US Restaurant Industry Stuck In Worst Collapse Since 2009

One month after we reported that the "restaurant industry hasn"t reported a positive month since February 2016", we can add one more month to the running total: according to the latest update from Black Box Intelligence"s TDn2K research, in June both same-store sales and foot traffic "growth" declined once more, dropping by -1% and -3%, respectively, extending the longest stretch of year-over-year declines for the US restaurant industry to 16 consecutive months - the longest stretch since the financial crisis - with sales rising in 45 markets while declining in 150 with Texas, the worst region in the US, suffering a 2.2% and 4.1% decline in sales and traffic respectively.

Source: TDn2K

As Black Box adds, "bad news is same-store sales and traffic growth were still negative in June and the second quarter of 2017; and year-over-year, same-store sales have been declining for the last six consecutive quarters."

While there was some offsetting "good news", namely that "June results were the best for the industry for both sales and traffic growth since January" - in other words a 3% decline in traffic is now spun as "good" -  it may have been due to a calendar effect and certainly was not enough to offset growing concerns about the relentless deterioration in the space.

“This is likely the result of a combination of factors,” commented Victor Fernandez, Executive Director of Insights and Knowledge for TDn2K. “While economic indicators have been pointing to some improved conditions this year, the reality is that we are also lapping over some weak results in 2016 which make the comparisons much easier for the industry in 2017.”

More importantly, on a topic that is especially dear to the Fed"s heart now that inflation has missed for 4 consecutive months, average guest checks grew at the same rate in Q2 as Q1, or 2.2%, still unable to offset the decline in overall traffic. What is concerning is that check averages have been growing more slowly since 2015, when the average check was up 2.8%, well above core inflation.

And in the biggest red flag for the Fed, Black Box" Fernandex confirmed that the Fed"s fears about lack of pricing power, at least in the restaurant sector, are justified, as “brands seem to be reluctant to implement significant price increases given the current environment." Making matters worse, in order to boost traffic, "price promotions have been widely utilized, especially by struggling brands and segments” said Fernandez. “Average guest checks for the ‘bar and grill’ sub-segment of casual dining remain flat year over year for the first two quarters of 2017, while casual dining overall has seen its guest checks grow by only 1.2 percent.”

According to Joel Naroff, chief economist at TDn2K, while employment continues to grow at a robust pace, a disconnect has emerged as "consumption, meanwhile, has slowed and vehicle sales have faltered." This is also evident in the latest retail sales data which has been on a steady decline for the past two years.

... a fact corroborated by Bank of America"s internal spending data:

In an effort worthy of a Fed economist, Naroff tried to spin that data, saying that "this is good news for other retail sectors, including restaurants, as credit growth is moderating. The rise in debt payments has funneled money from spending on other goods and services." Odd, it"s almost as if he is saying that savings and living within one"s means - two ideas that are anathema to any Keynesian - are... good. Still, he does admit that while the outflow from restaurants is ending, "an uptick in demand has yet to appear.”

Digging through the data, reveals that the decline is not uniform, and that affluent consumers are enjoying the recent promotional scramble, responding positively to those brands that provide a more experience-driven dining occasion. "Fine dining was the best performing segment based on same-store sales growth in the second quarter, followed by upscale casual. These were the only two segments with positive sales. They were also the top performing segments in the first quarter."

Here, too, a problem emerges because as the report admits, the ranks of the "affluent" are not growing: even those segments with positive growth in their same-store sales are doing so through increases in average guest checks and not through driving incremental guest visits.

In fact, all segments experienced a fall in their guest counts year over year during the quarter. The deteriorating traffic was attributed to increased competition for dining from within the industry (independent operators) and from other sectors (grab-and-go prepared food options, meal replacement kits, and other players like convenience stores and food trucks) which continue to grab additional share from traditional chain restaurants. The weakest segments based on second quarter results were fast casual and the ‘bar and grill’ sub-segment within casual dining.

Meanwhile, in a potential threat to the likes of McDonalds and Shake Shack, quick service, which was the top-performing segment in 2016 and was among the top three segments in 2015, is now struggling to keep up building on that rapid growth. The segment has now experienced three consecutive quarters of negative same-store sales growth, although one wouldn"t know it by looking at McDonalds" share price.

