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Get Four
|  | OCTOBER 5, 2004
 INDUSTRY IN FOCUS By Dennis Milton Tasty Choices for Investors S&P gives restaurants a good review, based on the trend of eating out and plumper projected sales as operators rely less on discounting What's on the menu for the U.S. restaurant industry? Standard & Poor's Equity Research Services projects steady but more moderate growth for the rest of 2004 and throughout 2005. We believe the solid growth projections for the U.S. economy will help maintain strong customer traffic throughout the industry. However, growth rates for same-store sales should moderate in the second half of 2004 and the first half of 2005, despite menu price increases, as it will be difficult for results to keep pace with the strength seen in prior periods. We expect profit growth to lag revenue expansion, however, due to continued input-cost pressures. While we expect poultry and dairy prices to retreat from the historical highs reached in the 2004 second quarter, food costs in general are likely to settle at higher levels than in previous years due to strong worldwide demand and rebuilding of low inventory levels. PRICIER MENUS. In addition, many of the casual-dining operators that had avoided steep increases in food prices by locking in year-long contracts will see their costs ratcheting up significantly as they renegotiate their lock-ins going forward. Despite our concerns about input costs, we retain a positive outlook for the industry in the long term. Demographic forces should continue to bolster demand in the casual-dining and quick-casual segments over the next several years. Meanwhile, increased reliance on premium products and less discounting should help fast-food outfits realize stronger sales growth and improved operating margins. To relieve some of the margin pressure created by increased food costs, many restaurant operators have significantly raised menu prices in 2004. Driven by an improved economy and strong menu innovation, customer traffic strengthened during the first several months of the year, despite the price hikes. CO-OPTING RIVALS. Since May, however, same-store sales growth has slowed. We believe this is due to the anniversary of last year's tax cuts, rising fuel costs that have eaten into consumer budgets, and severe weather in certain regions of the country. Recent hurricanes have forced store closings and dampened customer traffic along the Eastern seaboard, while flooding has been an issue in other parts of the country. Over the past several years, fast-food sales gains have lagged those of the full-service sector. During this period, fast-food market share was being eroded by new "quick-casual" concepts, which offered unique new food products. With a perceived higher level of food quality and service and despite higher price points, quick-casual operators like Panera Bread (PNRA ) were able to attract consumers, increasing the intense pressure on the fast-food industry. Fast-food players began to respond to the competitive threat from quick-casual concepts in 2001 and 2002 by co-opting them. Throughout the industry, larger fast-food operators purchased smaller quick-casual outfits to capture growth in this segment. LESS ECONOMICALLY SENSITIVE. Wendy's (WEN ) led the charge toward premium fast-food products with its highly successful salad offerings, which debuted in 2002. Last year, industry titans McDonald's (MCD ) and privately-held Burger King, both under new management teams, followed suit with their own premium products, changing the tenor of the entire industry. While the companies lowered their everyday prices for some of their more prominent products, their move from promotional discounting toward product innovation has significantly benefited overall industry profitability. This year, new products like Jack-in-the-Box's (JBX ) Pannido sandwiches (on ciabatta bread) and new hamburger products featuring Angus beef from Burger King and Hardee's are leading the industry drive to "upscaling" and are producing strong revenue growth. The full-service restaurant industry has benefited from a long-term trend toward eating out, driven by growth in disposable income, a shrinking price difference between dining out and cooking at home, and gains in the number of dual-income and single-parent families. Despite a weak U.S. economy over the past few years, demand remained strong in the sector, leading us to conclude that casual dining is less sensitive to economic conditions than previously assumed. From 2000-2003, sales at casual-dining restaurants increasing at an estimated compound annual growth rate of 4%. APPEALING BITES. Like the rest of the industry, same-store sales for casual-dining concerns were very strong in the first months of 2004 but slowed in the late spring and summer months because of restrained consumer spending and higher fuel costs, which have crimped family budgets. Furthermore, surging costs for commodities such as poultry, pork, and dairy products have eroded profit margins. Which companies does S&P's like in the group? Our top pick among restaurnant stocks is P.F. Chang's (PFCB ), which is ranked 5 STARS, or buy. Of the other outfits mentioned in this report, Wendy's and Panera Bread are each is ranked 4 STARS (accumulate), while McDonald's and Jack-in-theBox are each ranked 3 STARS (hold). Required Disclosures As of June 30, 2004, SPIAS U.S. research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings. 5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis. 4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis. 3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis. 2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain. 1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis. All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Other Disclosures This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company. SPIAS is affiliated with other entities, which may receive compensation for performing services for companies covered by Standard & Poor's Equity Research Services. Disclaimers This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.  Analyst Milton follows stocks of restaurant companies for Standard & Poor’s Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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