QSR EBIT margin trends continued to improve YOY in 1Q10, but compares get more difficult for the balance of the year.
Two weeks ago, I wrote about current casual dining margin trends (please refer to the June 2 post titled “CASUAL DINING – THE SQUATTERS’ INCOME IMPACT”) and QSR trends look rather similar from a YOY comparison perspective with 1Q10 having been the easiest compare of the year from an EBIT margin standpoint.
One major difference is that the QSR industry’s comps (as measured by our QSR index shown below) get easier for the rest of the year whereas the casual dining industry’s comps get easier for 2Q and 3Q and then get more difficult in Q4, as reported by Malcolm Knapp. According to our Hedgeye Risk Management QSR index, comps turned positive in calendar 1Q10 for the first time since calendar 4Q08, and that improvement included the significant negative impact of harsh weather in February.
Although many QSR companies stated on their most recent earnings calls that April trends were in line with March or slightly better, more recent comments from a handful of companies point to decelerating trends in May, at least on a 2-year average basis.
This morning Sonic preannounced its fiscal 3Q10 (quarter ended May 31) system same-store sales trends, reporting a 6% to 6.5% decline YOY. At the low end, this 3Q10 result implies a nearly 250 bp sequential improvement in 2-year average trends from the prior quarter, but it is important to remember that SONC management attributed about two-thirds of the reported 2Q10 decline in same-store sales to inclement weather. Excluding the weather impact, a 6.5% decline in 3Q10 implies a nearly 200 bp sequential deceleration in 2-year average trends. SONC’s preannounced 3Q10 trends combined with its 4Q10 same-store sales guidance of -4% to -8% point to a 5% to 7% decline in the back half of the year, 200 bps worse at the low end than the flat to -5% guidance management provided three months ago. Specifically, SONC’s press release stated, “The consumer environment continued to pose a challenge for same-store sales in the quarter, with same-store sales estimates for the system expected to decline between 6.0% and 6.5%. Though negative, same-store sales improved from March to April, but deteriorated in May.”
MCD trends did not deteriorate in May, but the company’s U.S. trends, though still strong on an absolute basis, have slowed on a 2-year basis in both April and May when you adjust for calendar shifts. CKR has also reported its monthly trends through May 17 and blended same-store sales decelerated slightly on a 2-year average basis in the most recent period. Carl’s Jr., however, which has greatly underperformed Hardee’s recently, posted slightly better numbers in the most recent period on both a 1-year and 2-year basis. That being said, same-store sales were still down 5.2%.
Reuters reported Monday that SBUX CEO Howard Schultz said "With 10 percent unemployment continuing in America, I think this is a time for continued thoughtfulness and discipline, but we have not seen a downturn from quarters in the past. So it has been relatively the same and consistent." This comment does provide too much insight into current trends, but it implies that trends remain at least in line with the company’s prior full-year guidance of mid-single-digit same-store sales growth as the company posted 4% and 7% growth in fiscal 1Q10 and 2Q10, respectively.
Based on this limited glimpse of current QSR top-line trends, I am not expecting trends to get better on a 2-year average basis in the second quarter as they did in 1Q; though easier comparisons will help trends on a 1-year basis.
Food cost trends
Like the casual dining names, QSR margins were helped by declining commodity costs for most of 2009, largely in the second half of the year. Although most companies continued to reap the benefit of lower food costs YOY in calendar 1Q10, most guided to higher costs for the balance of the year, particularly in 2H10. Beef costs, which make up the largest food ticket item for most of the QSR names, have increased 9.6% YOY (as measured by the S&P GSCI Live Cattle Commodity Index), and the CRB Foodstuffs Index is up 6.2% YOY.
SONC: Just this morning, SONC reported that it is expecting a 150 to 250 bp decline in 4Q10 restaurant level margin as a result of deleveraging and higher-than-expected beef costs.
MCD: Reported a 5% decrease in its U.S. basket of goods in 1Q10 and guided to a 2% to 3% decrease in the U.S. for the full-year, which implies increased pressure for the balance of the year. During a June 2 investor presentation, CEO Jim Skinner said commodities would be flat-to-slightly down.
BKC: Guided to a 4% YOY increase in its U.S. food costs in fiscal 4Q10 after beef costs increased 9% on a sequential basis in fiscal 3Q10.
WEN: 1Q benefited from lower YOY food costs, but the company is expecting a 2% to 3% increase in commodity costs for the full year, which will hurt margins for the balance of the year. “Although commodities were favorable in the first quarter, they are beginning to increase earlier than we had anticipated, especially beef.”
CKR: Management called commodity costs the “one wild card” on its last earnings call. For fiscal 1Q11, the company guided to a 100 to 110 bp increase in food and packaging costs as a percentage of company-operated sales. Food and packaging costs as a percentage of sales have decreased YOY for the last 6 reported quarters.
JACK: Guided to a 1% decrease in full-year commodity costs after costs declined 4.5% in the first two quarters of the year. Specifically, management stated, “Commodity costs are expected to increase by approximately 2% in the third quarter and 3% in the fourth quarter as compared to prior year. The increase in the third and fourth quarters is being driven by higher beef costs, which accounts for approximately 20% of our spend.”
YUM: 1Q10 U.S. operating income benefited from $5 million in commodity deflation; this benefit is expected to go away and turn inflationary as we trend through the year. Management is expecting costs to be relatively flat for the full year.
CMG: Food costs decreased in the first quarter but management expects food costs to increase slightly for the year, primarily in 2H, “due to modest commodity inflation enabled by increased consumer demand.”
Companies will be slow to offset these higher food costs with pricing as consumers continue to be under pressure in this economic environment and have not yet proven a willingness to spend more money. QSR demand trends are highly tied to unemployment levels and as MCD‘s CEO Jim Skinner stated at a recent investor presentation, “We don’t have a lot of price elasticity right now.” If MCD can’t raise prices, it leaves little room for the smaller players to do so. On the other end, higher food costs will put increased pressure on margins as companies continue to rely on value initiatives and promotions to drive traffic. The QSR companies on average posted higher YOY EBIT margin each quarter in FY09 even with same-store sales negative and with an increased focus on value. These trends will not be sustainable for the remainder of FY10 if commodity costs move higher, on a YOY basis, as expected.
Labor cost trends
On average, labor costs increased as a percentage of sales for the QSR companies for most of 2009. Based on the deleveraging of negative same-store sales and recent minimum wage increases, this is not surprising. The tough sales environment actually caused most QSR companies to focus on increasing the efficiency of its labor and this will likely continue for some time. To that end, management can’t cut labor costs forever without impacting the customer experience so the big cuts, even if sustainable, have already been made on a YOY basis.
As I stated in the casual dining post two weeks ago, if the jobs picture improves, it’s only a matter of time before we hear about higher labor costs. In an economy that is creating jobs, there is an increased incentive to quit and walk away from a lower-paying job (think restaurant server/cooks), and the restaurant industry will pay the price. QSR Web reported on this topic on Monday, saying that QSR operators are well aware they will have to work harder to retain employees in the coming months. Specifically, the article cited a recent Harris Interactive poll, which showed that one in five employees say they will look for a new job once the economy improves. Employees ages 18 to 34 say they are even more likely — 26 percent — to look for new employment or expect a promotion. A better economy will be good for top-line trends, but it will also put increased pressure on the labor cost line.