Dining Out In A Hot, Dry Season Restaurants are Doing Well, but Bracing, as Drought Drives up Grain and Food Prices

MARILYN MUCH, INVESTOR’S BUSINESS DAILY, (c) 2012 Investor’s Business Daily  

It was the second Sunday in July and lunch traffic at the Chipotle Mexican Grill (CMG) on Manhattan’s Upper East Side was as hot as a tamale.

Despite the heat, spicy burrito bowls, salads and tacos were going fast. A few blocks northwest, Panera Bread (PNRA) was also packed, with patrons filling nearly every seat in the two-story bakery-cafe.

Panera, Chipotle and other fast-casual eateries have led the restaurant industry’s rebound over the past few years. The trend should continue through this year, says Darren Tristano, executive vice president at industry consultant Technomic.

A slow economy has pushed lower- and middle-income consumers toward more affordable, but better quality dining experiences, he says. Fast-casual eateries offer fresh, high-quality food; pricier than fast-food chains, but cheaper than traditional casual dining restaurants.

“High unemployment and relatively high gas prices have had a negative impact on disposable income,” he adds. Fast-casual “has been successful in taking share from the other segments.”

Tristano forecasts fast-casual, which is a category within the quick service restaurant (QSR) segment, will see a hefty 8% rise in retail sales this year, excluding inflation. That compares with an estimated 4.3% gain to $402.88 billion for all restaurants and bars.

But as frugal consumers try to squeeze more bang from their bucks, restaurants are also upping menu prices. Why? Because higher food costs are threatening to narrow margins.

“Unfortunately, we’re seeing commodity prices continue to be a challenge,” said Jefferies & Co. analyst Andy Barish. “Recently we’ve had another big move in grains.”

Corn is up 38% since June 1 and is very close to last year’s record high. Wheat is up an equal amount and coffee gained 17%.

Pork prices also remain high, Barish says. And beef is approaching record highs as ranchers cull herds due to drought, squeezing the supply.

Analysts initially expected some relief in the second half of this year vs. the high costs a year ago.

Hot, dry weather in the Midwest is fanning fears of a shortfall in grains, “which really are building blocks that filter through the protein commodities,” he said. “Higher corn and soy prices mean relatively high chicken prices.”

Restaurants have been compensating with menu price hikes.

“Menu price increases are generally running 2% to 3%, which is a little more than the industry has taken in the past few years, to try to offset some of the commodity inflation,” said Barish.

But price hikes or no, there’s a lot of pent-up demand for dining out, says Tristano.

That demand is helping to drive nice gains at many of the nation’s top eateries. Investors have noticed.

The Retail-Restaurants group ranked No. 26 on Friday among IBD’s 197 industry groups. The group is up more than 13% so far this year, vs. the S&P 500’s 7.5% gain.

“There is still significant demand for restaurant stocks,” said Stephens Inc. analyst Will Slabaugh. “They’ve held up very well.”

But the industry saw investor expectations ease, he says, after Darden Restaurants (DRI) reported disappointing Q4 same-store sales on June 22. Overall sales at the casual-dining giant fell below views as same-restaurant sales declined at both its Red Lobster and Olive Garden chains.

Now, investors are on standby as other chains prepare to report second-quarter results. Among Slabaugh’s top Q2 performance picks are sports bar and grill Buffalo Wild Wings (BWLD) and coffee kingpin Starbucks (SBUX).

1.Business

Overall, we should see a mixed set of results in Q2, Barish says, although, with the environment “choppy,” it’s hard to generalize.

Buffalo Wild is in the casual, not the fast-casual category. Still, it’s managed double-digit sales and profit growth in 13 of the past 15 quarters. Thomson Reuters analysts expect a 17% EPS gain in Q2.

Slabaugh estimates Q2 same-store sales rose 5.8% vs. a year earlier, even vs. tough year-ago comparisons.

Buffalo Wild’s “customer proposition” is a lot different than its causal-dining peers, says Slabaugh. Customers come in on special occasion to watch games on its many TVs while they’re eating wings and having drinks with friends.

