald's (MCD) weak same store sales results for October announced today threatened to take down the entire restaurant space stock platform.

To be sure, McDonalds was weak (minus 1.8% worldwide). Weaker than most expected. Wendy's (WEN) same day reported plus 2.7% system same store sales and Burger King Carrols (TAST) reported a strong plus 6.2%, and an 'OK trend' thus far in October. What was of greater concern were the MCD sales components: with some analysts projecting an embedded 3% price increase in the US, either customer traffic was almost 5% lower or product mix shifted lower.

McDonald's sales momentum deterioration in the US and Europe was the most pronounced. APMEA (rest of world) had poor Japanese trends and bouncing Australian results, has been weak or negative for some time. The MCD powerhouse markets of France and Germany had to be down big time as MCD reported the UK was up.

One of the problems is MCD reports by calendar month. But not every month has the same number of weekdays and weekends each year, and MCD missed a Saturday and a Sunday this year.

This could be fixed. Fiscal year formats of 13 periods of 28 days have been standard for 30 years plus in this space and could so be adopted. Every back office system in the world has such flexibility.

I suspect the problem is getting franchisee reporting lined up. It's a change and will cost something. But we expect such systems from the QSR industry pioneer. And less stress on the publicly traded company is good for all.

Finally, while the same store sales metric is commonly understood in the business press, comparing to one prior year is not really the best measurement. It misses cumulative history. McDonalds was down versus 2011, but still up versus 2010, 2009, 2008, and so forth, likely all the way back to 2003. Wendy's and Burger King do not have the same advantage. Additionally reporting same store sales on a five year compound average growth basis could be more meaningful.

Restaurants Earning Fundamentals, Q2 2012: Outstanding OPTEMPO

In watching the Q2 2012 restaurant space earnings, six brands interested us by exhibiting what we define as outstanding operating tempo (OPTEMPO). Not only significant EPS beats of $.02 or more (meets or a penny over doesn't excite us much), but also positive traffic and positive early peek Q3 trends-that early Q3 trend prerelease info that some companies give. This quarter's entire group has performed well recently.

· Brinker (EAT)

· Texas Roadhouse (TXRH)

· Ruth Chris (RUTH)

· Popeye's (AFCE)

· Panera (PNRA)

· Papa John's (PZZA)

Common Denominators: Two casual dining operators, one fine dine operator, one bakery/café, one QSR pizza, one Chicken QSR operator. Two of the six are steak centric (RUTH, TXRH), with one other making inroads into higher steak menu mix (EAT). No big restaurant conglomerates (ala' DRI) involved, but of the two with two brands under the HOLDCO, one brand greatly predominates over the other (EAT: Chill's v. Maggiano's) and RUTH (Ruth Chris v. Mitchell's).
 

• Steak centric: we noted in 2011 that steak centric operators did well, no doubt by the improving travel/expense account traffic. RUTH's peer, DelFrisco (DFRG) via its first call since IPO noted +SSS of 5.1% and traffic of +2.2% at the flagship Double Eagle units.
• Positive traffic and early peek looks: All had positive traffic-RUTH greatest at +3.9%; AFCE and PZZA don't reveal traffic/check but one can so deduce it was positive).
• All had consensus earnings move up $.02 or more over the last 90 days-PNRA highest at +$.11, PZZA +$.09, EAT +$.07. Three of the six had 5 analysts or less providing estimates, with PNRA, TXRH and EAT well in double digit analyst coverage territory.
• None of these chains had eyeball high debt. Interestingly, none of the chains was actively refranchising, all were growing company units, with even franchisee heavy AFCE planning a significant slug of new company units.

Four of the six chains (RUTH, AFCE, PNRA, PZZA) had positive free cash flow increases from quarter to quarter. EAT and TXRH free cash flow was off from prior year but EAT is doing heavy duty remodels (and is still a huge cash generator) and TXRH is building new units.

Price/earnings ratios: only RUTH cheap but…

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.