SIR #12: Quick Service Restaurants Poised for Even Quicker Decline

December 31, 2010
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EXECUTIVE SUMMARY:

Rising commodity prices are leading to increased costs – pressuring margins for restaurant operators.

• Modest sales growth in 2010 raises concerns about the sustainability of a consumer recovery.

• Investor sentiment is largely bullish.  Optimistic assumptions, and high stock multiples are pricing in the best-case-scenario.

• Three quick service restaurants are particularly vulnerable, and offer exceptional short opportunities:

  • Chipotle Mexican Grill (CMG)
  • Panera Bread (PNRA)
  • Yum! Brands (YUM)

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The past six months have featured an astonishing run for agriculture (or soft) commodities. Emerging market demand for food products, coupled with currency concerns have charged prices for ALL commodities – with grain, beef, poultry and other “soft” commodity experiencing particularly strong demand.

In China, the government is facing potential civil unrest, as inflation makes it extremely difficult for many families to afford food and housing.

A global population with a higher standard of living has triggered sharp increases in demand for resource-rich food supplies.  From an investment standpoint, this has created an environment for both winners and losers in the agflation environment.

At this point, a number of well-known quick service restaurants (QSRs) face a much more difficult business environment, and should wind up on the losing side of the agflation ledger in 2011.

Margin Contraction

Even in the best of times, operating a nationwide restaurant chain can be a challenging business.  Companies in this industry must decide whether they want to compete based on quality of the menu, or based on price.  As any Business 101 student understands, the low-price approach must lean heavily on volume – as each individual unit sold accounts for a minuscule profit margin.

When competing on quality, the business isn’t necessarily any easier.  Restaurants must adapt to fickle changes in customer taste, and in challenging economic periods they must still offer value to customers.  Diners may be willing to pay more for a healthier or tasty meal, but premium prices can discourage a large portion of potential customers.

Many QSRs attempt to offer something to premium customers as well as to the price-conscious diner – with premium sandwiches alongside “value menu” items.  But regardless of what approach each QSR chain takes to attract customers, each company is facing the threat of margin contraction in the coming year.

The sharp increase in soft commodity prices directly affects food costs.  A few well-managed companies have long-term supply contracts in place, or have hedged their exposure using commodity futures.  But as these hedges expire and contracts are re-negotiated, food costs will rise, and it will be difficult to pass the higher costs on to consumers.

If restaurants have little to no pricing power, and still must accept higher costs, the natural result will be tighter profit margins.  As restaurant companies begin to report Q4 earnings, and issue guidance for the coming year, investors should brace for less-than-optimistic news and sharply lower stock prices.

Sales Growth (or Lack Thereof)

In 2010, US consumers increased their frequency of dining out.  Many QSRs saw positive traffic patterns as a result of offering value menu items.  Even though profit margins were more constrained, the increase in revenue was a good trade.  Earnings began to recover from crisis levels and investors embraced the recovery story.

But 2011 could very well be a different story.  Consumer confidence has been improving over the past few months, but may be reaching a peak inflection point.  Unemployment remains high and several business surveys point to flat year end bonuses (despite improving corporate profitability).

To a large degree, the improvement in QSR sales has been driven by lower price points and better perceived value.  But with food costs picking up, restaurants may not be able to continue to offer these value items at current prices – and any price increase would invite customers to think twice before hitting the drive-through or walking through the burrito line.

It’s difficult to come up with a scenario that would allow restaurant companies to significantly increase revenue guidance.  A full-fledged economic recovery could provide some support…  but even then we would likely face destabilizing inflation trends that would affect profitability.

We are much more likely to see revenue growth continue at modest levels if the economy continues a slow rebound – and the potential for a contraction in year-over-year revenue is not out of the question for mature chains who already have a large geographic footprint.

The Potential for Disappointment

Despite the potential challenges, restaurant investors have been extremely optimistic.  Prices for QSR companies have been climbing as companies increase the number of domestic storefronts – and some have been expanding aggressively into emerging market venues.

Profit margins have held up relatively well as companies have cut the fat (pardon the pun) out of operations, and in some cases delayed cap-ex investments to keep stores remodeled and in top shape.

Barron’s recently noted investors are paying premium prices, expecting strong earnings growth to continue.  But with macro challenges still casting a shadow on the industry, the danger of disappointment is significant.

Premium multiples for growth stocks certainly have their place.  When a company is young and growing rapidly – and the economic environment supports this growth – it makes sense to pay up for the opportunity to participate in the growth.  But when the majority of traders and investors are caught leaning on the bullish side, with significant challenges mounting, stock prices become vulnerable and nimble traders become profitable.

