Restaurant Stocks Look Pricey as Demand Headwinds Remain Underappreciated

Restaurant stocks look expensive as we take the industry’s pulse, with names in our coverage trading at a market-cap-weighted 10% premium to our intrinsic valuations. While demand has held up nicely to date, we’re seeing weak spots, with persistent declines in traffic and items per check suggesting price-conscious consumers and a more challenging pricing environment to come. Nominal same-store sales growth remains healthy, up around 5.7% industrywide over the past three months (RMS data), but traffic (down 1.4%) and items per check (down 3.7%) remain points of concern. We expect slowing sales momentum into the first half of 2024, resulting in a more promotional environment for the industry and a three- to four-year route to normalized restaurant-level profitability. The industry’s bargain bin looks sparse, but we see modest upside in Wendy’s WEN and Starbucks SBUX shares, which trade at 6% and 2% discounts to our $23 and $104 fair value estimates, respectively.

There are certainly positive takeaways from the most recent quarterly data, with wage growth slowing to 5%-6% a year in leisure and hospitality and with commodity costs clocking in between deflationary and disinflationary depending on restaurants’ commodity baskets (median producer prices are projected to fall nearly 6.5% in 2023, according to the U.S. Department of Agriculture). Therefore, we believe restaurant margin performance likely bottomed during fourth-quarter 2022 for operators in our coverage, with sticky menu price increases and easier annual comparisons for expense growth providing near-term tailwinds. Nevertheless, as demand softens and the industry’s promotional environment intensifies, we expect little incremental improvement over the rest of 2023, underpinning a challenging near-term operating environment for restaurateurs. We continue to view firms with strong pricing power, heavily franchised systems, and strong digital platforms as best positioned to outperform in the current environment.