RRGB Red Robin Gourmet Burgers Inc

The outlook for the restaurant industry is steadily improving despite the macroeconomic overhang, with the easing in food cost inflation and increase in same-store sales giving the group’s near-term earnings prospects a boost. The outlook for the rest of the year is optimistic given easy year-over-year comparisons.

Statistics bear out this relatively favorable environment. A recent survey by the National Restaurant Association revealed that the Restaurant Performance Index (RPI), measuring the present condition and outlook on the U.S. restaurant industry was 101.0 in April, up 0.4% sequentially. The RPI level was the highest in the last 10 months. The figure also exceeded the 100 mark for the third time in the last four months.

Current Situation Index, which measures comparable store sales, traffic count, labor costs and capital expenditures in the restaurant industry, was 100.1 in April, up 0.3% sequentially. The Current Situation Index stood above the 100 level for the first time in eight months, signifying the underlying strength in the industry.

The Expectations Index, which measures the restaurant operators' six-month outlook on the above indicators, was 101.9 in April, up 0.5% sequentially. The level was also the highest in 11 months. All three indices managed to beat the safety threshold of 100, reaffirming operators' positive outlook on the industry for the near term.

Yearly hikes in dividends on a regular basis by some industry leaders like McDonald's Corp. (MCD), Yum! Brands Inc. (YUM) and Brinker International Inc. (EAT) underscore their efforts to consistently return shareholder and franchisee value irrespective of the economic peaks and valleys. Another restaurateur, Cracker Barrel Old Country Store Inc. (CBRL), has doubled its dividend since Apr 2012.

Moreover, the Conference Board came out with its Consumer Confidence Index -- a barometer of U.S. consumer health -- on May 28, 2013. The index improved consecutively in April and May. The Index stood at 76.2, up from 69.0 in April, and this also marks the five-year high level.

The sentiment was also upbeat for the labor and housing market. Fuel prices are hovering below year-ago levels.  All these culminate to the general optimism in the sector. That said, we believe, issues like new stipulations related to "Obamacare," and excess supply may cloud the long-term picture. An extensive focus on value proposition along with moderate pricing power could also prove unfavorable to margins if exercised on a long-term basis.

Zacks Industry Rank

Within the Zacks Industry classification, the restaurant industry is grouped within the broader Retail sector. We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank http://www.zacks.com/zrank/about_ind_rank.php.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the restaurant industry is currently #43, down 6 spots in the last week. This is in the top 1/3rd of all industries ranked, highlighting the group’s near-term Positive outlook. The group’s favorable Zacks Rank placement is essentially a function of many restaurant companies’ improved earnings picture that prompted analysts to raise their estimates.

Key Performers in First-Quarter 2013

Not all companies performed equally well in the quarter. While some were laggards, others posted solid results mostly on their individual strength. Thanks to favorable weather last year, many restaurateurs faced tough comparisons in the first quarter and failed to exceed the year-ago quarter's solid comparable sales numbers. Most of the chains posted weaker-than-expected revenue numbers, but, on a bullish note, managed to score on earnings owing to cost savings and policies such as share repurchase. Operators blamed a softer economic trend for the insignificant growth in revenues.

Industry behemoth McDonald’s delivered weaker-than-expected results in the first quarter on both counts, while another renowned operator, Yum! Brands, registered weak sales owing to the recent ordeals in its China business. However, we believe both companies will rebound over the longer term, once global issues subside.

Some other notable companies like Brinker beat earnings but missed revenues. Burger King's (BKW) earnings were in-line but revenues outperformed. Krispy Kreme Doughnuts Inc. (KKD), Domino’s Pizza Inc. (DPZ) and Texas Roadhouse (TXRH) beat both revenues and earnings. Same-store sales growth at Krispy Kreme, Domino’s, Jamba, AFC Enterprises and Panera deserves a mention.

Road Ahead

According to the National Restaurant Association, the restaurant industry is projected to expand in 2013 on the back of U.S. recovery, albeit at a slow pace. Like 2012, focus on cost containment, extra value-for-price and international expansion will be on most restaurateurs' wish-list to tide over the some macro difficulties this year.

According to the National Restaurant Association, as much as 41% of restaurant operators expect to see an uptick in sales in the coming six months on an improving economy. Restaurant operators' capital spending plans are also riding uphill, reaffirming their positive outlook. We are optimistic of bottom-line expansion in the near term.