Heading into the New Year, three QSR chains with premium prices look vulnerable.  All three have chart patterns that are beginning to break down.  And all three could fall a significant distance before value investors decide to step in and risk their capital.

So let’s take a look at these short opportunities…

Chipotle Mexican Grill (CMG)

Quality ingredients particularly vulnerable to commodity price increase.

Higher priced menu could be a liability if consumer confidence peaks.

EPS growth can’t keep up with previous rapid expansion period.

Premium stock multiple leaves plenty of room for disappointment.

In July we mentioned Chipotle as a vulnerable restaurant stock with a potential drop ahead…  While optimistic investors continued to push the stock higher, the fundamental concerns are still in play.  At this point, the only major change is the fact that CMG’s price is roughly 70% higher and investors are once again exiting positions, with the chart is looking “toppy.”

Chipotle has carefully managed their corporate image by focusing on “food with integrity.”  This means the company seeks to purchase commodities from ethical farming organizations, and is attempting to use organic beef, poultry and pork whenever possible.

Considering the rapid growth of the organization, purchasing foods that meet these high standards has become a significant challenge.  More importantly, as emerging economies compete for access to agricultural commodities, premium organic foods are going to command an even wider price differential.

Also because of the relatively tight supply of premium organic food, CMG could face a number of unexpected supply shocks in the coming months.  When a resource is in heavy demand, a small imbalance or unexpected event can have an exaggerated effect on near-term price points.

Speaking of prices, Chipotle’s menu is relatively simple, and at the high end of the price range for most QSR companies.  The management team wants to distance itself from the general QSR category, putting themselves closer to a “casual dining” operation.  Logistically, CMG offers a QSR layout and since prices reflect the premium ingredients – the company is vulnerable to any increase in consumer price sensitivity.

Up to this point, CMG has generated most of its growth from geographic expansion.  Same-store-sales growth have been attractive, but the real benefit is in opening new locations.  The company has plenty of cash to burn when it comes to paying for new store openings, but Chipotle is unlikely to get the same impact from new stores that they have experienced in the past.

Chipotle has already expanded into the majority of very attractive US cities and now faces challenges when determining where to invest its growth capital.  Of course there are plenty of additional locations available – and management is committed to continued geographic expansion.  But each new store should see weaker sales levels and tighter margins than store openings over the past three years.

Despite these challenges, the stock price still reflects significant investor optimism.  Analysts are calling for 21% EPS growth next year, with earnings coming in at $6.57.  With the stock priced near $220, investors are paying 33 times forward earnings – a premium growth value that more accurately reflects the company’s history than its future growth expectations.

If CMG simply meets analyst expectations with earnings growing in the low 20% bracket, I would expect the stock to eventually trade with a multiple in the low 20′s.  This would represent a stock price near $145 – or a 34% decline from the current price.

However, if CMG stumbles and fails to meet those expectations, all bets are off! Growth investors would likely flee the scene and momentum traders could pile on short exposure.  Suggesting the stock could break $100 may sound outrageous today, but if earnings are below $5.00 per share, and investors refuse to give the company a growth multiple, the level could easily be breached.

CMG is well off its high, printed in late November.  The stock is beginning to roll over and recently broke below the 50 EMA.  Momentum traders are likely questioning the wisdom in continuing to play this scenario, and of course value investors will view this stock as too expensive.  If CMG doesn’t find support soon, it could become one of the first casualties in what could be a dismal year for restaurant stocks.

Panera Bread (PNRA)

Modest sales growth creates challenge for 2011 earnings assumptions.

Investors are paying a premium growth multiple, and could be blindsided by any flaws in the company’s execution.

Stock momentum has slowed with key trendlines in jeopardy.  Broken technical support could ignite short interest.

Panera Bread has been a strong success story, posting robust earnings growth over the last decade, and maintaining strong performance even during the 2008/09 financial crisis.  The company has received accolades from mainstream media outlets including recent favorable press from Businessweek, Forbes, and the Economist.

Once again, store expansion has been a significant part of the company’s growth – with nearly 1,400 locations operational today.  Management will continue to aggressively expand its footprint with roughly 100 new locations expected to open in 2011.  But similar to Chipotle, aggressive expansion in the past means that the most attractive store locations are now in place, and it is becoming more challenging to find new opportunities with the same demographics that existing locations enjoy.

The Panera Bread management team is working to determine the best strategy for this new period in the company’s life-cycle… A period in which cash flow is abundant, and growth opportunities are more difficult to find.  With this in mind, management is aggressively repurchasing shares – spending roughly $80 million in the third quarter alone.  While there’s nothing particularly wrong with this approach, it DOES signal a lack of opportunity as management sees more value in buying shares, instead of more aggressive expansion.

