February 11, 2016 / 5:33 PM / 2 years ago

After big selloffs, a second take on restaurant shares

NEW YORK (Reuters) - Restaurant stocks have sat like dry toast for the last six months, but investors are now starting to nibble back into the sector.

An El Pollo Loco restaurant is shown in San Diego, California, in this file photo taken May 13, 2015. REUTERS/Mike Blake/Files

After aggressively buying restaurant shares early in 2015, investors started dumping them midyear on fears that the industry was spread too thin. The public appetite for eating out was not expanding as fast as the industry itself and an anticipated bump in sales based on gasoline savings was not as big as expected.

Now, after more than a dozen restaurant companies - including El Pollo Loco LOCO.O, Cosi COSI.O, Famous Dave’s of America DAVE.O and trend leader Shake Shack SHAK.N - have lost more than half their value, some investors are coming back around.

“We are getting close to an investment opportunity in restaurant stocks,” said Bryant Evans, portfolio manager at Cozad Asset Management in Champaign, Illinois. He just bought into Darden Restaurants DRI.N, which owns the Olive Garden chain and is down almost 14 percent from last July, and pays a 3.4 percent dividend.

THE FUTURE IS BRIGHT, BUT ...

There are signs of a pick-up in the restaurant industry, with December sales up 7.5 percent from the same period a year earlier, according to Census Bureau data. Sector employment has been expanding as well; in January it was up 3.5 percent from January 2015, according to preliminary Labor Department data.

But investors need to choose wisely. Higher employment spells greater labor costs for an industry on the front lines of the battle for a higher minimum wage. Consumers have been tight with their gasoline savings. And the industry may have gotten ahead of itself.

“Overall sales in the industry are fine but it is being spread out over so many more restaurants that it is very challenging and competitive to drive same store sales and traffic,” said Andy Barish, a San Francisco-based analyst with Jefferies.

Fewer than three in 10 restaurant operators expect to have higher comparable sales in six months, according to a survey from the National Restaurant Association, the lowest level in more than six years.

SELECTIVE ORDERING A MUST

Few expect the next move in restaurant stocks to resemble early last year, when Shake Shack went public, doubling in price in its first four months.

Investors aggressively bid up shares then, inspired by data showing that consumers were starting to spend more in restaurants than on groceries. A sign that the excitement was reaching a peak may have come in October, when The Restaurant exchange traded fund BITE.O came to market.

Reality bit. Shares fell, in some cases sharply. At least one company - sandwich chain Jimmy John’s - pulled its IPO late last year. The Restaurant ETF peaked on its opening day and has fallen 12 percent since.

Now, shares are far lower than they were, but still not exactly cheap. The 41 restaurants in an industry index .TRXFLDUSPREST on average sport share prices 26 times earnings over the past year, making them more expensive than the S&P 500, which is trading at roughly 17 times, according to Thomson Reuters data. The index as a whole has fallen 6.5 percent from a Feb. 1 high, compared with a 3.7 percent decline in the S&P over that period.

Some, such as McDonald’s Corp MCD.N, trading near its all-time high on the popularity of its all-day breakfast menu, have outperformed.

Others have faced trouble. Wendy’s WEN.O shares fell the most in a year on Tuesday, even as it reported quarterly sales that beat expectations.

Investors seeking value in that space are looking at dividends: Cracker Barrel CBRL.O, Bob Evans Farms BOBE.O, DineEquity DIN.N, Darden and McDonald’s all yield more than 3 percent.

To reward investors long term, however, restaurants will have to win market share from their competitors without discounting away their profitability.

“That’s the challenge for the industry over the next couple years, to absorb some of this growth,” said Barish. “We’re seeing a very competitive pricing environment right now.”

Reporting by Rodrigo Campos; Editing by Linda Stern and Steve Orlofsky

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