High Costs, Low Traffic Continue To Hamper Restaurant Stocks

The restaurant industry’s sales trends in recent quarters have been strained given the soft consumer spending environment. This makes it prudent for investors to take a closer look at the dampeners threatening growth in the restaurant industry. Particularly, negative comps, given sluggish traffic along with rising costs, are taking the sheen out of restaurateurs.

These headwinds are a major reason for the industry’s sub-par stock market performance lately, with stocks in the Zacks Restaurant Industry up 5% over the past year, underperforming the S&P 500 index’s +12.8% gain.

Below we discuss some of the downsides hampering the restaurant industry:

High Expenses: Costs related to various comps and sales boosting initiatives along with restaurant re-imaging expenses are hurting margins for companies like Domino's Pizza, Inc. (DPZ), The Wendy's Company (WEN) and Brinker International, Inc. (EAT). Though these initiatives offer long-term advantages, the costs related to them are expected to continue to dampen margins in the near term. Additionally, resorting to more discounting and value bundling might further put pressure on casual dining operators’ already tight operating margins.

Moreover, restaurants like Cracker Barrel Old Country Store, Inc. (CBRL) and Dave & Buster's Entertainment, Inc. (PLAY) intend to make additional unit openings going forward. Thus, higher marketing and pre-opening costs associated with the same are expected to hurt profits.

Also, there has been considerable debate in the recent past over restaurant workers’ wages. Workers at quick-service restaurants claim that their employers' profits have not trickled down to them proportionately, which is leading to strikes for wage hikes. These incidents significantly hurt the reputation of restaurants. As a result, the companies are compelled to make minimum wage increases, which again lead to narrower margins. Moreover, higher labor costs due to a competitive labor market are expected to continue to keep profits under pressure.

Meanwhile, recruitment and retention of employees has emerged as a top challenge for restaurant operators in 2017. As the economy keeps improving and employment levels rise, there is more competition for qualified employees to fill vacant restaurant positions. Meanwhile, restaurant management turnover is a critical headwind for operators as turnover rates are now nearing a 10-year high, as per TDn2K’s People Report. This is further compelling restaurants to either hike wages or provide benefits, at the cost of margins, to retain or attract employees.

Soft Comps & Traffic Trends: Over the past few quarters, consumer behavior has been volatile and their willingness to spend on most goods, especially eating out, is showing signs of decline. Most of the restaurateurs are thus bearing the brunt of soft comps and traffic trends. In fact, the second quarter of 2017 marked the sixth consecutive quarter of negative comparable sales for the restaurant industry as a whole, per a report by TDn2K’s Black Box Intelligence. Given the persistent negative comps trend, there has been a lot of buzz about the restaurant industry hitting recession.

But it is to be noted that the chief reason for the drop in same-store sales is an increased number of new restaurants amid limited growth in eating-out budgets as well as increased pressure from grocery stores. Moreover, per market analysts, diners are spending more per visit instead of visiting chain restaurants more often, which is hurting traffic. Also, increase in menu prices is at times preventing them from dining out. This unwillingness of Americans to dine out is thus pulling down restaurateurs’ sales.

Slowdown in New Restaurant Openings: As the operating environment has become increasingly challenging, the decline in sales volumes have begun to impact the returns on new restaurant openings. As a result, some of the restaurants are slowing down their development plans for 2017.

Notably, management at Red Robin Gourmet Burgers Inc. (RRGB) noted that the 2016 class of new restaurant openings generated revenues that were about $2 million below their expectation, limiting overall revenue growth for the company. Red Robin has thus slowed down its unit growth plan significantly for 2017 and 2018.

BJ's Restaurants, Inc. (BJRI) has also reduced the number of planned restaurant openings to 10 in 2017 compared with 17 restaurant openings in 2016. The reduction is due to the company’s continued belief that the sales headwinds in the industry call for greater focus on traffic and sales building initiatives.

Such slowdown in their development plan in 2017 is likely to dent sales growth in the year.

Macro & Political Issues/Company-Specific Challenges: The restaurant industry is grappling with difficulties like intense competition in the U.S., decelerating growth in Asia, concerns in Latin America along with weakness in some parts of Europe, where economic/political conditions are expected to be challenging after U.K.’s exit from the 28-member economic bloc. Naturally, restaurateurs like McDonald's (NYSE:MCD), Papa John's International Inc. (PZZA), Dunkin' Brands Group, Inc.’s (DNKN), Starbucks Corporation (NASDAQ:SBUX) (SBUX) and others with exposure to some of these regions are facing the heat.

