Restaurant Stocks: Costs, Traffic, Comps Loom Large

While an improving U.S. economy and slightly lower energy costs are driving consumer spending, it would be prudent for investors to take a closer look at the dampeners threatening growth in the restaurant industry. Particularly, sluggish comps growth and traffic trends along with rising labor costs could spell trouble for the restaurateurs.

Below, we discuss some of the headwinds that are plaguing the restaurant industry:

High Expenses: Costs related to various sales and comps boosting initiatives along with restaurant re-imaging expenses are hurting margins for companies like Domino's Pizza, Inc. (DPZ), The Wendy's Company (WEN) and Brinker International, Inc. (EAT).

Moreover, restaurants like Red Robin Gourmet Burgers Inc. (RRGB), Panera Bread (NASDAQ:PNRA) Company (PNRA) and BJ's Restaurants, Inc. (BJRI) intend to make additional unit openings going forward. Thus, higher marketing and pre-opening costs associated with the same are expected to hurt profits.

Also, there has been considerable debate in the recent past over restaurant workers’ wages. Workers at quick-service restaurants claim that their employers' profits have not trickled down to them proportionately, which is leading to strikes for wage hikes. These incidents significantly hurt the reputation of restaurants. As a result, the companies are compelled to make minimum wage increases, which again lead to narrower margins. Also, higher labor costs due to the competitive labor market are expected to continue to keep profits under pressure.

Restaurant management turnover is another critical headwind for operators as turnover rates are now at the highest level since the recession, according to a report by Black Box Intelligence. This is further compelling restaurants to either hike wages or provide benefits, at the cost of margins, to retain or attract employees. Companies like Chipotle Mexican Grill (NYSE:CMG), Inc. (CMG), The Cheesecake Factory Inc. (CAKE), McDonald's Corp (NYSE:MCD). (MCD) and Domino's Pizza are working on these lines.

Soft Comps & Traffic Trends: Most of the restaurateurs have been bearing the brunt of soft comps and traffic trends in the first half of 2016, which is a matter of concern. Per market analysts, diners are visiting chain restaurants less often and instead spending more per visit, which is hurting traffic. Throughout the beginning of this year, consumer behavior has been volatile and the willingness to spend on most goods, especially eating out, has shown signs of decline.

Moreover, increase in menu prices at times prevents them from dining out. In fact, the second quarter of 2016 marked the second consecutive quarter of negative comps growth in the restaurant industry, per a report by TDn2K’s Black Box Intelligence.

Macro & Political Issues/Other Challenges: The restaurant industry is grappling with difficulties like intense competition in the U.S., decelerating growth in Asia along with weakness in some parts of Europe, wherethe economic/political conditions are expected to be further challenging post Brexit.Naturally, some restaurateurs like McDonald's, Brinker International and Papa John's International Inc. (PZZA) with exposure to these regions are facing the brunt.

Also, food safety issues among consumers have been hurting comps of restaurants like Yum! Brands (NYSE:YUM), Inc. (YUM), which has faced serious food safety allegations in China. Back in the U.S., Chipotle continues to reel under the negative publicity associated with the E. coli and norovirus outbreaks in several states, which surfaced toward the end of 2015, which has impeded sales of the fast-casual restaurant.

Currency Headwinds: Negative currency translation is a concern for companies like Domino's Pizza, Yum! Brands and McDonald's as these have considerable overseas presence. Thus, fluctuating currency exchange rates might hurt the international sales of these companies.

In fact, given recent currency fluctuations, McDonald’s expects foreign currency translation to have a more considerable impact on reported results than estimated earlier. Notably, the company expects adverse currency translation to hurt EPS in the range of 9 cents to 11 cents for 2016, up from the earlier guidance of 5 cents to 7 cents. Moreover, Domino's Pizza anticipates foreign currency to have an $8 million to $12 million year-over-year impact on pretax earnings in 2016.

Affordable Care Act: The Affordable Care Act, commonly known as Obamacare, would continue to have an adverse impact on restaurant operators. The Affordable Care Act requires employers to extend health benefits. The law entails restaurants with 100 or more full-time equivalent employees to offer health care coverage to substantially all full-time employees and their dependents beginning this year.

Meanwhile, from the beginning of 2016, the Affordable Care Act was implemented for organizations with 50 to 99 full-time-equivalent employees. Employers will have to suffer penalties if they do not follow these rules.

In any case, it will increase the costs for restaurant operators like Darden Restaurants (NYSE:DRI), Inc. (DRI), Panera Bread, Papa John's International Inc. (PZZA) and The Wendy's Company (WEN) that are already reeling under the pressure of higher costs.

To avoid this, most companies are trying out different labor models like involving more part-timers and cutting work hours. Meanwhile, some companies have limited their hiring, which will eventually increase unemployment rate.

To Conclude

Although the restaurant industry has its share of headwinds in the form of high costs, and slowing comps growth and traffic, implementing the right pricing strategy, increasing global presence and focusing on supply chain revenues can offset these negatives.

Let us see how these companies fare and register profits in the coming days. In “Restaurant Stocks’ Initiatives on Track: Time to Invest?” we focused on the conditions which are expected to drive the industry forward.

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