The companies to be concerned with right now aren't necessarily those with exposure to China reporting dreadful results such as Alcoa (AA); it's actually a sector that dots the U.S. landscape only.
Profits at major sit-down restaurants and fast eateries are under siege. Wall Street's estimates are starting to trickle lower for the fourth quarter of 2015 and fiscal 2016, and P/E multiples are being reined in.
The reasons for this -- which admittedly I did not appreciate earlier in the year -- are several. Minimum wage costs are on a steady climb across the country. The starting rates that servers and cooks are demanding in high cost of living states such as New York and California are increasing, and are well above adjusted minimum wages.
The cost of beef remains elevated, and not every chain is going to pursue cheaper chicken or pork dishes, as sometimes they don't make sense for the consumer demographic. Egg prices continue to be high as well, due to the wiping out of tons of sick birds earlier this year. The problem stemming from that is that it has turned once highly profitable breakfast hours into losses for many fast food establishments. Rent costs are on the upswing, too, as fast casual players such as Chipotle (CMG) and Shake Shack (SHAK) pursue aggressive expansion initiatives.
In turn, restaurants are pushing through some serious price increases. Even still, the price increases are not offsetting the higher costs of doing business. Just take a look at Dunkin' Donuts (DNKN), which issued a bad sales warning last week as traffic slowed due to price increases implemented by worried franchisees. Domino's Pizza (DPZ) had another stellar quarter in the U.S., with a 10.5% increase in same-restaurant sales. Yet, a combination of stubborn costs in the U.S. and foreign currency translation took a chunk out of the bottom line.
The reality is that the market is realizing the very structure of the restaurant business is crumbling -- except those upstart companies such as a Blaze Pizza that could command premium prices for their unique menus (unique for now; after a while the novelty will wear off and they, too, will be susceptible to structural shifts in the industry). Ultimately, I think restaurants will have to start closing a good number of locations over the next five years to keep costs under control.
Shares of the biggest names in the space have come under considerable pressure since minimum wage increases swept across the country in the summer. Here are the three names I would be most concerned about.
- Denny's (DENN): the company has been performing well this year, posting a gain of more than 7% in same-store sales in the second quarter. Profit margins expanded nicely, too. But I think the market continues to be too optimistic on the name, given the high costs for eggs and the increased wage costs that are going to weigh on company-owned store profit performance.
- Brinker International (EAT): have not been impressed with the company's traffic results at Chili's and Maggiano's of late. Furthermore, the company's same-restaurant sales at Chili's, while remaining in the positive, have lagged several key competitors. Coupled with the rising cost environment, I think the stock has further room to the downside.
- Red Robin Gourmet Burgers (RRGB): the company's stock is priced for high growth, but an argument could be made that it hasn't delivered that high growth. Same-restaurant sales rose decently in the second quarter, but there were better performances in the sector from comparable companies. I am concerned about how much further the company can push up its already pricey burgers to compensate for elevated beef costs and rising employee wages. Further, the company's restaurant base is mostly company-operated rather than franchised, which puts it at risk of having to directly absorb the higher costs of doing business.