Fast Casual Buzz Drives A Big Week For Restaurants

T he past week marked a juncture of sorts in the restaurant trade.

Industry heavyweightMcDonald's ( MCD ) announced what appears to be an extensive restructuring plan. Shares ofChipotle Mexican Grill ( CMG ), flagship of the game-changing fast-casual segment, dived after the company announced that its ethical stance on pork products had eaten away at revenue. And high-profile names likeDunkin' Brands ( DNKN ),Domino's Pizza ( DPZ ),Starbucks ( SBUX ),Yum Brands (YUM) andCheesecake Factory (CAKE) all spiked on strong quarterly results.

Restaurants are in many ways different from what they were five years ago -- or even one year ago. More than 20% of the 58 stocks in IBD's Retail-Restaurants industry group have gone public in the last five years. Four of them went public in the last 12 months.

The IPOs -- and aggressive expansion by chains like Starbucks, Chipotle and others into new areas -- give consumers more choices for where and what to eat. Older chains face fresh ideas, new competition (for both customers and employees) and rising standards among consumers. Investors have tapped the trend, holding the restaurants group in or near the top 20 rankings for the past six months among the 197 industry groups that IBD tracks.

Restaurant stocks have had mostly good news in recent months, with favorable macro trends like lower gas prices and a better jobs picture outweighing headwinds such as higher food and labor costs.

Most analysts remain upbeat on the sector, particularly in niche categories such as fast-casual and quick-service.

The fast-casual sector focuses on freshly prepared food at affordable prices and includes names like Chipotle andPanera Bread (PNRA). Quick-service involves any type of restaurant -- from McDonald's to Starbucks -- that can serve customers immediately.

Much of Wall Street's attention has focused on fast-casual chains, partly due to recent IPOs such asZoe's Kitchen (ZOES),El Pollo Loco (LOCO),Habit Restaurants (HABT) andShake Shack (SHAK).

Not all of the fast-casual news has been good, with Chipotle's 7% nosedive on April 22, following disappointing Q1 results, topping the list. But the sector has gotten a big leg up from the improving economy and job market.

As more people recover financially -- especially those in low- to middle-income groups -- they want more for their dining dollars than a burger and fries at the drive-thru window, says Darren Tristano, executive vice president at food-industry tracker Technomic.

"These groups are starting to go out and spend money, and we are seeing the benefit in fast casual because it offers a better experience for the customer," Tristano told IBD. "When they have money they want to treat themselves."

Another growth category has been family-style restaurants such as IHOP,Denny's (DENN) andCracker Barrel Old Country Store (CBRL), he says. "This category has been in decline for a decade, but last year it had growth of around 3%."

Still, the quick-service category might hold the most near-term growth potential, according to a recent research report from Miller Tabak analyst Stephen Anderson.

"We see the focus shifting from casual dining to quick-service for near-term gains," he noted.

That's partly because quick-service chains such as Dunkin' Brands andJack in the Box (JACK) are less susceptible to rising labor costs than other chains, he says.

A rise in the minimum wage in some states has led to higher wages throughout the restaurant industry, while the Affordable Care Act, otherwise known as ObamaCare, has raised health insurance costs.

Anderson reckons that the combined impact of higher wages and new ACA mandates will "translate into margin pressure" for much of the restaurant industry.

He says that the margin pressure will be higher for full-service restaurant companies such as Cheesecake Factory and Red Lobster/Olive Garden parentDarden Restaurants (DRI) than for quick-service establishments.

Full-service restaurants, Anderson said, "typically have a higher percentage of labor relative to quick-service chains; tend to have a higher concentration of company-owned units; and would be affected by changes in tip wages."

1. Business

The biggest players in IBD's Retail-Restaurants group are familiar global brands like McDonald's, Starbucks and KFC parent Yum Brands.

