HEDGEYE OPINION
To finish the year, restaurant stocks rode the #TrumpTrade, with an +11.6% run post-Election through year-end, compared to S&P’s +4.6%. With many forces at work, it is still unclear how such a rally could persist despite the dire restaurant landscape, currently characterized by aggressive promotions, lagging traffic, and precipitous declines in same-store sales.
Below is a note by Hedgeye Demography Managing Director, Neil Howe, in which he lays out his case for why restaurants are struggling and what some brands have done to stay ahead of the curve.
MARKET WATCH:
What’s Happening? The late-year market rally has brought many restaurant stocks to new highs. But the industry’s underlying metrics tell a different story. Even as ever more restaurants close their doors, same-store sales growth and traffic growth continue on the steady downward trajectory that began two years ago.
Our Take: Most of these stocks are overvalued. Consumers simply aren’t eating out like they used to, for reasons spanning from cost concerns to generational change. While some companies seem to have found a playbook that works for the rising generation of Millennial customers, those that can’t adapt to America’s changing tastes are in for trouble.
A quick look at restaurant stocks reveals that shareholders expect smooth sailing in 2017.
Fast food establishments from Wendy’s (WEN) to McDonald’s (MCD) to Jack in the Box (JACK) have all seen their prices soar over the past two years. Even the maligned casual dining segment has its standouts, such as Darden Restaurants (DRI), owner of chains such as Olive Garden and LongHorn Steakhouse. The fast casual segment has stumbled lately, led by Chipotle (CMG) and its food safety woes—but establishments like Panera Bread (PNRA) and Potbelly (PBPB) have posted gains.
SO…WHO’S RIGHT?
Yet there’s no way around it: The restaurant industry is struggling—and has been struggling for the past two years. According to data from industry tracker Black Box Intelligence, same-restaurant sales growth has been declining on a year-over-year basis since February 2015, with growth turning negative in March 2016. That growth has stayed negative ever since (through October). Industrywide same-store traffic has been doing even worse: negative growth in each month since February 2015.
The latest quarterly data from NPD Group show that total restaurant visits again declined YOY in Q3 2016 (down 1%), while quick service restaurant visits declined for the first time in five years.
Commerce Department data confirm that restaurants are not participating in the late-year retail sales boom. Food and beverage stores (such as grocery stores) continue to experience sales growth, while food service and drinking places are posting losses.
These troubles have manifested in a major “restaurant shakeout” that apparently isn’t eliminating restaurants fast enough. The total number of restaurants doing business in the United States has declined in each of the last two years. (To put this in perspective, the number of restaurants rose even at the height of the Great Recession.) This year alone, prominent chains such as Bob Evans (BOBE), Ruby Tuesday (RT), Souplantation, and Don Pablo’s either have closed locations or have shuttered entirely.
Until recently, the industry at least has been able to count on a surging fast casual segment as a beacon of hope. That’s no longer the case. NPD Group data indicate that YOY fast casual traffic growth was flat in Q1 2016—but dropped by 3% in Q2 2016 and 1% in Q3 2016. To some extent, the entire segment has been dragged down by Chipotle, which continues to struggle more than a year after its food safety scandal. It certainly hasn’t helped that traffic at the lunch hour (when fast casual chains usually clean up) has dropped off.
DRIVERS
Declining food prices cost restaurants. It’s now historically cheap to eat at home relative to eating out. BLS data show that YOY growth in the Consumer Price Index (CPI) for “food at home” has been plummeting since early 2015—and has been negative for all of 2016, with the current rate of decline at its steepest since 2009. At the same time, the CPI for “food away from home” has been growing at over 2% since 2011. The YOY growth margin between CPI for food at home and food away from home sits near 5%—one of the widest ever recorded.
Analysts attribute smaller grocery bills to lower prices on commodities such as wheat and corn, as well as to U.S. producers beefing up their flocks of egg-laying chicken and cattle.
But why aren’t restaurants passing along the cost savings from lower food prices? Remember, food comprises just 25% to 38% of a restaurant’s total costs. The remaining share of restaurant costs has been growing at a quicker pace than food costs have been declining—thanks to wage growth due to sustained high worker demand, higher urban rents, and new minimum wage laws in many cities.
A boom in nontraditional dining options. Restaurants have more than just grocery stores to contend with. Consumers today can get a prepared meal from the convenience store, the gas station, the food truck, and even in the mail via food subscription services. Many grocery store chains are upping the ante with their own hot-and-ready meals—a dining category that has grown nearly 30% since 2008, according to the NPD Group.
DIY foodie culture. Another steady headwind for the industry since the last business cycle has been America’s growing obsession with food as an art form. (See my complete discussion of “foodie” culture here: “The ‘Foodie’ Frenzy.”) Yes, this may seem counterintuitive—but while some high-end establishments undoubtedly are reaping the benefits of Boomers with refined palates, the middle and lower tiers of dining are losing Xers and Millennials who can fly their foodie flags without breaking the bank.
