The long love affair with dining out – engaged in by both Canadians and Americans – may be waning.
It's hard to believe, but it's what some are concluding after a summer of underwhelming results, particularly slowing growth numbers, from many of the major names in the North American restaurant industry. Explanations for the phenomenon vary, as some cite the widening gap between the cost of cooking at home and the expense of eating out, and others point to the uncertainty of the U.S. presidential election. (This cannot be so, because if true, there would be a run on Mexican restaurants out of fear of a Donald Trump victory.)
Given this ennui, you might expect stocks in the restaurant sector to be cheap. For sure, there has been some true carnage in the sector, as nearly half of a group of 73 U.S. and Canadian restaurant stocks are down for the year, with some off 30 per cent or more. Despite that, though, the median price-to-earnings ratio for the group is 21 times the next 12 months' earnings – and nearly 27 times the past 12 months'. Those numbers aren't much different than those in July, 2013, the last time I took a broad look at the restaurant sector – when sentiment was much higher. That pricing – more steakhouse than fast-food value menu – makes it all the more difficult for investors to pick potential winners in the sector.
Let's first look at the restaurant stock scene. The story is much the same as in July, 2013 – Canadian restaurant stocks are dominated by dividend-paying income stories, while many of the most popular U.S. restaurant names are expensive, high-flying growth stories. But there's been a few changes to the offerings since then. Growth-oriented Restaurant Brands International Inc., the parent of Burger King and Tim Hortons, has designated a Canadian headquarters and TSX listing. Multibrand Cara Operations Ltd. went public, and, along with MTY Food Group Inc., they offer investors stories that de-emphasize the dividend (all yield around 1 per cent) in favour of the prospect of adding many more units, either in Canada or internationally.
The case for U.S. restaurant growth stocks is tied, perhaps unsurprisingly, to the country's large population: A successful regional chain can go public with more restaurants than a Canadian market leader like Boston Pizza, yet still have the majority of the United States untouched by its expansion. That thesis has kept P/Es for the sector high, as a company that does things right can (theoretically) be the next Chipotle, going from one store to more than 1,000 in a couple of decades. (We will set aside Chipotle's recent issues with food-borne illnesses for this example.)
The problem now, however, is that recent results for chains big and small have led many to question what, exactly, is wrong with the restaurant industry. Brett Levy of Deutsche Bank noted that results and sentiment "meaningfully softened" throughout the second quarter, with many companies providing "sluggish" outlooks for the second half of the year. Numerous companies reported a deceleration in same-store sales, the revenue figure that compares sales in locations open for at least one year.
"We would argue few companies offered convincing points of view on what is going on, why the weakness has materialized or where the industry is going, which has led to another quarter of restaurant stocks underperforming," Mr. Levy wrote in his "Menu Musings" wrap-up of the quarter. He writes that with "limited insight into when any meaningful rebound will begin (or how sustained the recovery will be)," earnings guidance for the remainder of 2016 has become more muted, and it's "increasingly difficult" for him to become more positive about restaurant stocks' near-term performance.
Gregory Badishkanian of Citigroup Global Markets Inc. says explanations for the "malaise" include the widened price gap between eating food at home versus eating out, "deal fatigue" at hamburger restaurants, lack of new products, tougher comparisons with prior periods (McDonald's, particularly, had a good 2015), macroeconomic concerns and election uncertainty.
When same-store sales weaken, the first stocks to get hit are the high-priced young growth stories that don't have the track record of operational excellence to fall back on. Two companies highlighted in my July, 2013, article, Noodles & Co. and Fiesta Restaurant Group, an operator of Caribbean and Tex-Mex concepts, are down 33 and 23 per cent, respectively, on the year, with Noodles & Co. now down nearly 90 per cent from its peak. (Analysts expect a loss for Noodles, so it has no forward P/E, according to Standard & Poor's, and Fiesta still has an 18 P/E.)
Other formerly hot names that are down but still expensive: Shake Shack, which has fallen nearly 10 per cent but has a 71 P/E; burger chain Habit Restaurants Inc., off 35 per cent but still sporting a 49 P/E; and Ignite Restaurant Group Inc., which went down in flames rather than ignite, to the tune of an 82-per-cent decline this year. (It also has no forward P/E.)
If there is a winner in the U.S. group, it is Panera Bread, the bakery/café chain that was one of the few to show sales strength in the second quarter, and a gain in its stock price since. Panera is trading near its all-time high, and, with a forward P/E of more than 30, investors are paying for the privilege of backing a winner.
In Canada, investors seem focused more on cash payouts, or the future growth narrative, than the most recent sales reports. Seven Canadian restaurant stocks are trading within 90 per cent of their all-time highs, but of those five, just two – Keg Royalties Income Fund and Boston Pizza Royalties Income Fund – picked up the pace of sales in the second quarter. (See table below.)
The other five reported slower same-store sales numbers when compared to 2016's first period, but some offered up other compelling stories, like an increase in payouts (Pizza Pizza Royalty Corp.) or international expansion (MTY Food Group's purchase of Baja Fresh Mexican Grill).
In all, it represents a potential case of indigestion for investors who are putting their money in restaurant stocks even as fewer of their friends and neighbours are using their free cash to actually dine out in them.