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Ironically, in addition to challenges from falling guest counts, the inability to pass through price increases, rising competition and declining overall spending, strong challenges continue to confront restaurants in both staffing and retaining enough qualified workers. We say ironically, because as we showed after the latest jobs report, restaurant/fast food/waiter/bartender hiring remains the only strong spot in the US labor market. As the chart below shows, starting in March of 2010 and continuing through June of 2017, there have been 89 consecutive month of payroll gains for America"s waiters and bartenders, an unprecedented feat and an all time record for any job category. Putting this number in context, total job gains for the sector over the past 7 years have amounted to 2.4 million or over 14% of the total 16.7 million in new jobs created by the US over the past 89 months.

And yet, according to BlackBox, restaurant operators are pessimistic regarding the difficulty of recruiting in the upcoming quarters. According to TDn2K’s People Report, when it comes to finding enough qualified employees to staff the restaurants and retaining them once they are hired, the industry is still facing an uphill battle with rolling-12-month restaurant hourly employee turnover increased again in May. Turnover for restaurant managers is also on the rise and is tracking at a 10-year high, with brands reporting that the majority of applicants are coming from competing restaurants.

And while one has yet to see it emerge in average hourly earnings, the result is - at least according to Black Box - pressure on restaurant wages, "which are expected to increase in the upcoming quarters." Almost 75% of restaurant companies report that they are offering higher wages as an incentive for potential employees.

Meanwhile, as the restaurant industry is stuck in its longest slump since the "second great depression", US consumer spending continues to decline, with declines not just across the chain restaurant space, but also at food and beverage stores...

... hammered by rising healthcare, housing and college costs, even as the broader US population is now burdened by a record $1.4 trillion in student loans.

In such an environment restaurants - from mediocre QSRs to the upscale sector - will continue facing challenges in both traffic and pricing.

As Black Box" Naroff concludes in an attempt to put a silver lining on the situation, "the summer season should be solid as people have money to spend. Unfortunately, until wage gains improve, which so far continue to be disappointing, no major acceleration in spending at restaurants should be expected.”

McDonalds Is Replacing 2,500 Human Cashiers With Digital Kiosks: Here Is Its Math

The stock market is luvin" McDonalds stock, which has continued its recent relentless rise to all time highs, up 26% YTD, oblivious to the carnage among the broader restaurant and fast-food sector. There is a reason for Wall Street"s euphoria: the same one we discussed in January in "Dear Bernie, Meet the "Big Mac ATM" That Will Replace All Of Your $15 Per Hour Fast Food Workers."

In a report released this week by Cowen"s Andrew Charles, the analyst calculates the jump in sales as a result of the company"s new Experience of the Future strategy which anticipates that digital ordering kiosks (shown above) will replace cashiers in at least 2,500 restaurants by the end of 2017 and another 3,000 over 2018. Cowen also cited plans for the restaurant chain to roll out mobile ordering across 14,000 U.S. locations by the end of 2017 (we did not show that particular math, but the logic was similarly compelling).

Here is a snapshot of the math that Cowen, likely in conjunction with management, used to come up with the cost-savings as McDonalds increasingly lays off more and more minimum wage workers and replaces them with "Big Mac ATMs"

MCD is cultivating a digital platform through mobile ordering and Experience of the Future (EOTF), an in-store technological overhaul most conspicuous through kiosk ordering and table delivery. Our analysis suggests efforts should bear fruit in 2018 with a combined 130 bps contribution to U.S. comps. We believe mobile ordering better supplements the drive-thru business where 70%+ of U.S. sales are transacted. In our view, MCD"s differentiation lies in the operational enhancements of mobile ordering that includes curbside pick-up of orders in order to not disrupt the drive-thru.

Below we show Cowen"s full math laying out why the restaurant chain"s client-facing fast food workers are now obsolete:

We are most excited for mobile ordering, Experience of the Future and the launch of fresh beef to help drive U.S. same store sales in 2018. We provide analysis for the latter three, which cumulatively we expect to contribute roughly 150 bps to U.S. same store sales in 2018, respectively. This gives us confidence to raise our 2018 U.S. same store sales forecast from 2% to 3%, in excess of Consensus Metrix’s 2.5%.

