Traders Eat Up Restaurant Stocks on Growth Bet: EcoPulse

Shares of full-service restaurants are leading other consumer-discretionary companies, a sign investors are betting Americans will spend more on dining out.

The Bloomberg U.S. Full-Service Restaurant Index -- comprising Brinker International Inc., Darden Restaurants Inc. and 19 other companies -- has risen about 10 percent since Feb. 15, compared with a 4.5 percent increase for the Consumer Discretionary Select Sector Index, which includes Target Corp., Walt Disney Co. and 80 other members. That follows almost nine months when restaurant stocks lagged behind their discretionary peers by about 15 percentage points.

Investors are looking beyond a recent spate of weak same-restaurant sales to “catalysts that could drive top-line growth during the rest of this year,” said Bryan Elliott, an analyst in Atlanta at Raymond James Financial Inc. “The news has been bad, but the stocks are outperforming,” which shows increased confidence about investing in this industry.

Restaurants see improvement as “sales risks seem to be falling and inflation is lessening,” Elliott said. That’s because potential diners are adjusting to higher payroll taxes and the industry is facing easier comparable sales, along with falling commodity prices, he said.

Declining Sales

Darden has outpaced the consumer-discretionary index by 2.4 percentage points since Feb. 21, the day before the Orlando-based company pre-announced a decline in sales at restaurants opened more than 16 months for its fiscal third quarter compared with a year earlier. Cheesecake Factory Inc. has led the broader index by 8.8 percentage points since Feb. 20, when it reported fourth-quarter earnings and revenue that missed analysts’ estimates. The Calabasas Hills, California-based company is scheduled to release first-quarter results April 24.

Higher payroll taxes and gasoline prices helped “destroy” consumers’ willingness to eat out earlier this year, Elliott said. Paychecks shrank after Congress and President Barack Obama let the tax that funds Social Security benefits revert to 6.2 percent from 4.2 percent. A gallon of regular unleaded is up about 23 cents since Dec. 31, though prices have fallen 7.1 percent since peaking at $3.79 on Feb. 26, based on data from Heathrow, Florida-based AAA, the largest U.S. motoring organization.

‘Feeling Squeezed’

As a result, many Americans still are “feeling squeezed” in what’s become an “allocation nation,” where consumers choose between discretionary items to purchase each month, said Malcolm Knapp, a New York-based consultant who created the Knapp-Track Index and has monitored the industry since 1970.

This has pressured Darden’s customers; the company reported March 22 that same-restaurant sales fell 4.6 percent at its Olive Garden, Red Lobster and LongHorn Steakhouse chains in the three months ended Feb. 24.

Even so, restaurant stocks in March traded above previous highs set in February and late last year relative to the consumer-discretionary index, signaling a positive sentiment shift among traders, said Jim Stellakis, founder and director of research at Greenwich, Connecticut-based research company Technical Alpha Inc. and also a chartered market technician. “Investors are taking a glass-half-full approach to these stocks as they continue to allocate money to them since they broke above that resistance level.”

Low Expectations

Amid “extremely low expectations” for the industry, many restaurants could offer a “better risk-reward” than other components of the consumer-discretionary index, said Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at the private-banking unit of KeyCorp in Cleveland. These companies have “at least some chance” of overcoming the pessimistic outlook that’s already been “baked into prices,” particularly if other living expenses decrease, leaving consumers with more spending money, he said.

While Darden and Cheesecake Factory missed earnings forecasts, the flow of money into these stocks hasn’t slowed, Stellakis said. “People are shrugging off these bad reports because they thought results were going to be a lot worse.”

Sales at casual-dining establishments rose 2.2 percent in March, snapping the worst three consecutive months of sales since 2010, according to the Knapp-Track Index of monthly restaurant sales. Traffic grew 0.7 percent in March after falling 5.9 percent the prior month, driven in part by “huge, unsatisfied demand” among would-be diners who weren’t eating out as often as they’d like, Knapp said.

Rotating Options

Household budget constraints have forced people to “rotate from one type of discretionary spending to another” with options including restaurants, recreation and home maintenance, McCain said. “When they free up money, they look for what has the greatest bang for the buck.”

While that re-allocation principle has benefited restaurants recently, it could turn back into a headwind. Income gains and job creation are the two primary drivers of sales, though “a bunch of wild cards” remain, including budget debates in Washington, Knapp said.

Employers added 88,000 workers in March, less than half the 190,000 forecast in a Bloomberg survey of economists, data from the Labor Department show. Retail sales unexpectedly fell 0.4 percent last month, the most since June, following a 1 percent gain in February, based on Commerce Department figures. The sales data prompted economists to trim spending forecasts.

Attracting Investment

Restaurant stocks still are attracting investment as their demand environment improves amid declining food prices, Elliott said. He upgraded Brinker to outperform from market perform on April 3 in part because it will reap efficiency gains from operating initiatives such as new kitchen equipment, while delivering “solid” earnings growth and dividend increases. The Dallas-based company is scheduled to report fiscal third quarter results on April 23.

“These companies have pretty solid business models despite volatility in the industry,” Elliott said. “It’s more stable than investors gave it credit.”

Some investors have experienced a “melt up” from an “extreme level of bearishness” to one that’s less pessimistic, said Larry Miller, an analyst in Atlanta with RBC Capital Markets. That’s reflected by increased exposure in their portfolios to full-service companies, which are more “offensive-oriented and pro-growth.”

About 30 percent of investors surveyed by RBC said they’re currently underweight full-service stocks, down from 60 percent the prior month.

“People are making earlier bets on an improvement in the macroeconomic backdrop that will allow same-store restaurant sales to improve,” Miller said, adding that industry data should support this shift within the next few months. “When everyone’s bearish, there’s only one way for the stocks to go: up.”