2009 – THE ENDING TO A PERFECT STORM

In late November, I outlined my call that 2009 would be a better year for restaurant stocks (please refer to my November 30 post titled “Building a Case for Casual Dining in Early 2009”). Specifically, I highlighted five catalysts, including 1) lower gas prices, 2) a fiscal stimulus package, 3) reduced restaurant capacity, 4) a decline in commodity prices and 5) valuation. With these catalysts already starting to take hold, I am sticking with my call!

Throughout 2008, restaurant management teams repeatedly referred to the operating environment as the perfect storm as sales declined at the same time a majority of their input costs hit historical highs. These two factors alone crushed margins, particularly within the casual dining industry.

We have not yet seen an end to the pressure on restaurants’ top-line results, though according to Malcolm Knapp data, January casual dining trends were less bad than December. Commodity costs, however, should be less of a burden in 2009. Most management teams are expecting food cost increases to moderate on a year-over-year basis, largely in 2H09. As the table below shows, all but one of the most prevalent restaurant commodity inputs (chicken) are down on a year-over-year basis in 2009 (based on the average prices year-to-date in 2009 vs. 2008). And, the declines are rather significant, except for pork, which is essentially flat.

Higher gas prices hurt restaurant margins in 2008 from both a cost standpoint, as companies were forced to pay higher fuel surcharges, and from a revenue/demand perspective as higher gas prices deterred consumers from going out to eat. Although gas prices are up 20% year-to-date, they are still down over 40% on a year-over-year basis, which should benefit consumers and restaurant margins alike.

In addition to lower year-over-year commodity inflation, most restaurant management teams are now more prepared to cope with the current sales environment as they have pared back on new unit development and directed more focus to better managing costs. All of these factors combined should help mitigate the impact on margins from continued sales deleveraging. That being said, I would not expect to see any material improvement in margins until sales begin to improve.

On a number of different levels we are setting up to see some very bullish trends in 2H09. We have already established the commodity tailwind that most restaurant operators will see in 2H09. From a MACRO standpoint, the potential for the consumer to prevail, begging to feel “less bad” as we move through the summer is a real possibility. Like it or not, progress is being made to heal the country, especially as it relates to the health of the banking system. Whether it’s the stimulus package, bank bailouts or small business loans, the current administration is pressing ahead with a number of initiatives to restore consumer confidence. This is positive for restaurant stocks!

For the past three years, as the restaurant industry led the down turn in the economy, easy comparisons were meaningless. As we head into 3Q09 and 4Q09, the tailwind of easing commodity prices and a stronger consumer could lead to improving same-store sales and margin expansion. Easy comparisons will once again be investable.