Experience of the Future Features Lower ROI Than Mobile Order, But Offers Greater Potential Longer Term

We are constructive on the use of guest facing technology for the restaurant industry. MCD’s longer-term U.S. story revolves around Experience of the Future (EOTF), a holistic operational and technological overhaul to the store base. MCD’s March 2017 investor meeting centered around the initiative with interactive displays. Perhaps the most conspicuous piece of Experience of the Future lies in digital kiosk ordering, which have seen success in International Lead Markets. Additionally, food ordered via the kiosk is delivered to the customer’s table. We believe EOTF better enhances the instore experience, which represents roughly 30% of domestic sales compared to mobile ordering, which allows customers to avoid leaving their cars.

Our ROI math suggests EOTF leads to a 9% cash/cash return in Year 1 in the 55% of domestic stores that do not require a store remodel, and 5% in the 45% of stores that require a remodel, which is a predecessor to implementing EOTF. Our math is premised on total costs of $150,000 for the Experience of the Future enhancement, and $700,000 of all-in costs when including EOTF as well as a store remodel. MCD has offered to pay 55% of the cost for Experience of the Future, in excess of the 40% the company contributed to the store remodel initiative beginning in 2010, for restaurants that commit to the program by the end of 2017.

McDonald’s targets a high-teens return on incrementally invested capital (ROIIC, or McSpeak for evaluating ROI), improving to the mid-20% range beginning in 2019. We believe EOTF’s ROI is captured over time as the sales lift does not dissolve as in the case of a traditional restaurant remodel. Rather, the lift should sustain as we expect consumers to increasingly embrace technological change. This is evidenced across concepts, such as Panera’s experience with 2.0, as well as McDonald’s own experience in Canada, where kiosks saw 12-13% sales mix in Year 1 and 27% in Year 2. We also note kiosk ordering will also likely lead to labor savings over time which should help boost ROIIC, but is unlikely for the foreseeable future.

In 2017, MCD expects to end the year with EOTF offered in 2,500 domestic locations from 500 at 2016-end. MCD targets the majority of domestic locations to feature EOTF by 2020, but has not given intermediary targets. The amount of stores adding EOTF depends on franchise reception to the initiative but we see positive indicators given our checks as well as the company’s disclosure that 90% of franchisees approved of the initiative after taking the same interactive tour that was given at the March 2017 investor day.

We estimate 3,000 locations to add EOTF in 2018, which should lead to a 70 bps contribution to U.S. same store sales assuming an even cadence of restaurants adding the initiative over the course of the year. Further we assume the mix of stores adding EOTF in 2018 reflects the mix of overall stores needed to add EOTF, or 55% of stores that already have a remodel while 45% require a store remodel. McDonald’s  has previously announced plans to remodel 650 restaurants in 2017, which we expect will also add EOTF.

Summarizing all of the above: the workers you see in the photo below are now an endangered species.

The Marlboro Red Consumer Sentiment Indicator

After last earnings season I noted without a strong rebound in consumer spending, I expect aggregate earnings growth to slow later this year (especially if declining energy prices cause credit to tighten). While asset inflation remains unchecked, consumer spending does not appear to be responding or accelerating. Two consumer companies on my possible buy list announced earnings this week – both suggest the operating environment remains challenging.

Casey General Stores (CASY), the convenience store operator, reported results on Monday with sales and earnings that were less than expected. Specifically EPS declined to $0.76 from $1.19 during the quarter and $4.48 vs. $5.73 for the year. During the quarter, same-store fuel gallons declined -0.5%, while grocery same-store comps increased 1.5% and prepared food/fountain comps were up 3.2%.

Management noted that similar to others in its sector, Casey’s “experienced downward pressure on customer traffic which had virtually impacted same-store sales across all of our categories.” Management blamed decelerating customer traffic on the weak agricultural economy, the difference in food away and food at home prices, and competitor promotional activities.

Management commented further on the agriculture economy saying, “The USDA anticipates either a flat to slightly declining farm income in calendar 2017. So we’d anticipate this piece of the challenging environment to continue to at least to the end of the calendar year.”

