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Which Restaurant Stocks Should Whet Investors' Appetites?

A comprehensive look at the restaurant industry.

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Restaurant stocks have generally performed quite well during the last two months. Recent economic data suggests consumer spending has stabilized, which sent restaurant stocks soaring from their early March lows despite relatively lackluster first-quarter results. The National Restaurant News Restaurant Index--an index of 61 publicly traded restaurant stocks across all categories--is now up 20% since its low on March 6, 2009. Although the performance of the overall index lagged the S&P 500, which is up 33% during the same period, casual-dining stocks generally outperformed the market during the last few weeks because of increasing consumer confidence and improving traffic trends. Quick-service chains, on the other hand, have underperformed because of indications that traffic is slowing.

Where should investors turn to satisfy their appetites for restaurant stocks? Several Morningstar analysts recently attended the annual National Restaurant Show in Chicago hoping to find answers to this question. We attended several presentations hosted by industry professionals and met with the management teams of several publicly traded and privately held restaurant operators. Although we have fewer 5-star stocks in our coverage universe following the recent runup, we believe there are still opportunities for investors to add restaurant stocks at attractive valuations.

 

Signs of Stabilization, but Head Winds Remain
During the last two years, the $560 billion restaurant industry has endured a perfect storm of economic head winds, including fewer meals eaten away from home, higher unemployment, commodity price inflation, wage rate hikes, and increasing pressures to adopt environmentally friendly standards. Restaurants were affected earlier than most industries, starting as early as the fourth quarter of 2006, which we attribute to increasing competition from nontraditional competitors such as grocers and warehouse clubs and a leveling off of the number of meals purchased away from home. Fundamentals deteriorated even further as the economic crisis worsened last year, with most restaurant operators reporting 15-17 consecutive months of negative comparable-store sales, according to a survey from the NPD Group.

The economic downturn has a different impact on various restaurant categories. According to an American Express study, the number of transactions increased in quick-service restaurants as consumers traded down to cheaper options, while casual dining held up better compared with fine-dining restaurants. However, the average check size was down across all categories. The American Express study also noted a significant reduction in business/corporate diners compared with individual diners, as corporations cut expenses. Previously, corporate firms contributed to about 30% of total restaurant sales, with a higher proportion in casual and fine dining restaurants. Additionally, the number of consumers dining at out-of-town restaurants decreased more than consumers dining at local restaurants, because of reduced travel.

Industry experts we spoke with had mixed growth forecasts for the restaurant industry. Even though there are signs of pent-up consumer demand--more than a third of households surveyed by the NPD Group reported that they were not eating out as much as they would like--we believe it may take several years for restaurant traffic to fully recover. Forty three percent of restaurant operators do not expect the economy to recover for one to two years while another 42% think it will take longer than that. As such, we expect that restaurant industry participants will increasingly compete with one another for market share. However, this will not come easy, as the industry is well known for its price wars and nonexistent switching costs. In our view, most restaurants simply do not have the bargaining power or supply-chain efficiencies to compete with  McDonald's (MCD) or  Darden Restaurants (DRI) on a low-cost basis. We believe other firms must differentiate themselves through a more compelling value proposition, new menu innovations, or engaging marketing messages to effectively compete over a longer horizon.

 

Driving Traffic Is Key to Success
To drive traffic, restaurant operators are increasingly turning to a more compelling value proposition, with some emphasis on smaller portions. During the last two quarters, smaller, shareable meals have resonated well with restaurant customers. For example, Chili's (a subsidiary of  Brinker International (EAT)) top-selling burger is now its Big Mouth Bites sliders, which replaced the traditionally-sized Big Mouth Burger. Although they carry lower price points, the new menu additions helped to improve the average restaurant check size as customers use the smaller dishes as add-ons to entree orders or ordered multiple small-plate items.  Cheesecake Factory (CAKE) also reported the small-plate menu helped to drive higher restaurant-level margins because such dishes have lower food costs than regular-sized entrees. With consumers increasingly focusing on value-oriented offerings, we expect these menu additions to be key revenue and operating margin drivers over the foreseeable future.

Even though the restaurant industry is highly promotional, particularly among quick-service chains, we do not believe excessive discounting or couponing will be a viable long-term solution to driving traffic. The restaurant industry is inherently a low-margin business to begin with, and excessive discounting is not sustainable over an extended horizon, in our view. Instead of discounting premium products, we prefer to see firms offset sluggish traffic with lower-priced items but also smaller portions. We believe this is the best strategy to increase customer visitation frequency without sacrificing profitability.