Instead of spending big on a gourmet meal, thrifty foodies can patronize the local farmers market and whip up an Instagram-worthy meal on their own. The growth of this “informal” economic activity is reflected in employment data showing that working-age adults have more time on their hands than ever.
LOOKING TOWARD THE FUTURE
In the years ahead, generational change will serve up new challenges—as well as opportunities—for restaurants.
As I’ve noted elsewhere (see: “Who’s Picking Up the Restaurant Tab?”), Boomers are eating out more than previous generations at age 55+. The latest BLS data show that in 2015, consumers age 65 and older spent 20% more of their annual food budget on food away from home than they did in 1994—the greatest growth of any age bracket. High-SES Boomers still enjoy the opulence of a pricey steak and a fine wine (especially if they’re on an expense account), while low-SES Boomers have no problem settling for a bag of fast food.
But as Boomers continue to age out of the workforce, the industry will have to count increasingly on Xers and Millennials whose consumption habits pose more of a challenge. Xers are still struggling to get back on track financially following the recession. Many neither desire nor can afford fine dining—or even casual dining. This pragmatic generation is drawn to options (dining in or eating fast food) that provide the most bang for their buck.
Millennials, meanwhile, continue to buck the historical trend of young adults eating out. In 1988, consumers under age 25 spent 54% of their annual food dollars on food away from home. By 2015, that share had dropped to 48%.
WHAT RESTAURANTS ARE TRYING
Emphasizing freshness—which poses logistical problems. One might expect that restaurants, in their efforts to maximize sales, would be getting onboard the growing public demand for fresh, natural ingredients. Surprisingly, however, America’s desire for all-natural has yet to transform the restaurant industry.
Going natural poses a number of problems for restaurants. Fresh food inevitably drives up cost—a particular problem for price-sensitive fast food patrons. Dabbling in natural also makes it tough to create a coherent brand. Arby’s realized this in 2014 when it abandoned its “Slicing up Freshness” mantra in favor of a campaign that showcases what it does best: selling sandwiches stacked with meat.
All-natural is also tough to achieve in a commercial setting because of the myriad health issues it poses. Just look at Chipotle, whose decentralized supply chain opened the door for a disease outbreak.
Low-end restaurants are moving upmarket—and high-end ones are moving down, toward “masstige.” Many lower-tier establishments are classing it up, trying to maximize their cachet—and thus, their revenue. Last summer, McDonald’s opened a high-end “pop-up” restaurant in Tokyo featuring everything from real cutlery to upscale food. Starbucks (SBUX), meanwhile, is re-entering the high-end café stratosphere that it once dominated: At the Starbucks Reserve Roastery & Tasting Room, customers can learn about unique coffee preparation methods and taste-test rare brews.
High-end brands, on the other hand, are reaching out to the masses. Wolfgang Puck offers everything from a fast casual option (Wolfgang Puck Express) to supermarket soups (through a partnership with Campbell’s). The rampant growth of delivery services like Caviar has made this strategy easier than ever: Even if an upscale brand doesn’t offer delivery itself, it can ensign a third-party driver to do the deed for just a sliver of the profit.
Some eateries with delivery operations are maximizing their position within the industry’s “middle space.” Sit-down restaurants have been hammered by the rise of alternative dining options. But those with a delivery presence can use stay-at-home dining to their advantage.
Exhibit A: Domino’s Pizza (DPZ), which has posted strong YOY revenue growth thanks largely to its investment in digital delivery infrastructure. CEO Patrick Doyle even says, “We are as much a tech company as we are a pizza company.” Joining in are companies like Panera (PNRA), which will offer delivery from 15% of its stores by year’s end.
More drastically, private delivery restaurant upstarts like Sprig and Munchery are going all-digital, boasting no physical presence whatsoever.
Going all-in on a fun, social experience. Some of the biggest standouts within the restaurant industry have been casual chains like Dave & Buster’s (PLAY), Texas Roadhouse (TXRH), and Buffalo Wild Wings (BWLD)—which all posted double-digit YOY sales growth in 2015. What do these chains have in common? A festive, fun atmosphere in which customers can socialize. Dave & Buster’s in particular owes much of its success to a years-long Millennial rebrand featuring youthful TV programming, higher-quality menu items, and cutting-edge games.
The restaurant industry sits at a crossroads, and the possibility of a recession in the next calendar year doesn’t help. But establishments with a sound generational playbook—one that features high-quality food, fun, or a combination of the two—could keep from going stale.
Please call or e-mail with any questions.
Howard Penney
Managing Director
Shayne Laidlaw
Analyst