Labor costs were also discussed, with management calling labor very tight and wage pressures challenging. I thought the following comment was interesting, “It’s not uncommon for people to jump ship for $0.25 raise here and there, and so that has been a challenge.”

One of my favorite economic reports, the Marlboro Red Consumer Sentiment Indicator (MRCSI), was mentioned again this quarter and continued to suggest the consumer remains cautious.

Management commented, “I mean one of the things that we faced in the cigarette category, we do see, albeit it’s gradual but it’s been continuing for the next several quarters, a movement away from carton to pack purchasing. We’ve also seen it moving away from full value purchasing to a more discounted brand, which could be a generic brand.”

And finally, management had some interesting comments on their fiscal 2017 expectations versus actual results. Management explains, “…there’s no question that when we put our goals out for fiscal 2017, I’m not sure we fully anticipated the customer response, the consumer response I should say in relation to the economic conditions.” Management went on to note they are taking economic conditions into account more this year than they did last year.

Although Casey’s stock declined 8% on the news, trading at 18x EV/EBIT, it continues to trade over my estimated business valuation. Casey’s is one of the many high-quality companies I follow and like, but in my opinion, remains too expensive to generate future adequate absolute returns. Hence, it remains on my possible buy list, but not in my portfolio.

United Natural Foods (UNFI), the distributor of natural and organic foods, also announced earnings results this week. Although results appeared as expected, annual sales guidance was revised lower and its stock declined -4%.

Management noted the grocery environment remains challenging (side note: Isn’t it interesting restaurants often blame grocery stores for taking market share, yet grocers continue to struggle? Maybe it’s not where the consumer is spending, but how much the consumer has to spend).

Specifically, management stated,

“Net sales finished below our expectations in the third quarter driven by broad-based retail softness, the rationalization of business in conjunction with our margin initiatives and lack of inflation.”

“Same-store sales in many of our retail customers were under pressure or negative during the quarter. Our retail customers are facing competitive pressure not only from other food retailers but also from many channels now carrying assortment of better-for-you products.”

“…when you look at general same-store sales and year-over-year, quarter-over-quarter, many of the retailers across most of the channels are facing some real headwinds in terms of growth. And as part of that, we’ve seen certainly a fair number of store closings as retailers are coming together. And so in the near term, that’s been a real headwind for us.”

Kroger reports next week, hopefully providing us with more useful grocery and consumer data points. That said, for those waiting for the consumer to get the U.S. economy out of its 1-2% growth funk, further patience may be required. From a bottom-up perspective, I’m not seeing it.

US Restaurant Industry Suffers Worst Collapse Since 2009

What tentative hope had emerged for a rebound for the U.S. restaurant industry at the start of the year, was doused last month when in its February Restaurant Industry Snapshot, TDn2K found that "Restaurant Sales and Traffic Tumble in February" and reported that same-store sales fell -3.7% in February, with traffic declining -5.0% . It did however leave a possibility that things may turn around as a result of the prompt disbursement of withheld tax refunds in the month, which it suggested may have adversely affected sales and traffic.

Alas, that did not happen, and restaurant struggles continued in March as sales and traffic again declined year-over-year: same-store sales were down 1.1% while traffic dropped 3.4%. March results were disappointing for an industry desperately trying to reverse performance trends; with sales now negative in 11 out of the last 12 months, the longest stretch since the financial crisis. There was a modest improvement sequentially, however, and while still negative, sales improved by 2.5% points compared to February as traffic rose marginally by 1.6%.

Explaining the sequential "improvement", Victor Fernandez, executive director of insights and knowledge for TDn2K, said “March sales were expected to be somewhat better than February due in part to the catch-up of tax refunds that were initially delayed in February. In addition, the industry likely benefited from the shift in the Easter holiday, which fell in March in 2016. For the largest segments (quick service and casual dining), this holiday represents a potential loss of sales."

However, it was not enough: “The fact that sales were still negative in March given these tailwinds highlights the challenge chains have faced since the recession. Factors like restaurant oversupply and additional competition for dining occasions continue to take their toll on chain traffic.”