The National Restaurant Association estimates a 3.8% year over year increase in total restaurant sales to $660.5 billion in 2013. However, inflation-adjusted sales suggest only 0.8% growth. If realized, this would mark the third straight year of above $600 billion total industry sales. The limited-service eating-place segment will likely grow faster than the full-service restaurant segment.

Favorable Outlook for the Upcoming Quarter

A faster pace of recovery in the U.S., easy year-over-year comparison and events such as Mothers’ Day will likely boost the second-quarter same-store sales of most of the companies.

Darden’s successful value proposition and its gradual positioning in the upscale segment, solid first-quarter earnings and revenue growth along with raised full-year guidance at Cracker Barrel, Papa John’s International and Krispy Kreme, reinvigoration of Yum!’s Taco Bell and Domino’s Pizza’s entry into the pan pizza category are likely to prove beneficial.

However, the shift in Easter from second quarter last year to first quarter this year will likely be a drag on the sales. Further, companies like Yum! and McDonald’s, which have considerable exposure in the Chinese market, could face a setback owing to the recent outbreak of the Avian Flu scare.

OPPORTUNITIES

Cooling Commodity Inflation in the US

The food cost inflation seems to have lessened despite the severe drought in the Midwest growing region last year. Food costs account for about one-third of restaurant sales, thus making the industry vulnerable to food cost inflation.

As suggested by the U.S. Department of Agriculture (USDA) report, price inflation for all food is expected at 2.5-3.5% in 2013 down from the prior expectation of 3-4% level. Commodities like fish and seafood, dairy products, fats and oils, cereals and bakery products and other foods will likely witnessed a decline in prices.

However, prices for beef, pork and poultry are expected to remain firm in 2013, with beef prices being the highest. The drought in the Midwest growing region last year resulted in steeper grain costs, which in turn pushed up the feed costs. Companies like Red Robin Burger (RRGB), McDonald's and Texas Roadhouse have the higher exposure to the beef market and will likely feel the brunt of beef inflation.

But there is some good news. The market is abuzz with assumptions that feed prices will cool off with the new harvest season and that could lead to lower chicken prices in 2014.

Continued Job Growth in the Sector

The restaurant industry has been one of the major contributors to job growth in the U.S. over the last couple of years. The sector employs around 10% of the U.S. workforce. According to the National Restaurant Association, in 2011 and 2012, total U.S. employment grew a respective of 1.0% and 1.4% while restaurant employment increased 1.9% and 3.0%.

The National Restaurant Association expects this industry to create 2.4% additional jobs compared to a projected 1.5% gain for total U.S. employment.

Domestic and International Unit Expansion

Emerging from a lackluster economy from more than three years back, most of the companies have accelerated their pace of restaurant openings. A relative recovery in consumer confidence has also encouraged companies to return to unit expansion.

Besides spreading out in their home country, the companies also aim to test waters in foreign shores. Restaurateurs are primarily concentrating on emerging markets that provide ample opportunities for expansion. The burgeoning middle income population in emerging countries encourages the companies to shift their spotlight from the somewhat saturated domestic market.

Several food chains, including Denny's Corp. (DENN), Pollo Tropical of Carrols Restaurant (TAST), Starbucks Corp. (SBUX) and Krispy Kreme are tapping the fast-growing Indian market. McDonald's Corp. and Yum! already have considerable coverage in India and are now aggressively expanding in China to capitalize on the fast-paced economic growth there. Latin America has also become a preferable venue for expansion.

Refranchising, Revamp & Menu Innovations – a Common Trend

Though refranchising was common in the restaurant sector, it has gotten a boost of late given the benefits of this business model even in an anemic economy. The franchise-centric model helps to reduce volatility in earnings and enhances cash flow generation. Companies like DineEquity Inc. (DIN) and Burger King Worldwide Inc. (BKW) are some examples of highly franchised brands.

Additionally, restaurants are responding in a variety of ways to address heightened competition in a somewhat over-supplied domestic market. Most industry players are remodeling their restaurants to give an up-market feel as well as rolling out new and smaller prototypes to augment the perception of value and drive traffic, thereby reducing construction and occupancy costs and enhancing returns on capital. Operators like McDonald's, The Wendy's Company (WEN), Darden Restaurants Inc. (DRI) and Jamba are working along these lines.

This is not the end. Having stabilized their financial positions, the operators are constantly striving to add offerings to their menu card in order to cater to the ever-changing palates of customers. Limited Time Offers, loyalty programs and social media are also drawing attention as marketing tools.

