By Kris Rosemann
What’s going on with restaurant stocks these days?
Sonic’s (SONC) announcement of preliminary results for the fiscal fourth quarter of 2016, ended August 31, has been the latest catalyst to drag the restaurant sector (BITE) lower due to it reporting “lower-than-expected traffic, reflecting lower consumer spending in restaurants and continued aggressive competitive activity.” Our newsletter portfolios have not been spared the pain as shares of Dividend Growth Newsletter portfolio holding Cracker Barrel (CBRL) have faced pressure since its fiscal fourth quarter report September 14, and Best Ideas Newsletter portfolio holding Buffalo Wild Wings (BWLD) has suffered as a result of the weak data as well.
Sonic’s report was not the first we’ve been hearing of slowing consumer spending in restaurants in the US, and more specifically in the growth of same-store restaurant sales among restaurant chains. For example, same-store restaurant traffic fell 2.7% and 3.9% in the months of August and July, respectively, according to Black Box Intelligence. Average guest check increases have helped offset some of the traffic weakness, but a number of factors could mitigate progress in check increases. After all, how many menu price increases are consumers willing to take? Where is the tipping point where traffic really starts to fall off?
Retailers and restaurants continue to work to solve the spending habits of millenials, and neither industry has had a significant amount of success as of late. Millenials choosing independent eateries and new concepts (think Five Guys and the like) has been tabbed as one of the issues plaguing traffic among public constituents in the restaurant industry, a trend that fits closely with the perception of the generation. As a result, we don’t expect such a trend to reverse itself in a meaningful way anytime soon. This could result in many restaurant chains scrambling to rebrand and reorganize to appeal to a segment of the population that will only become more important as time passes.
A more visible negative impact on average check increases is expected to come from increasingly competitive pressures across the industry. For one, restaurants are not sitting by idly as they watch traffic dwindle, and the discounting dynamic we have seen in retail in recent quarters is becoming more prominent. With promotional initiatives such as the McDonald’s (MCD) McPick 2 menu, Wendy’s (WEN) 4 for $4 deal, and Yum! Brands’ (YUM) Taco Bell’s comparatively lower prices across its menu becoming much more commonplace, operating profit margins at the restaurant level, particularly in the quick-service space, are likely to continue to feel the squeeze — offset in part on a consolidated basis by refranchising efforts for those pursuing such initiatives.
The possibility for (or better stated, the probability of) a higher federal minimum wage is inching closer to reality and will inevitably heighten the pressure on margins on operators across the industry, in our view. If technology does not eventually replace higher cost labor, we would expect the trend toward refranchising among public players to continue to proliferate. By passing rising operating costs down to the franchisee, franchisors are able to avoid the threat of rising minimum wages on their respective bottom lines, as margins are augmented, capital costs are reduced, and free cash flow is enhanced. McDonald’s recently-heightened refranchising efforts, in our view, are largely driven by this dynamic as the fast-food giant prepares for an ever-changing political landscape post 2016 election.
Somewhat nudged between the restaurant and retail industry is the grocery space, which is also feeling pressure as a result of food prices dropping precipitously. For example, the price of food has dropped in nine consecutive months, the longest streak since 1960 excluding a stretch in 2009 during the midst of the Financial Crisis. Lower food costs in the grocery sector may be impacting restaurant traffic, in part. As consumers look to maximize the enjoyment levels of their personal income, materially lower prices for everyday groceries is impacting the allure of restaurants. Restaurant traffic trends are not shielded from this dynamic, as the convenience of eating out may not be a big enough pull for many consumers on the margin. Eateries must compete with all food sources, not just other restaurants.
Some of the drop in food costs can be attributed to low oil and grain prices, but aggressive discounting, similar to what we’re seeing in the restaurant space, has played a role. In addition to the typical pricing competition from the likes of Walmart (WMT) and Aldi, dollar stores and online retailers such as Amazon (AMZN) continue to pressure. Such a dynamic has forced the likes of Kroger (KR), for example, the largest grocery store chain in the US, to slash prices in search of growing sales and market share. Though Kroger has largely succeeded on those fronts, shares are down more than 25% year-to-date. From where we stand, rivalries probably have never been more intense across the retail and restaurant spectrums than as of late.
The image below, courtesy of Driehaus Capital, shows the correlation between same-store sales of restaurants and the relative value consumers see in eating at home compared to eating out. As consumers get more bang for their buck at grocery stores, same-store traffic at restaurants suffers. The impact of the weakness in grocery store prices in 2009, the last time we have seen a streak of price drops similar to what we are now, can be seen in the chart as well. We’re paying very close attention.
Of course we are not expecting doom and gloom across the restaurant, grocery, or broader retail sectors, but we do feel the need to remind investors to keep a close eye on margins and free cash flow trends should recent traffic developments find material staying power. As we know, expectations of free cash flow are not only the basis of our estimates of intrinsic value of a given company, but are also drivers of our expectations of dividend strength. Pay very close attention to changes in Dividend Cushion ratios.
With all of that being said, we continue to like our top picks in the restaurant space. Cracker Barrel remains one of the top dividend plays in the space, in our opinion, and it maintains a healthy Dividend Cushion ratio of 1.7, while Buffalo Wild Wings recently registered a 9 on the Valuentum Buying Index. Cracker Barrel’s unique concept and store experience and Buffalo Wild Wings’ ongoing traction in the bar and grill space are hard not to like over the long haul. Importantly, the valuation of neither firm is full at current levels, and while it may take some time as broader macro trends sort out, we look forward to both holdings eating away at the discrepancy between price and fair value.
Food Retailers: CASY, COST, CVS, GNC, KR, SVU, SYY, TGT, UNFI, VSI, WBA, WFM, WMT