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What's on the Menu for Restaurants?

R.J. Hottovy, CFA

R.J. Hottovy: In many ways, restaurants find themselves in a similar position that retailers did a decade ago with Amazon's integration of Whole Foods and other retail initiatives likely triggering a ripple effect across the grocery store industry; mobile technology's evolving consumer views on convenience and experience; and delivery and other off-premise solutions gaining widespread consumer adoption. Like the retail industry, we don't expect all industry participants to survive. We'd like to highlight five predictions for the restaurant industry over the next several years.

One, the ripple effect from online grocery will become more pronounced for restaurants. Amazon grabbed a lot of headlines when it announced that it was acquiring Whole Foods in 2017. However, to this point, we really haven't seen a meaningful impact on restaurants due to online grocery. Industry traffic was already weak before the announcement and has only modestly improved since then. However, with Amazon finding ways to bring Prime memberships into the physical stores through discounts at Whole Foods locations and other tactics that grocery stores and mass merchants will likely deploy as countermeasures, we expect that restaurant guest traffic across all tiers will remain uneven into 2019.

Number two, expect additional restaurant closures and decelerating industry growth. With restaurant operators already dealing with stagnant guest traffic trends and likely to face labor, rent, and food cost inflation in the years to come, Starbucks and Chipotle won't be the last operators to announce restaurant closures in 2018.

Number three, there is room to grow for concepts that have adapted evolving consumer preferences. While we expect slowing industry growth trends in the next five years, we don't see an outright restaurant recession and see growth opportunities for those chains that continue to adjust to evolving consumer preferences.

Number four, the recent pullback in restaurant industry valuations has created buying opportunities. After peaking in 2017, restaurant industry valuations have contracted the past two years as refranchising activity has subsided and restaurants reinvent themselves amid rapidly changing consumer preferences. While the industry strikes us as fairly valued at current levels, there are a handful of restaurant concepts that screen well using a number of new benchmarks that haven't received enough credit from public or private market investors.

Number five, Starbucks' recovery will be volatile, but there still is a long-term investment case to be made. Of any restaurant name in our coverage list, we believe that Starbucks will likely garner the most investor scrutiny over the near future with still sluggish U.S. sales trends, new sources of competition in China, its recent consumer packaged goods partnership with Nestle, questions about the current executive team, the involvement of activist investor Bill Ackman, and the potential headline risk associated with Howard Schultz's political aspirations.

While each of these risks brings its own set of executional challenges and the possibility of management changes in the near future, we think the company is positioned for a comeback through restaurant layout changes and new menu innovations focusing on health and wellness and authenticity.

Even though we see turbulent times ahead for restaurant operators and slowing industry growth rates, we believe there still is a place for investors' portfolios for wide-moat restaurant companies like McDonald's and Starbucks that understand where technology is heading and making necessary changes to address evolving consumer expectations regarding restaurants.