The war for topline market share shows no sign of abatement. Many management teams lament the aggressive discounting environment, yet are faced with no alternative but to comply. Favorable food costs made this strategy largely accessible in 2009, but 2010 may be a different story.
Operational cost pressures are relatively benign for restaurant operators at present. However, starting in the third quarter, QSR chains will face significantly more difficult compares in food and labor costs. The chart below illustrates how QSR food costs are set to place increasing pressure on margins as 2010 rolls on. Additionally, the CRB Foodstuffs Index is trending upwards. Although the 4Q09 year-over-year change in the Index is 15.7%, the index troughed in 2Q09 and we expect food costs to be of little help to QSR earnings in 2010, particularly in the back half of the year (as commodity contracts are renegotiated).
Labor costs have historically increased and this trend is not expected to reverse any time soon. Healthcare premiums have been rising and, while healthcare is front and center in Washington, D.C. at the moment, President Obama has made his support known for labor-related legislation such as the Employee Free Choice Act. The trend of unionization poses a threat to the QSR industry, as we discussed in our 1/14/10 post, “QSR: DON’T MESS WITH MACRO”. As the chart below indicates, labor costs as a percentage of sales also troughed in 3Q09 for QSR chains. This implies a difficult compare for QSR labor costs in 3Q10.
Accordingly, EBIT margin trends are also reflecting the difficult scenario facing QSR in 3Q10. Margins rose 295 bps in 3Q09 year-over-year and 226 bps in 4Q09. Examining the food and labor trends, and taking into account the magnitude of the cost-cutting measures undertaken in 2009, it is clear that earnings growth is going to be far more tightly linked to top line trends in 2010 than in 2009.
Top line trends in the QSR segment have been showing weakness lately, partially caused by weather, but significantly driven by the issue of unemployment. Unemployment is being cited as an issue by most management teams. Some operators, such as Jack in the Box, have underlined the endemic levels of joblessness among certain demographics (young males, young male Hispanics).
The discounting environment persists as companies compete for traffic. Even as BKC’s scheduled step-down from the $1 double cheeseburger approaches, MCD’s decision to sell all fountain drinks for $1 for 100 days from Memorial Day indicates that there will be no cease-fire in the QSR discounting war in the near-future.
The chart below shows the steep drop in QSR same-store sales that began meaningfully in 2Q09. The bifurcation of comps and margins shows that last year’s performance was driven by lower food costs and cost-cutting initiatives; this year, in the absence of an unlikely surge in same-store sales, the margin compares will negatively affect earnings in the QSR segment. So far in 2010, weather has been affecting comps and the stock performance has been strong; though the FSR segment continues to outperform. However, I expect margin compares to challenge QSR earnings growth from here – particularly in the third quarter.