Sales growth for PNRA has been surprisingly light – well below the 20% target growth rate for earnings.  In 2011, the company expects same-store-sales growth of 7% to 8% for stores open a year and a two year target of 11.5% to 13.5%.  This implies that management is counting on slightly increasing margins along with new store openings to supply a significant portion of expected earnings growth.

Management expects to be able to increase menu prices by about 1.5% during the coming year – a hike that will not likely cover increases in food costs.  So the expectations for 22% earnings growth in the coming year appear to be very optimistic and once again investors will be vulnerable to disappointment.

The stock is currently trading at about 23 times expected earnings for next year, which might appear to be reasonable at first blush.  But when you consider the risk to earnings growth, the light revenue increases over past quarters, and the potential for margin compression next year, the danger quickly becomes apparent.

If PNRA still continues to grow next year, but only increases earnings by 10%, EPS would likely fall below $4.00.  If this were to happen, the failure to meet expectations would be a wake up call to investors and traders, and the stock’s growth multiple would quickly contract.  Using a PE ratio of 15, and EPS of $4.00, PNRA could reasonably trade near $60 sometime in the next year.  This would represent a decline of 40% and still assumes growth for the company.

Of course, if PNRA sees earnings actually decline during 2011, the stock could be hit much harder.

At this point, the stock is only a few percentage points off its high logged in December.  But Tuesday’s action has pushed the stock below the 20 EMA, which has proven to be support for the stock since the August 1 breakout.  If traders cannot recover this line quickly, it could be a psychological defeat that would encourage momentum traders to exit their positions.

Keep a close eye on this growth darling as a true breakdown and a failure to hold $100 could set up a very attractive short trade.


Yum! Brands Inc. (YUM)

Anemic sales growth raises concerns over long-term earnings projections.

Exposure to emerging markets may turn out to be more of a liability than a growth opportunity.

Significant debt raises risk profile for the entire company.

If you look at the YUM stock pattern for the majority of 2010, you might confuse Yum! Brands with a small-cap growth stock.  After hitting a low of $32.49 in February, the stock tacked on 61%, topping out at $52.47 in early November.

However, despite the strong stock performance, YUM as a company has little fundamental strength. The past four quarters feature sales “growth” of  (negative 1%), 6%, 4%, and finally 3%.  The earnings figures are a bit better with growth of 9%, 23%, 16% and 4% respectively.  So despite flat sales increases, YUM has been able to cut costs and keep earnings moving modestly higher.

The environment in 2011 should make this feat a little more difficult.  Analysts are expecting earnings growth of 13% in 2011, but as food prices continue to march higher, YUM investors are beginning to hit the exits.

In order to keep earnings growing at this level, YUM will almost certainly need to increase prices by a significant amount.  This could be a difficult feat for franchises such as Taco Bell which cater to low-budget fast service diners.  Even higher priced KFC and Pizza Hut will likely face resistance from customers if menu prices are increased by any material amount.

When it comes to growth, YUM has significant exposure to emerging markets.  For the majority of 2010, the investment community saw this as an asset with China representing the primary growth engine for the global economy.  But as the PBOC begins to increase rates and policy makers attack inflation, YUM could see this strategy backfire.

Emerging markets may have provided the world with growth over the last several years, but deflationary effects on developed nations, coupled with rampant inflation across the BRIC investment block are causing investors to question long-term growth assumptions.

If YUM sees less growth from emerging markets, more competition in the US, and a weak consumer in Europe, then the stock could quickly give back the gains posted in 2010.  In fact, a stock multiple of 12 (reasonable for a mature enterprise like YUM) and no change to analyst estimates would still put the stock below $34.

At this point, investors seem unconcerned with YUM’s 300% debt to equity ratio.  As with most major risks, the liability simply doesn’t matter…  until it DOES matter.  Today, YUM has plenty of cash flow to service the debt, and management is willing to carry the leverage to accentuate returns and reinvest in EM expansion.

But this level of debt can quickly become a problem if margins are constrained by higher food costs, or revenues are hit by weak emerging markets.  The company doesn’t have to actually default on any of its debt for the stock to take a significant hit.  Just the threat of a liquidity crisis could set off alarm bells and in today’s environment investors are more likely to sell first and ask questions later.

Over the past several weeks, YUM has been trading in a very tight range.  Bullish investors are pretty much done accumulating shares, and are now waiting to see whether the emerging market storm will pass over or become a bigger problem.  A break lower would set off technical alarms and attract bearish traders.  At the same time, resistance is building between $50 and $52 – a level that will be difficult to breach without significantly positive news out of the company.

Higher commodity prices lead to tighter profit margins.  Emerging market weakness leads to modest growth or possibly a contraction in earnings.  And of course both of these major factors create an attractive environment to capture short profits.


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