In fact, Dunkin' Brands’international comps growth has been suffering over the past few years at both its Dunkin’ Donuts and Baskin Robbins divisions. Discretionary spending is under pressure due to a number of factors including sluggish local economies, currency devaluation and oil prices.

Back in the U.S., throughout 2016, Chipotle Mexican Grill (NYSE:CMG), Inc.’s (CMG) results continued to be affected by the negative publicity linked with the food-borne illnesses, which first surfaced toward the end of 2015. The company’s earnings and revenues have been under tremendous pressure since then. In fact, comps witnessed a decline of 20.4% in full-year 2016. Despite various strategic initiatives, we believe it will take some time for the company to completely restore its economic model as well as customers’ trust and return to its former glory.

Moreover, the recent closure of a Washington-area outlet due to an apparent norovirus alert has started a fresh round of food-safety scare. Evidence of rodents was found at a Dallas outlet, further adding to the woes.

Meanwhile, Brinker International has substantial exposure to the energy-exposed markets. Though it expects these markets to improve over the long term, with the current volatility in energy prices, revenues in these markets would remain under pressure in the coming quarters.

On the other hand, we note that traffic has been one of the major reasons for the recent decline in comps at Cracker Barrel. For Cracker Barrel, the problem of declining traffic affects the company in more than one way. Firstly, traffic decline in restaurants causes sales to fall, which can only be combated through a significant increase in prices. Secondly, lesser guests at restaurants result in a decline in guests for the retail segment of the company as most shoppers at Cracker Barrel are the restaurants’ guests. Thus, the high correlation between the two segments weighs heavily on the company.

Currency Headwinds: Negative currency translation is a concern for companies like Domino's, Yum! Brands (NYSE:YUM), Papa John’s, Restaurant Brands International, Inc. (QSR) and McDonald's as these have considerable overseas presence. As the U.S. dollar continues to show strength against various other currencies, the negative currency impact is likely to hurt the international sales of these companies.

Moreover, Papa John’s and Domino's revenues are also being affected by the British Pound’s plunge in value since the Brexit vote in the summer of 2016. Meanwhile, Restaurant Brands’ Tim Hortons brand realizes much of its business from Canada. Thus, any fluctuation in the Canadian dollar with respect to the U.S. dollar impacts the company’s revenues greatly.

Affordable Care Act: The Affordable Care Act, commonly known as Obamacare, is having an adverse impact on restaurant operators. The Affordable Care Act requires employers to extend health benefits. The law entails restaurants with 100 or more full-time equivalent employees to offer health care coverage to substantially all full-time employees and their dependents beginning this year. Meanwhile, from the beginning of 2016, the Affordable Care Act was implemented for organizations with 50 to 99 full-time-equivalent employees. Employers will suffer penalties if they do not follow these rules.

This has increased the costs for restaurant operators like Darden Restaurants (NYSE:DRI), Inc. (DRI), Red Robin, Dave & Buster's and Brinkerwhich have numerous company-owned units and laborers, and are already reeling under the pressure of higher costs.

To combat this, most companies are trying out different labor models like involving more part-timers and cutting work hours. Meanwhile, some companies have limited their hiring, which will eventually push up the unemployment rate.

However, the collapse of the Republican-led bill which would have replaced Obamacare means that the Affordable Care Act is here to stay. Naturally, restaurateurs are worried since they will have to continue shouldering increased labor costs.

Stocks to Avoid

Some of the players in the space that induce our cautious-to-bearish outlook are Starbucks, Brinker,Jack in the Box Inc. (JACK), BJ's Restaurants and Buffalo Wild Wings Inc. (BWLD). While Starbucks, Brinkerand Jack in the Boxcarry a Zacks Rank #4 (Sell), BJ's Restaurants and Buffalo Wild Wings have a Zacks Rank #5 (Strong Sell).

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

To Conclude

The amalgamation of rising costs, weak comps, consumer spending uncertainty on dining out, higher restaurant prices, decline in at-home food costs, market saturation and the changing preference of consumers has been weighing on sales and hampering restaurant stocks’ performance. Nonetheless, by increasing global presence, implementing the right pricing strategy and providing unique offerings, restaurant operators can offset these negatives to some extent.

It is to be seen how these companies overcome the hurdles and get back their groove in the coming days. In “Will Mobile Ordering, Delivery Drive the Restaurant Industry?” we focused on the conditions which are expected to drive the industry forward despite the headwinds.

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