Will High Costs, Low Traffic Hurt Restaurant Stocks In 2016?

A gradually improving U.S. economy and lower energy costs are driving improved consumer spending and the resultant improvement in sales are tailwinds for the restaurant industry. But are they enough? Let’s find out.

High Expenses to Dent Margins: Costs related to initiatives to boost comps, and pre-opening and restaurant re-imaging expenses are dampening restaurant margins. 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.

Restaurant management turnover is another critical headwind for operators as turnover rates have not only returned to pre-recession levels, they are now exceeding them, according to a report from 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, Inc. (DPZ) are working on these lines.

Soft Traffic Trend: Traffic has remained negative in all of the first four months of 2016, which is a matter of concern for the industry. 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, showed signs of decline. Moreover, increases in menu prices at times prevents them from dining out. Restaurants that are bearing the brunt of soft traffic include Brinker International, Inc. (EAT) and BJ's Restaurants, Inc. (BJRI).

Macro & Political Issues/Other Challenges: The restaurant industry is facing difficulties like intense competition in the U.S., a slowly recovering European economy and decelerating growth in Asia. Naturally, some restaurateurs like Brinker International, Cheesecake Factory and Papa John's International Inc. (PZZA) that have wide exposure in these regions, are facing macro headwinds.

Also, food safety issues among consumers have been hurting comps of restaurants like Yum! Brands (NYSE:YUM), Inc. (YUM), which has faced serious allegations regarding food safety in China. Back in the U.S., Chipotle bore the brunt of successive incidents of food-borne illnesses, like salmonella, E. coli and norovirus, which dampened sales of the fast-casual restaurant in 2015 and 2016.

Currency Headwinds: Fluctuating currency exchange rates are also a concern. Currently, the strong U.S. dollar is lowering the value of overseas sales of companies like Domino's Pizza, Dunkin' Brands Group, Inc. (DNKN), Yum! Brands and McDonald's as these have considerable overseas presence. Meanwhile, McDonald’s and Yum! are also likely to be hurt by the devaluation of the Chinese yuan in the form of weak sales going forward, as China is one of their key operating regions.

Affordable Care Act to Hurt Margins: The Affordable Care Act, commonly known as Obamacare, is expected to have an adverse impact on operators. U.S. health care reform as per the Act imposes several new requirements on employer health benefits. The law entailed restaurants with 100 or more full-time equivalent employees to offer health care coverage to substantially all full-time employees and their dependents from last year.

Meanwhile, it is applicable for restaurants with 50 to 99 full-time-equivalent employees from 2016. Also, penalties are being levied on employers if the rules are not followed. In any case, it will increase the costs for restaurant operators like Darden Restaurants (NYSE:DRI), Inc. (DRI), Panera Bread (NASDAQ:PNRA) Company (PNRA), Papa John's and The Wendy's Company (WEN) that are already reeling under the pressure of higher food costs and other expenses, thereby hurting margins.

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

To Sum Up

Although the restaurant industry has its share of headwinds, 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.

Check out our latest Restaurant Industry Outlook here for more on the current state of affairs from an earnings perspective and the trend for this important sector.

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