As TDn2K further adds, with a same-store sales decline of 1.6%, the first quarter of 2017 was the fifth consecutive quarter of negative results. The last time the industry experienced a similar period was in 2009 and the first half of 2010, as the economy began recovery following the recession. Only this time the move is in the opposite direction. 

Furthermore, the first quarter of 2017 followed a very disappointing 2.4 percent sales drop in the fourth quarter of 2016, highlighting the difficult operating environment currently facing many operators.

Worse, same-store traffic dropped even more, or -3.6% in Q1, consistent with the average -3.4% quarterly declines experienced since the beginning of 2016.

The growth rate in check average continues to trend down slowly. For the first quarter of 2017, the average check was up 1.9%, somewhat lower than the average 2.3%growth reported for 2016. This is likely the result of brands relying more on promotions and conservative menu price increases in response to continual declines in traffic. It confirms that restaurants don"t have even the most modest pricing power to offset volume declines.

On the other side of the spectrum, as has been the case in recent quarters, segments with the highest and lowest average check experienced better results. The strongest performance in the first quarter came from upscale casual, followed by fine dining and quick service. It is important to mention that fine dining and upscale casual are among the segments most negatively impacted by the shift in Easter.

Meanwhile, the worst segments in the first quarter were family dining and fast casual. Family dining concepts were also among the most negatively affected by the Easter shift.

A separate report from the National Restaurant Association found that its proprietary Current Situation Index, which measures current trends in four industry indicators (same-store sales, traffic, labor and capital expenditures), stood at 98.8 in February – up 0.2 percent from a level of 98.6 in January, however this was the fifth consecutive month in which the Current Situation Index contracted (below 100), as  operators continued to report dampened same-store sales and customer traffic levels.

Furthermore, the NRA found that restaurant operators overall continued to report soft same-store sales in February, with results that were similar to January’s levels. 33% of restaurant operators reported a same-store sales increase between February 2016 and February 2017, while 51% reported a sales decline, a deterioration from January. Restaurant operators also reported dampened customer traffic levels in February.

Only 27% of restaurant operators reported an increase in customer traffic between February 2016 and February 2017, while 57% reported a decline in customer traffic. In January, 26  percent of operators reported higher customer traffic levels, while 54% said their traffic declined.

One notable finding in the TDn2k report was that despite waiters and bartenders being the fastest growing job category under the Obama "recovery", restaurant operators list finding enough qualified employees to keep restaurants fully staffed as a primary concern. This is mainly due to skyrocketing restaurant churn rates as current restaurant workers believe they can find better options elsewhere, only to return disappointed. Turnover for restaurant hourly employees as well as managers increased again during February according to TDn2K’s People Report. These rates are currently higher than they have been in over ten years and rising.

Making matters worse for restaurants, some are finding that only by  offering higher compensation can they retain workers. So even if wages have been increasing slowly in recent years, this is expected to change soon as the labor market continues to tighten. In fact, according to a recent survey by People Report, about 80% of restaurant companies reported having to offer additional financial incentives to attract candidates in tough recruiting markets. In most almost all cases, those incentives take the form of higher base pay. Who would have though that there is a shortage of line cooks and waiters in the US.

While many continue to seek answers in the pernicious tailspin in the US restaurant industry within the supply side - pricing, competition, layout - the reality is that the key variable may remain with demand.  As some have speculated, it could simply be the reluctance or inability to eat out when money is being inflated elsewhere, to cover higher cost-of-living increases in other areas, such as rent or healthcare, even as wages for large parts of the population remain frozen.

To be sure, restaurant spending is a thermometer for discretionary spending, which varies with how well consumers are doing, and it’s the first to react as Wolf Richter correctly points out. When consumers hit their limits, the first things they cut are discretionary items, such as eating out.

As such, the worst tailspin in the US restaurant industry since 2009 remains the biggest flashing red alert suggesting that when it comes to that invincible dynamo behind the US economy, the American consumer, things have not been this bad in a long time.

