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    MARKET EDGES

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The following companies are currently enjoying positive same-store sales and margin growth as of the most recently reported quarter: CMG, BJRI, PNRA, SBUX, YUM (US), DPZ, MCD, DIN, PFCB, DRI, RT, MRT, KONA.  All of these companies, with the exception of DPZ and KONA, were operating with positive same-store sales and expanding margins during their most recently reported quarter.  Also, as one can see in the chart at the bottom of this post, these stocks saw significant price gains during the fourth calendar quarter.  It is important to note that, since the end of the fourth quarter, MCD, MRT, and RT have all slowed from a price performance perspective.

Last time around, I highlighted YUM China, TXRH, MRT, CAKE, and RT as five names that I believed were “moonlighting in Nirvana”.  As it happened, YUM China, TXRH, and CAKE dropped out of the quadrant into “Trouble Brewing”, the lower-right quadrant where same-store sales remain positive but margins are contracting on a year-over-year basis.  

RT posted a strong quarter for 2QFY11 and seems well-poised for the remainder of the fiscal year.  In the immediate term, 3QFY11 could show some weather-related top-line softness.  From here, I still believe that MRT faces significant headwinds from a margin perspective and could well drop out of Nirvana.

YUM China will likely face continuing labor, food, and paper inflation throughout 2011.  On the last earnings call, management guided to 5% food and paper inflation in China with wage inflation running in the mid-teens.   As of February 2nd, the date of the most recent earnings call, management expected the modest price increase taken by the company just before Chinese New Year to cover the majority of the company’s inflation expectations (at the time) for the year.  I would expect that inflation expectations may  have changed somewhat given that many foodstuffs have increased markedly over the last five weeks.  Clearly, given the record margins YUM enjoyed last year, driven by commodity deflation, some year-over-year margin contraction is to be expected.  It will be interesting to see if comps slow in China during this year as compares step up in difficulty.

As a side note to trends in China, MCD has reported that January/February (combined) same store sales in China were up mid-to-high single digits.

MRT is not contracted on any beef prices for 2011 and that commodity has risen sharply in 2011.  Management has expressed confidence in its ability to take price as business traffic has been increasing at their restaurants.  The company has indicated its willingness to take price if necessary to offset inflation.  Obviously, margins may come under pressure as beef costs are absorbed and top-line trends may weaken if price is passed on to the customer. 

CMG is a notable constituent of Nirvana at this juncture.  The top-line growth has been nothing short of spectacular but there are definite negative factors impacting the outlook for the company.  Commodity headwinds are impacting Chipotle at least as much as any other restaurant chain given their sourcing of food ingredients from the spot market in order to abide by their “Food with Integrity” mantra.  Labor costs are also a question mark from here; federal investigations of 50 Chipotle restaurants in Minnesota resulted in the firing of 450 workers for not possessing the appropriate paperwork.  An internal review of hiring practices in Washington, D.C., has resulted in a further 40 jobs becoming vacant. 

The Deep Hole quadrant has been vacated by a large number of names over the past two quarters.  SONC, JACK, and CPKI are still languishing down there, however, as same-store sales are negative and margins are contracting on a year-over-year basis. 

SONC is a name that has received a boost recently on the back of a sell-side upgrade and a preannouncement of 2QFY11 sales of between +1% and +1.5%.  While this will mean that SONC is due out of the bottom-left quadrant when 2QFY11 results are reported a week from Tuesday.   However, as I wrote on March 8th, compares are stepping up materially from here and the preannounced same-store sales range for 2QFY11 actually implies a slowdown in two-year average trends.  Interestingly, following a strong showing in 4Q, SONC is down almost 14% year-to-date.

The lower-right quadrant, “Trouble brewing” , is where YUM China, TXRH, CAKE, and WEN are operating at present.  With the exception of WEN, which is in the midst of a turnaround, each of these names has dropped from the upper-right quadrant as a result of declining margins in 4Q10.  WEN is a name that I have a bullish outlook on; the sale of Arby’s and simplification of the menu will lead – in my view – to continued top-line growth and leverage over costs as well as labor efficiencies.  WEN’s stock gains in 4Q were somewhat muted but, for the reason I mentioned above, the stock has performed strongly since mid-January.

The upper-left quadrant, “Life-line” is currently inhabited by EAT and BWLD.  BWLD is a unique company in the restaurant industry; continuing commodity cost favorability due to declining chicken wing prices is greatly boosting margins.  The company is vulnerable to an NFL strike and, as that situation seems to be worsening, it could definitely effect traffic at BWLD if the points of contention between the players and owners is not resolved in time to save the 2011 season.   The company’s stock price declined in 4Q10 but has outperformed year-to-date, gaining over 20%.

EAT is a name I have been positive on for some time.  Operational improvements and sales-driving initiatives are greatly improving Chili’s performance.  Sell-side sentiment is only just beginning to change on this name and I believe there is significant outperformance left for this name in 2011.  Following a gain of 11% in 4Q, year-to-date the stock has risen an additional 17%.  I believe it is likely that, as EAT reports 3QFY11 results, the company will be operating in “Nirvana”, with positive same-store sales and margins.

RESTAURANT QUADRANT PERFORMANCE – 4Q11 - quadrant 314

 

 

Howard Penney

Managing Director