Restaurateurs are offering loyalty programs at their units to enhance value dining as well as hone sales when customers are spending less enthusiastically on dining yet seeking incentives for doing so. Most of the operators rely on social media for promotions by incorporating Facebook (FB), online review sites, Twitter and blogs aggressively into their marketing mix. National Television advertising is also an important tool for promotion.

Focus on Hispanic Guests

In a bid to tap the rapidly growing Hispanic customer base in the U.S., many restaurant units are launching a new language setting in their ordering app for smartphones. The restaurants are also introducing a national online marketing campaign targeting Hispanic guests. These brands are Dunkin' Brands Group (DNKN), Domino’s Pizza, The Wendy’s and Denny's.

As per data published by market researcher NPD Group in Feb. 2012, the Hispanic community accounts for about 16% of the U.S. population based on the 2010 U.S. Census. The U.S. Census projects the Hispanic population in the country to increase 34% from 2010 to 2020. This encouraging data might have shifted several restaurateurs’ attention towards this community.

Breakfast & Beverage: A Breakout

Breakfast has accounted for nearly 60% of the U.S. restaurant industry and remains a key driver of traffic growth in recent years. Leveraging the trend, McDonald’s, Jamba Inc. (JMBA), DineEquity and Yum! have all broadened their breakfast menus.

Non-alcoholic beverages remain another sweet spot in the U.S. eateries. The market also has the ability to grow further through innovation, especially in healthier solutions. We see juicing giant Jamba geared up to leverage the trend by adding all-fruits to its line-up. Apart from Juicing, both Jamba and Starbucks are brewing more opportunities in the tea category.

M&A Activity Gaining Precedence

Merger and acquisition activity is also gaining momentum in the sector. The companies are looking at potential business partners to foray into different zones and unlock value. Private equity firms are citing potential in the restaurant industry and accordingly making buyout deals. One of the latest acquisition deals worth mentioning is the buyout of Caribou Coffee Company by JAB Group.

Apart from acquisitions, the companies are also divesting their relatively slow-moving brands in order to spur growth. One of the latest divesture deals that warrants a look is the sell-off of Mimi's Café concept of Bob Evans Farms Inc. (BOBE) to LeDuff America.

Currently, CEC Entertainment Inc. (CEC) and Bloomin' Brands Inc. (BLMN) carry a Zacks Rank #1 (Strong Buy). Companies with a Zacks #2 Rank (short-term Buy rating) include Krispy Kreme, AFC enterprises, Burger King, Cheesecake Factory, Chuys Holdings (CHUY), Cracker Barrel, Texas Roadhouse, Wendy’s, and Sonic Corp. (SONC). These companies have positive earnings estimate revision trends, highlighting the favorable momentum in their underlying businesses.

WEAKNESSES

Bleak Global Economic Backdrop

The strengths aside, the companies are caught up with macroeconomic tensions like implementation of austerity measures in Europe owing to the sovereign debt crisis and decelerating growth in Asia.

The recent same-store sales performance of McDonald’s is indicative of a slowdown in the Asian countries like China and India as well as European nations like France and Germany. Japan also continues to be a dampener as it is still on the way to recovery from last year's earthquake.

Affordable Care Act to Hurt Margins

Since the sector plays a key role in the nation's employment picture, the recent Affordable Care Act by president Obama, commonly known as Obamacare, is expected to have an adverse impact on the operators' margins starting in 2014.

The law entails companies to provide coverage for workers or face government penalties, though not applicable for employees who log less than 30 hours per week on average.

To avoid these austerities, most companies are trying out different labor models like involving more part-timers and cutting work hours in advance of the implementation of the healthcare reform. Darden Restaurants is one of these.

Rising energy cost is another risk faced by restaurateurs. The industry accounts for one-third of the energy used by the retail sector in the U.S., as per the Green Restaurant Association.

Stringent Food Standards

Consumers’ inclination toward fresh organic menu and the fuss about nutrition pose challenges. Consumers generally tend to visit restaurants offering locally produced food. Focus on child nutrition is also a priority. While these criteria are giving a competitive advantage to companies like Chipotle Mexican Grill, others often find it difficult to meet these standards.

There are some names that induce our cautious outlook. These include Red Robin Gourmet Burgers, Yum!, Kona Grill Inc. (KONA), Brinker, Buffalo Wild Wings Inc. (BWLD), Panera Bread Co. (PNRA), Chipotle Mexican Grill Inc. (CMG), Cosi Inc. (COSI), BJ’s restaurants all of which retain the Zacks #3 Rank (Hold). McDonald’s still carries a Zacks Rank #4 (Sell) due to persistent deceleration in comparable store sales.
 
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