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'Fast-Casual' Restaurants Get the Order Right

R.J. Hottovy, CFA

RJ Hottovy: The restaurant industry has been one of the more interesting categories across the broader consumer cyclical sector over the past couple of years, marked by a number of macro, industry, and structural changes.

Among them are notable changes in consumer preferences and what they are looking for among restaurants. A number of things have sparked this, including the rise in millennials and minority audiences, which has called for a greater demand for different flavor profiles as well as better-for-you products. We've also seen consumers demand increased customization in their menus. Also the increased adoption of smartphones has led to calls for greater mobile ordering and payments, as well as something as simple as restaurant Wi-Fi.

At the same time, "fast-casual" restaurants have really done a good job picking up on and addressing these changing consumer needs. This group has been growing at about a mid-teens clip the past decade, compared to about a 4% growth rate for traditional quick-service restaurants and casual dining restaurants.

What's also interesting is that this is coming at the same time that a lot of traditional retailers are struggling with e-commerce, which has left a lot of excess real estate in the markets, facilitating growth in fast-casual concepts, and this is something that we expect to grow.

However, because there are few retailers to choose from, and the fast-casual category has been such a hot space, it's also inflated valuations in many cases, leading to fewer investment opportunities. That isn't to say there aren't some intriguing investment names in this category, the first of which is Panera (PNRA). The company is undergoing a major remodeling program to get people through the door quicker, as well as embracing technology. We also think there is a potential long-term opportunity from catering and delivery as well as franchising efforts.

Yum Brands (YUM) is trading also at about a 10% discount to our $88 fair value estimate. I think Yum is one of the more intriguing emerging-markets stories out there in the market, and if you can withstand some of the volatility that the company has had in China, I think it will offer some long-term opportunities as well.

The final name is Starbucks (SBUX). It's trading at about a 5% discount to our $50 fair value estimate. I think this company is doing a very good job of transitioning itself into a retail and consumer packaged goods hybrid, getting more into grocery stores and warehouse clubs. But it also has an intriguing portfolio of secondary brands that they can utilize for future growth.