Credit Suisse: Customer Blowback Over Starbucks' Refugee Hiring Spree Could Crush Same Store Sales

A few weeks ago we wrote about how the controversial decision of Starbucks" CEO Howard Schultz to hire 10,000 refugees, a clear shot at the Trump administration"s immigration policies, seemingly backfired as his "brand perception" took a sudden and massive hit, a clear signal once again that coffee drinkers would prefer to not have a side of political propaganda with their $5 morning java (see "Starbucks" "Brand Perception" Takes A Massive Hit After Announcing Plans To Hire 10,000 Refugees").

Now, Credit Suisse"s Restaurant team, led by Jason West, is warning that Schultz"s latest attempt to cram his political opinions down the throats of his customers could cause the company to miss upcoming same-store-sales estimates.

We have analyzed online “net sentiment” data (positive vs. negative online mentions) provided by NetBase to gauge changes in Starbucks’ brand perception. This follows recent media reports that SBUX’s decision to hire 10,000 refugees over the next five years could have upset some customers, perhaps negatively impacting sales trends. Our work shows a sudden drop in brand sentiment following announcement of the refugee hiring initiative on Jan. 29th, to flattish from a run-rate of ~+80 (on an index of -100 to +100). Net sentiment has since recovered, but has seen significant volatility in recent weeks. While this is only one data point, the analysis leaves us incrementally cautious on SBUX’s ability to meet consensus US SSS forecasts, which call for SSS to accelerate from +3% in F1Q17 (Dec. qtr.) to ~+3.5% in F2Q and ~+5.5% in 2H17.

Potential impact to F2Q SSS: NetBase data show that net sentiment remained depressed for 10 days in late Jan. and early Feb. and was particularly volatile through the remainder of Feb. We see potential for a scenario in which US SSS slowed for a few weeks following news of the refugee hiring initiative, negatively impacting full-quarter SSS by ~70-80bps under a reasonable bear case. This assumes that (1) SSS during the initial 10-day stretch were ~flat, (2) SSS averaged +2% during the remaining 3 weeks of Feb. (when net sentiment saw particularly high volatility) and (3) SSS during the rest of the qtr (Jan. and Mar.) average +3.5% (in line with consensus forecasts for F2Q), putting F2Q US SSS at ~+2.8%. We caveat that we found little to no correlation over longer time periods between the net sentiment data and US SSS. However, in our past work on Chipotle (CMG: Neutral), we found that large and sudden spikes in net sentiment coincided with similar shifts in SSS trends.

For those who missed it, here are some excerpts from the politically charged message drafted by Schultz to his employees with "deep concern and a heavy heart":

I write to you today with deep concern, a heavy heart and a resolute promise. Let me begin with the news that is immediately in front of us: we have all been witness to the confusion, surprise and opposition to the Executive Order that President Trump issued on Friday, effectively banning people from several predominantly Muslim countries from entering the United States, including refugees fleeing wars. I can assure you that our Partner Resources team has been in direct contact with the partners who are impacted by this immigration ban, and we are doing everything possible to support and help them to navigate through this confusing period.

Hiring Refugees: We have a long history of hiring young people looking for opportunities and a pathway to a new life around the world. This is why we are doubling down on this commitment by working with our equity market employees as well as joint venture and licensed market partners in a concerted effort to welcome and seek opportunities for those fleeing war, violence, persecution and discrimination.  There are more than 65 million citizens of the world recognized as refugees by the United Nations, and we are developing plans to hire 10,000 of them over five years in the 75 countries around the world where Starbucks does business.

Building Bridges, Not Walls, With Mexico: We have been open for business in Mexico since 2002, and have since opened almost 600 stores in 60 cities across the country, which together employ over 7,000 Mexican partners who proudly wear the green apron. Coffee is what unites our common heritage, and as I told Alberto Torrado, the leader of our partnership with Alsea in Mexico, we stand ready to help and support our Mexican customers, partners and their families as they navigate what impact proposed trade sanctions, immigration restrictions and taxes might have on their business and their trust of Americans.

Unfortunately, Schultz quickly found out the hard way that while most adult-aged Americans can agree that they like coffee, roughly 50% disagree with his leftist political opinions.

Meanwhile, the only folks that don"t seem to be noticing the controversy surrounding Starbucks" latest mishap are the company"s shareholders.