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Restaurants Are Cooking Again

By Dennis Milton Growth appears to be back on the menu for the U.S. restaurant industry. An improving economy has allowed the group to recover from one of its weakest periods in recent memory. The rebound is particularly evident in strong same-restaurant (units open more than one year) sales comparisons for January to March, 2004, which reflected reduced price discounting in the fast-food segment and more moderate weather conditions than in 2003.

Another positive factor for the industry: a favorable cost environment. Historically low food costs and tepid wage inflation have helped maintain healthy profitability despite higher costs for employee health insurance and certain meat products.

FEWER DISCOUNTS. Although Standard & Poor's Equity Research thinks overall labor and commodity costs may trend upward in 2004, we expect profit margins to remain healthy. We believe that the improving economy will help to improve customer traffic throughout the industry, especially in the first half of 2004, when comparisons will be more favorable as the prior-year period was affected by poor weather and the start of the war in Iraq.

Despite our concerns regarding input costs, we retain a positive outlook for the industry in general. Demographic forces should continue to bolster demand in the casual-dining and quick-casual segments over the next several years. Meanwhile, diminished reliance on price discounting in the fast-food segment should allow profits to continue climbing from the weak results posted during late 2002 through the spring of 2003.

Over the past several years, fast-food sales gains have lagged those of the full-service sector, due in part to competition. Fierce price discounting was led by industry giants McDonald's (MCD) and privately held Burger King, both of which have since embarked on rebranding efforts, with varying degrees of success (see BW Online, 4/20/04, "A Tall Order for McDonald's New Chief "). This move away from promotional price discounting should benefit overall industry profitability.

EATING OUT MORE. The full-service restaurant industry has gained from a long-term trend toward eating out, driven by disposable-income growth, a decline in the price difference between dining out and cooking at home, and more dual-income as well as single-parent families. Despite recent economic weakness, demand has been strong, suggesting that casual dining is less sensitive to economic conditions than previously assumed.

Earnings at full-service restaurants in general have been bolstered by increased traffic, reduced costs, and leveraging of fixed costs against an expanding sales base. Many outfits have also moderated their expansion plans, promoting a more positive supply/demand relationship.

As a result, same-unit sales growth remained stable when the economy was weak. Since the beginning of 2002, companies have accelerated capital spending on new units. While S&P isn't concerned with oversupply in the near future, this trend bears watching.

HEALTHIER OFFERINGS. Another development to keep an eye on: The growth of "quick casual" limited-service or self-service restaurants, geared toward adults, which feature upscale menus that boast more than burgers and fries. These restaurants are already siphoning business from fast-food chains, although no accurate way exists to measure how much. Limited-service chains favor investment in the quick-casual concept because it offers diversification from their existing business models.

Also, many restaurant chains, in response to strong customer demand -- and perhaps in an attempt to insulate themselves from potential liabilities -- have begun offering healthier foods and increasing their low-calorie and low-carbohydrate offerings. The fast-food industry has seen even more dramatic changes, perhaps because it has the most to lose from consumer perceptions regarding the healthfulness of its food offerings and potential lawsuits.

Investors also need to keep abreast of new and proposed legislation throughout the U.S. concerning smoking in restaurants -- and worker compensation -- that may affect profitability or alter current corporate expansion plans.

What stocks does S&P like at the moment? Our top selection in the group is P.F. Chang's China Bistro (PFCB), which carries S&P's highest investment ranking, 5 STARS (buy). We're also positive on Krispy Kreme Doughnuts (KKD), Panera Bread (PNRA), Rare Hospitality (RARE), and Ryan's Family Steak House (RYAN), each of which is ranked 4 STARS (accumulate). McDonald's is ranked 3 STARS (hold). Analyst Milton follows stocks of restaurant companies for Standard & Poor's Equity Research

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