Panera has had double-digit earnings and sales growth for the last nine quarters. Analysts estimate a 21% increase in Q2 profits. Barish figures the quarter’s same-store sales were up 5% vs. a year ago.

Dunkin’ Brands Group (DNKN), which went public last July 27, owns Dunkin’ Donuts and the Baskin-Robbins ice cream chain.

Roughly 75% of annual revenue comes from Dunkin’ Donuts, which has more than 10,000 stores worldwide, 70% of which are in the U.S. Nearly two-thirds of its U.S. franchisee sales come from coffee.

Dunkin’ Brands is a nearly entirely franchised business model, which essentially eliminates store operating expenses, resulting in higher margins than many of its peers, says Slabaugh.

Barish says the company’s key Dunkin’ Donuts U.S. business likely had at least a 5% pop in Q2 same-store sales over last year.

Chipotle has owned 13 straight quarters of double digit-sales and earnings growth. Analysts estimate a 40% jump in Q2 profits, vs. a 35% rise in Q1.

Among the main drivers of its business is its food culture, says spokesman Chris Arnold.

“That has us looking for the best ingredients we can find from more sustainable sources and preparing everything using classic cooking methods,” he said.

Another driver is Chipotle’s “people culture,” he adds. The company identifies top performers and develops them into leaders. As a result, nearly all its store managers come from within the ranks of its line staff, he says.

“That helps the service and ensures high standards,” he said. “So customers receive excellent service and a great experience consistently.”

2.Market

In spite of the positives, the overall restaurant industry’s results have been about as mixed as a tossed salad. It’s very hard to read the environment, says Tristano.

“On an overall basis, it’s improving, but it’s improving slowly,” he said.

Tristano’s retail sales forecast for total restaurants and bars of 4.3% this year is higher than the 3% to 3.5% increase of 2011. Technomic sees a 4.7% increase in such sales in 2013.

QSR sales should grow 4.5% this year, while sales at full-service chains, are estimated to rise 4%.

“Quick service overall (which includes fast-casual) has been holding up better than casual dining,” Slabaugh said. “It’s a more approachable price point and dining occasion than casual dining.”

Barish says QSR chains are benefiting from changes such as improved product quality and restaurant remodels.

He says we may still be seeing more consumers trading out of casual dining into QSR.

Starbucks has upped its game with an agreement to acquire San Francisco-based Bay Bread and its La Boulange bakery brand, as well as to hire renowned French baker Pascal Rigo.

Slabaugh says the proposed buy makes a lot of sense.

“What the consumer has been asking for from Starbucks is better food quality and a broader food offering,” he said.

Even the more traditional, casual dining segment, although it trails quick service, has begun to show some improvement, says Tristano.

“That’s primarily because they’ve declined over the past five years and are starting to rebound and come up from the bottom,” he said. “We’re starting to see slow growth out of the casual dining brands.”

3.Climate

In June, consumer confidence in the economy and personal finances worsened to the lowest levels since January, leading to lower spending intentions, according to the Discover U.S. Spending Monitor. The survey showed nearly 47% of consumers expect to spend less on purchases, including dining out.

The U.S. unemployment rate has ticked back up to 8.2%, and the stock market is volatile, adds Slabaugh. He says these factors have contributed to a lot of uncertainty among U.S. consumers, putting pressure on sales.

Still, the fundamentals of the U.S. consumer are continuing to get better. Slabaugh cites trends such as falling gasoline prices.

“As the headlines become more positive from a macro perspective, I think restaurants will be great place to be in terms of investing,” he said. “I see this in the back half of 2012 into 2013.”

4. Outlook

Barish is “cautiously optimistic” about industry prospects.

“I would like to see a little better economic environment,” he said.

His buy recommendations include Dunkin’ brands, Starbucks and Panera.

“As the slow recovery continues, you have to pick and choose spots and be in the right places,” he said. “The large chains that we monitor in the public markets are better positioned to gain share in this slow recovery from small players or private companies.”

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