Now that the dust has settled after the first-quarter earnings season, we’ll look back at the quarter that was for the restaurant industry. We’ll also take a look at some of the trends currently affecting the sector, and preview the upcoming earnings season.
The Quarter That Was
As we have noted previously, severe weather that blanketed much of the country in ice and snow hurt traffic and comparable-store sales in the March period. The lower volume essentially lead to narrower margins, as many of the restaurant operators failed to offset high fixed costs. The uneven economic landscape, as well as the timing of Easter (the holiday occurred in the second quarter of 2014 as opposed to the first quarter of last year), hurt some members of this group while helping others. Finally, rising labor and food costs also posed a problem for many companies in the March period, a trend that will most likely persist in the near term. All told, the opening three-month period of the year was not a great time for restaurant stocks, and now that it is in our rearview mirror, decliners outnumber advancers by a margin of about two to one. Most the declines were moderate, but shares of Chipotle Mexican Grill (CMG), The Wendy’s Company (WEN), Papa John’s International (PZZA), and Panera Bread Company (PNRA) were all hit especially hard, and only Wall Street darling CMG has started to make a comeback. Too, shares of Potbelly (PBPB) have been a major disappointment, losing more than half of their value since debuting late last year. Still, not all was bad, as the likes of McDonald’s (MCD –Free McDonald’s Stock Report), Sonic (SONC), Domino’s Pizza (DPZ), and Ruby Tuesday (RT) have all been on nice runs of late.
Costs Are Rising
The largest hurdles for restaurant operators are no doubt tied to input expenses, whether labor or food. Recently, the calls for an increase in the federal minimum wage from politicians and Average Joes alike have been growing louder, especially ahead of this year’s midterm elections. President Barack Obama has called for a minimum wage hike in his last two State of the Union addresses, asking to move the figure to $9.00 an hour in 2013, and upping the ante to $10.10 this past January. (The current federal minimum wage is $7.25.) There have already been numerous protests and demonstrations by fast-food workers around the country, and the idea of “giving America a raise” has been gaining a lot of momentum these days. Twenty-two states and the District of Columbia already have laws on the books that require a minimum wage above the current federal mandate, but these companies still worry about the fallout of pushing pay higher. More recently, Seattle has made national headlines after enacting a minimum wage of $15.00, surpassing San Francisco’s $10.74 to become the nation’s highest. We expect overall labor expenses to continue rising in the near term, both from higher minimum wages as well as increasing group medical costs, and investors should certainly keep an eye on these trends.
The other large input is food. Given the diverse set of menus and different purchasing practices of each member of the industry, restaurants are usually not affected in the same manner or on the same scale. That said, there has been a general trend of rising prices for inputs, be it coffee or limes or beef or pork. Prices for specialty items have also been pushed notably higher. The elevated costs related to foodstuffs has been weighing down margins almost across the board, and managements have been relatively quick to take action and raise menu prices. One notable exception here has been chicken wings, and Buffalo Wild Wings (BWLD) took full advantage of the lower prices posting a 70%-plus share-earnings gain in the March quarter. That said, the benefit is expected to dissipate in the not-too-distant future if it hasn’t already.
If recent announcements are any indication, the upcoming earnings season will likely be much better for the restaurant industry, and Value Line is expecting the vast majority of restaurateurs to report year-over-year profit gains in the upcoming quarter. Popeyes Louisiana Kitchen (PLKI) recently topped bottom-line expectations and raised its 2014 global sales forecast by more than a full percentage point, which caused its shares to rally handsomely. Cracker Barrel Old Country Store (CBRL) also gave investors much to cheer about recently with its third-quarter earnings release. (Its fiscal years end on the Friday closest to July 31st.) The company bucked recent trends and performed well in the challenging environment, as higher average checks boosted the top line while cost management enabled a 21% share-net gain. Drive-in chain Sonic, family-style restaurant operator Bob Evans Farms (BOBE), and casual dining mainstay Ruby Tuesday will all report earnings in the not-too-distant future, due to their non-December yearends, giving investors a preview of what is likely to happen in late July when most of the restaurateurs clue in Wall Street to what happened in the second quarter, though we expect a much better showing from this group and a positive outlook for the remainder of 2014.
Tying Up Loose Ends
As we discussed in previous Roundups, struggling Darden Restaurants (DRI) was looking to sell or spin off its Red Lobster business and focus on its other chains, mainly Olive Garden. In May, the company agreed to sell the chain to Golden Gate Capital for $2.1 billion (or about $1.6 billion after taxes). Investors were less than pleased with the news, and DRI stock fell modestly, though it has held steady at the current level since. While the cash infusion will be nice (management is looking to pay down debt and buy back shares), we think this was a missed opportunity. In a rush to unload this underperforming asset, we think Darden left some money on the table. Moreover, management now has to turn its attention to reviving another stagnant brand in Olive Garden, which is no easy task.
At the time of this writing, the author did not have positions in any of the stocks mentioned.