An expanded breakfast menu has also become a popular way to increase traffic. During the last 12 months alone,  Starbucks (SBUX), privately held Dunkin' Brands, and  Panera (PNRA) have each expanded their breakfast offerings, and McDonald's plans to complete the rollout of specialty coffee drinks at its 14,000 domestic restaurants later this year. Although unemployment rates could have an adverse impact on breakfast sales--most experts we spoke with did not expect unemployment rates to peak for another six months--we expect breakfast sales to exceed those of other meals because of their lower price points and portability.

Restaurants have also increasingly embraced technology to drive traffic. According to a NPD Group survey, 58% of restaurants are using their Web sites or direct e-mail marketing campaigns to drive traffic, while 34% are using social networking Web sites, such as Facebook, Twitter, or Yelp, to increase consumers' awareness of new products or other promotions. We are intrigued by  Chipotle Mexican Grill's (CMG) new "My Chipotle" advertising campaign, which launched last month, as it will rely on customer-originated content. An increasing number of restaurants are also using  OpenTable (OPEN), which sold 3 million shares in its initial public offering two weeks ago, because it offers potential diners an easy way to make reservation online. According to experts we spoke with, a well-designed marketing campaign can generate $3-$4 in incremental sales for every dollar spent.

Still, we believe that an economic recovery is more likely to be L-shaped than V-shaped, and discretionary categories are likely to be weak for some time. As such, we expect restaurant traffic to be down in 2009 and flat in 2010. Although consumers surveyed said they were not eating out as much as they would like, we anticipate that it will take some time before we see a sustainable positive growth trend in restaurant traffic because of reduced consumer incomes and increased savings.

Cost Management Remains a Priority
With consumers dining out less frequently, it is not surprising that cost-containment measures have become a key priority for restaurateurs. To offset economic head winds, restaurants have reduced staffing, pared back inventory purchases, delayed capital projects, or actively negotiated with suppliers for better rates. Although easing commodity costs provide some relief, we believe restaurant operators are running out of options with which to curb margin erosion.

By far, the most popular way that restaurants have managed costs was by cutting payrolls, with 89% of restaurateurs surveyed by the NDP Group reporting a decrease in labor expenses. More specifically, restaurants are staffing fewer workers, reducing hours of operation, or educating employees to be more efficient. Prior to the economic downturn, labor costs generally made up about a third of a restaurant's cost base, and employee turnover rates were notoriously high. However, costs have fallen dramatically in recent periods as turnover rates moderate, partially as a result of employees' increasing flexibility toward labor hour changes amid economic uncertainties.

Nearly half of restaurants surveyed by the NPD Group do not plan to make any significant investments for another six months. Although we believe this strategy is appropriate for restaurants under extreme financial duress, we believe stronger restaurant operators with stronger balance sheets have an excellent opportunity to improve their competitive positioning by purchasing real estate and equipment at attractive prices. Eventually, demand will likely push input prices higher once economic conditions improve, and restaurateurs might not have another opportunity to capitalize on attractive asset prices or low financing rates in the future.

Another key cost-cutting initiative is vendor negotiation. Although this traditionally has been an area where restaurant operators have had little success, suppliers are also struggling to weather the challenging economic environment and may be more willing to make concessions. Several restaurant chains also plan to consolidate their vendors. Sally Smith, CEO of  Buffalo Wild Wings (BWLD), outlined her firm's plan to narrow its suppliers to 10-12 preferred partners, well below the average for a national casual dining chain. We view this as an effective cost-containment strategy, as it could provide restaurants with easier access to food and other raw materials at more predictable, competitive prices.

Lease negotiations also remain a possibility for restaurant operators. Although commercial real estate landlords have remained somewhat steadfast in maintaining existing lease terms, a few restaurant chains have been successful in renegotiating lower rents during the last year, usually in return for longer lease terms. According to a recent interview with CEO Rick Schaden, privately held Quiznos has renegotiated as many as 90 leases during the last year, reducing rent by 15%-20% by extending the duration of existing leases. Starbucks is also seeking rent reductions of between 20% and 25% as a part of cost-savings initiatives outlined late last year. We view lease negotiations as a positive, but it may take time before rent reductions have a meaningful impact on restaurant income statements.

 

Despite Tight Credit Markets, Some Deals Are Getting Done
Credit markets remain exceptionally tight, and restaurants generally have limited access to capital. According to the NPD Group, almost 60% of restaurant operators said they had been affected by the credit crisis, including ordering less inventory or fewer remodeling initiatives. There are fewer sources of capital, and several traditional lenders (including  GE Capital (GE) and  Bank of America (BAC)) have curtailed their restaurant-lending programs considerably. Banks in general have become much more restrictive, with recent deals reflecting higher credit spreads, stricter covenants, shorter maturities, and higher transaction fees (see the sample restaurant term sheet below). Cash-injection requirements are at an all-time high, with most lenders requiring a 25% down payment before considering a new loan.

