Key Takeaways
September 2016 marked the fourth consecutive month of same-store restaurant sales declines, but the pressure is not indiscriminant.
Millennials account for nearly a quarter of restaurant spending and are anticipated to account for 40% of restaurant purchases by 2020. Their preferences are becoming important considerations for the strategic planning of restaurants.
Fast food restaurants with exposure to the coffee and breakfast segments appear to be faring better than those with limited or no exposure to the segments.
Experiential dining is becoming increasingly important in the full-service arena as the gap between grocery prices and food away from home prices has widened of late.
By Kris Rosemann
The broader restaurant sector (BITE) has been under pressure as of late, “Restaurant Traffic – What’s Going On?” and companies have found plenty of explanations as to why they are suffering, “Retail Weakness: Blame the Election?” According to Black Box Intelligence, same-store sales in the third quarter of 2016 fell 1% in the restaurant industry, and traffic declined 3.4%, marking the group’s worst quarter since the second quarter of 2010. Should year-to-date trends continue, 2016 would mark the industry’s worst year since the Great Recession plagued performance in 2009. Nevertheless, we’re not backing off of our top two choices in the space, Buffalo Wild Wings (BWLD) in the Best Ideas Newsletter portfolio and Cracker Barrel (CBRL) in the Dividend Growth Newsletter portfolio, but we are keeping close tabs on developments in the industry.
September marked the fourth consecutive month in which US same-store restaurant sales dropped, but not every restaurant operator has been languishing along with the group. We’ve identified a few restaurants that have been able to outperform with respect to comparable store sales, and core drivers of such outperformance could be indicative of what US consumers are now looking for when they visit a fast food or fast casual restaurant: coffee and breakfast.
Could this be the differentiator restaurants need to attract millennials, who are set to represent 40% of restaurant purchases by 2020 and currently account for just under a quarter of restaurant spending? In addition to closer attention being paid to how food makes its way to their tables, millennials are not beholden to traditional meal times or food choices. Breakfast as a late-night snack, or a burger for breakfast is no longer a far-fetched meal choice.
A great example of a fast-food chain targeting the new-age consumer is Jack in the Box’s (JACK) strategy. Channel checks have shown the firm is trending towards ~1.5% comparable sales in the current quarter, supporting the case for its differentiated plan of attack. The company has a late night shareable menu–aimed at the millennial demographic–and has been serving breakfast all day for more than 20 years. However, Jack in the Box has taken advantage of the growing purchasing power of a younger generation, and it now generates ~40% of total sales from breakfast or late night sales. It is also testing the waters with a late night delivery program in San Francisco in which it will open up its entire menu for delivery until 3 am.
Perhaps the most recognizable restaurant name of all, McDonald’s (MCD), was able to overcome the lapping of the launch of its All Day Breakfast initiative and turn in impressive global comparable store sales growth of 3.5% on a year-over-year basis in the third quarter of 2016. We have been skeptical of the staying power of improvements resulting from McDonald’s turnaround plan, but US comparable store sales advanced 1.3% from the year-ago period despite the aforementioned headwinds experienced across the industry. The restaurant is pulling on an additional lever to extend the momentum of its recent same-store sales performance in the form of an expanded All Day Breakfast menu, which now includes muffins, biscuits, and the ever-popular McGriddles.
McDonald’s and Jack in the Box are not the only fast food restaurants beating the broader restaurant space in terms of comparable store sales growth. Dunkin’ Brands’ (DNKN) Dunkin Donuts franchise reported US comparable store sales growth of 2%. Though the pace of expansion was largely a result of record-breaking beverage sales, management pointed to strong demand for breakfast sandwiches as well. Comparable same-store sales growth for Dunkin’ Donuts is expected to come in a range of 0%-2% in the full year 2016, but the real growth story at the firm is its long-term expansion plans to roughly double its US store count, particularly in the Western US where its penetration rate is significantly lower than the Eastern and Midwestern portions of the country.
Other restaurant rivals support Dunkin’ Brands’ assertion that coffee and breakfast sales continue to be key growth drivers. Restaurants Brands International’s (QSR) Tim Hortons franchise, for one, reported impressive comparable sales growth in the US of 4.5% on a year-over-year basis thanks to strength in coffee, cold beverages, and breakfast sandwiches. The firm’s other franchise, Burger King, did not fare as well, as it reported a modest decline in comparable sales of 0.5% in the US and Canada. It is worth noting that Burger King does offer breakfast items, but it stops serving from the breakfast menu at 10:30 am; perhaps the franchise would have been able to not only outpace the industry but turn in positive comparable sales in the third quarter of the year if it extends its breakfast hours, too.
Drive-in fast food restaurant operator Sonic (SONC) reported a 2% decline in system same-store sales in the fourth quarter of its fiscal 2017, ended August 31. Though the firm does offer its entire menu all day, sales of its breakfast products only account for 6% of total sales, as it is better known for its specialty drinks, burgers, hot dogs, and ‘Faves & Craves.’ Its breakfast menu is rather limited compared to that of McDonald’s, especially after the latter introduced an expanded menu in phase 2 of its All Day Breakfast initiative. Sonic is expecting fiscal 2017 same-store sales to be down 2% to roughly flat compared to fiscal 2016, when system same-store sales advanced 2.6%.
Turning to the fast-casual space, Panera (PNRA) reported strong third quarter results, though a connection between its company-owned comparable net bakery-café sales growth of 3.4% and breakfast and coffee was not offered by management. However, breakfast and coffee products are both a large portion of what the firm has to offer. The broader appeal of Panera, in our view, remains its position as a trusted provider of a healthy alternative to fast food. The company continues to aggressively target a younger generation as it recognizes the growing omni-channel approach being taken in commerce and implements technological advances in its bakery-cafes.