However, the stocks with the strongest combination of fundamental and technical attributes are niche players such asPapa Murphy's Holdings (FRSH), a Canadian company whose restaurants sell uncooked pizzas that you can bake at home;Sonic (SONC), a fast-food burger and sandwiches chain; andPopeyes Louisiana Kitchen (PLKI), a quick-service chain that specializes in fried chicken.

The restaurant industry is divided into numerous categories, ranging from cheap burger joints to fine dining. That doesn't mean that companies in the same category sell the same things, however.

For example, one side of the fast-casual universe includes restaurants that specialize in fresh-made burgers and hand-cut fries. Stocks in this group include Habit and Shake Shack.

On the other side are restaurants that focus on healthier fare free of additives and preservatives, and that offer choices for customers on vegetarian, vegan and gluten-free diets. This group includes Zoe's, Chipotle and Panera.

Even within these subcategories are differences. For example, Zoe's sells beer and wine. Most large fast-casual chains don't.

In an interview with IBD last month, Zoe's CEO Kevin Miles said that while he sees Chipotle and Panera as rivals, "there are a few in the space that we don't see as direct competitors, such as burger or pizza restaurants. When our customers aren't eating at Zoe's, they are eating atWhole Foods (WFM) or at 'better-for-you' grocers."

2. Market/Climate

The National Restaurant Association estimates the U.S. restaurant market at around $709 billion, with annual sales growth of just under 4% (un-adjusted for inflation).

Higher costs of chicken, pork and other commodities forced many restaurant chains to raise prices in recent quarters. Many have done so successfully, thanks to a rise in business tied to lower gas prices and the improving economy.

A survey of 20,000 restaurants by market researcher Black Box Intelligence found that industry-wide, same-restaurant sales during the first quarter rose 2.8% from the prior year. It followed a 2.5% increase during the 2015 fourth quarter.

For the first time in more than three years, same-restaurant sales have risen for nine consecutive months, analyst Anderson says. He expects 2015 same-restaurant sales growth to average 1.5% to 2% for casual dining, 2% to 3% for quick-service restaurants and 3% to 4% for fast-casual restaurants.

3. Outlook

For most analysts, the one metric that will have the most impact on the performance of restaurant stocks is the nation's employment growth. When more Americans have jobs, more Americans spend money dining out.

At the same time, higher employment usually leads to more competition for workers, which pushes wages up in the restaurant industry. To succeed, restaurant companies must figure out a way to offset higher labor costs with a rise in menu prices.

"The brands doing well today will likely be able to increase wages and pass along that increase to customers," Tristano said.

Likewise, he says, the brands not doing well won't be able to raise prices, which means that their only way to deal with higher labor costs is to try to get by with less staff.

Fast-food and casual dining chains will be the most vulnerable, Tristano says, particularly those that have a lot of franchised restaurants without much corporate backing.

"Brands just getting by right now will have a difficult time dealing with labor costs," he said. "We may see many restaurant closures when that happens."

4. Technology

One technology that analysts are keeping an eye on is a Wi-Fi enabled tablet that lets diners order at the table, entertain themselves before or while dining, and quickly pay their bills when they're finished dining.

The tablet, made by Dallas-based tech firm Ziosk, has the potential to "transform the industry and enable casual dining to much more effectively compete with fast casual," according to Sterne Agee analyst Lynne Collier.

She said that early adopters "will be at a competitive advantage." Those early adopters includeBrinker International (EAT), owner of the Chili's and Maggiano's chains; andRed Robin Gourmet Burgers (RRGB), owner of its namesake chain of burger restaurants.

"We expect rollout to additional casual dining companies over the next 12 to 24 months," Collier noted, though she didn't specify which companies.

Longer term, she expects other segments of the restaurant industry, including fine dining establishments, to be users as well.

Panera Bread andBuffalo Wild Wings (BWLD) report quarterly results on Tuesday. Ruth's Chris Steak House ownerRuth's Hospitality Group (RUTH) reports next Friday.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.