More than a few experts theorized that restaurant industry lending will take longer to recover than the overall market because of the high number of bankruptcies during the last few years (including Bennigan's and Steak & Ale, among others). According to Kevin Cronin, a senior executive with Bank of America's Global Corporate Banking Group, the restaurant funding market will not stabilize until the consumer savings rate exceeds 8% (compared with 4.2% during the first quarter of 2009) and household debt service ratios fall to about 10.5% (from 13.9% during the fourth quarter of 2008).

Although there are fewer transactions getting done, we believe a handful of good deals are still taking place. For the most part, larger quick-service chains are getting what little capital is available, which includes specialized-lending programs for large franchisees.  Wells Fargo (WFC) and  US Bancorp (USB) both recently developed specialized financing programs for McDonald's U.S. franchisees, including options for restaurant acquisitions, unit rebuilds and relocations, and equipment purchases (including funding for new equipment used for the specialty coffee rollout). Wells Fargo also has a similar program in place for  Yum Brands (YUM) franchisees.

On the other hand, smaller restaurant chains certainly have less access to capital. Small business loans are down 57% year over year according to Siegel Financial Group. As a result, smaller restaurant chains have been forced to seek out alternative sources for funding. Private-equity funding is still available, assuming the restaurant chain has demonstrated the ability to deliver earnings before interest, taxes, depreciation, and amortization (EBITDA) margins in the low-teen range (including corporate overhead expenses). We also heard from multiple sources that community and smaller banks remain a viable source of funding. By and large, community banks did not have the same exposure to subprime lending or derivatives that larger banks did during the recent credit crisis, meaning they may be more willing to provide funding for restaurant chains. That said, the asset-securitization market remains closed. In the past, large franchise restaurant operators used the asset securitization market to monetize franchise revenue streams, but most experts agreed that this is no longer an option.

Valuation multiples for restaurant industry transactions have been mixed during the last several quarters but have generally fallen from historical norms, leaving few attractive options for overleveraged sellers. According to the Wells Fargo Restaurant Finance Team, the current restaurant transaction is taking place at an earnings before interest and taxes (EBIT) multiple of about 7 times, compared with a historical range between 10 and 14 times. On an EBITDA basis, most restaurant transactions are taking place at 4.9 times for public companies and 6.4 times for private companies, compared with 5.4 times and 9.0 times in 2006.

During the last few weeks, the lending environment has improved, but most lending experts noted that the sustainability-of-execution window is "highly uncertain." That said, we believe some restaurant operators could benefit from the "lowest cost of capital in several years," according to Bank of America's Global Corporate Banking Group. In fact, several of the larger steakhouse chains, including  Texas Roadhouse (TXRH) and Darden Restaurants' Longhorn Steakhouse, used the last recession to secure funding at attractive rates, which was then used to accelerate growth during the last several years. In general, we believe restaurant operators with solid capital structures may be well-positioned to secure attractive financing packages. Given current real estate or equipment prices, taking advantage of lower financing rates could be a key to emerging from the current economic downturn in stronger financial health.

How Will Restaurants Fare in the Future?
Generally speaking, we expect restaurant operators to face a challenging operating environment throughout 2009 and well into 2010. Although consumer confidence has risen during the last few months, it's still unclear whether there will be a corresponding increase in discretionary spending. Accordingly, we anticipate conservative spending patterns at restaurants during the next several months. Moreover, consumers have become more accustomed to discounting, and we believe operators may have a difficult time moving consumers back up the pricing continuum. Competition also remains fierce, with restaurants increasingly fighting with one another and other channels for market share.

Which restaurant stocks do we prefer in this challenging consumer environment? Given the difficulties faced by smaller operators, we believe larger participants with economic moats will fare the best over a longer horizon because of resilient top-line growth, scale advantages, and healthy balance sheets. Among casual dining chains, we believe Darden Restaurants has separated itself from other participants through a mix of profitable core brands and emergent concepts coupled with ample scale benefits. However, we believe the market's recent optimism over casual dining chains may be a bit premature because of prevailing consumer-spending head winds, and we believe the quick-service industry may offer more attractive opportunities. In particular, we remain confident that McDonald's and YUM Brands can weather economic head winds more effectively than their competition and deliver solid fundamentals over an extended horizon.

 

 

R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.