Panera is also benefitting from the pain of major fast-casual competitor Chipotle (CMG), who has yet to show any real signs of a recovery from the food safety scandal that rocked its world in 2015. Comparable store sales fell 22% on a year-over-year basis in the third quarter of 2016, a continuation of recent trends and exemplary of the unforgiving nature of consumers when it comes to food safety and product quality. Customers are simply not coming back at a rapid pace after the 2015 scandal, as comparable transactions fell 15% in the quarter, which helped shrink restaurant-level operating margins to half the magnitude of that of the year-ago period. Promotional gimmicks have not been enough to re-establish the allure the firm had as recently as mid-2015.
What we originally believed to be a transient issue has turned into an extended public relations nightmare for Chipotle. Though we do not necessarily question the safety of its food, we view its brand as damaged and the potential reward that would come along with a return to favor in the eyes of consumers is not worth the risk that the firm never comes out from under the shadow of the headlines that have plagued its results. Consumers are slow to forgive.
Activist investor Bill Ackman’s hedge fund Pershing Square Capital Management, is the second largest shareholder of Chipotle, with its stake coming in just under 10%. Ackman reportedly believes the firm’s board is long overdue for major adjustments and that it needs to ramp up marketing spending, cost controls and information technology capabilities. Management has recently stated its plans to invest in digital ordering and payments, increase cost cuts, and will pursue other strategies for its ShopHouse Southeast Asian Kitchen concept after recording an impairment charge on its assets. While we do not disagree with Ackman’s line of thinking, we believe at this point in time it will take more than improved ordering and payment technologies and cost cuts to fix what is truly wrong with Chipotle.
In the full service restaurant space traditional breakfast hot spots are also outpacing the rest of the group. Dividend Growth Newsletter holding Cracker Barrel reported solid comparable restaurant sales growth of 3.2% in its fiscal fourth quarter, ended July 31, but it expects the metric to slow to a range of 1%-2% in fiscal 2017, “Cracker Barrel Rocks Back on Weak Guidance.” We continue to be fans of Cracker Barrel’s differentiated atmosphere, and the additional selling power that comes from its retail-focused waiting room. Though Denny’s (DENN) and IHOP parent company Dine Equity (DIN) have yet to report third quarter results, both reported second quarter same store sales that outpaced the broader industry’s 0.7% decline, albeit slightly.
But what else is working in the full-service restaurant space? The widening gap between restaurant and grocery store pricing has made experiential dining increasingly more important. Cheesecake Factory (CAKE) cites the personalized experience of its restaurants as a key driver for its 1.7% growth in comparable restaurant sales in the third quarter of 2016. Management believes the share-ability of its food is an attractive proposition, especially to younger generations. According to the firm, its brand is the second most ‘Instagrammed’ restaurant brand, trailing only Starbucks (SBUX).
However, being tied to certain consumer trends within experiential dining can be a harmful proposition for a restaurant. Best Ideas Newsletter portfolio holding Buffalo Wild Wings is an example of this, as third quarter same-store sales fell 1.8% and 1.6% at company-owned and franchised locations, respectively. The firm is feeling pressure from decreased viewership of the NFL this year, as same-store sales for NFL game days in September and October have trended in-line with non-NFL days. Nevertheless, the company is encouraged by improving trends in its business in addition to the progress it is seeing in various sales-driving initiatives.
Same-store sales at Buffalo Wild Wings improved in each of the three months in the third quarter, and it is experiencing positive momentum in take-out sales and its Blazin’ Rewards loyalty program, two key initiatives the firm is implementing. Online ordering and mobile app updates are expected to continue the momentum in take-out sales, which now account for 16% of the company-owned restaurant sales. The loyalty program has added a same-store sales boost of up to 2% in the markets in which it has been implemented, currently ~25% of US restaurants. Full implementation of the loyalty program is expected by mid-2017.
Restaurant-level margins will also be in focus for Buffalo Wild Wings in coming years. It has set a target of 20% for restaurant level margin by the end of 2018, and management has identified opportunities for improvement in cost of sales, labor, and operating expenses in 2017. For example, renegotiated pricing for boneless wings and other chicken is expected to improve gross margins by 20 basis points alone in 2017.
Additional long-term sales drivers for Buffalo Wild Wings generally correlate with the changing role millennials (MILN) play in restaurant spending. Daypart diversification (dinner currently accounts for nearly half of sales) towards less traditional meal times could help capture the attention of a younger generation, as should the development of RTaco and Pizza Rev, two fast-casual concepts. The growth of RTaco will give the company a presence in the breakfast arena, though the contribution of both concepts to company-wide revenue is currently negligible.
All things considered, we continue to believe Buffalo Wild Wings will be a long-term winner, ”3 Reasons Why Buffalo Wild Wings is a Long-Term Winner (July 2015).” Management appears to be on the right track in its loyalty program initiative, and the firm developing a community of passionate wing and beer loving sports fans loyal to the Buffalo Wild Wings name would be a huge positive in terms of noticeable same-store sales bumps in the near term and brand loyalty and recognition over the long run. Mr. Market appears to be encouraged by management’s comments that the loyalty program could provide incremental same-store sales growth of up to 2%, and we can’t say we disagree with the sentiment.
While we aren’t pleased with Cracker Barrel’s equity performance, we believe it has suffered as a result of the negative sentiment across the industry, even as it continues to deliver and expect positive same-store sales growth. The country store and restaurant operator’s dividend remains one of the most compelling across the restaurant space, based on its ~3.5% yield and Dividend Cushion ratio of 1.7.
Bon appétit!