Is Fast-Casual Dead?

By John Bromels - August 20, 2012 | Tickers: CMG, BAGL, GMCR, PNRA, SBUX | 0 Comments

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Dead?  Of course not: the line out the door at my local Chipotle (NYSE: CMG)--usually when I'm already running late--is "living" proof (sorry; couldn't resist).  But after a banner year in 2011, pretty much every fast-casual stock has taken a beating in the spring or summer of 2012.  Is fast-casual's rapid growth extinct?

In 2011, fast-casual was all the rage.  In fact, according to Chicago-based market research firm Technomic, Inc., the largest 150 U.S. fast-casual chains saw revenue increases of a super-sized 8.4 percent in 2011 while restaurants overall grew at a meager 3.5 percent.  But that all changed between March and August of this year.  Check out the damage:

Beware the Ides of March, indeed!  In the five months since, virtually every fast-casual stock has underperformed the S&P 500, most by a significant margin.  Now, it's also worth noting that virtually all U.S. restaurant stocks in all categories (fast-food, sit-down) have also had a rough year (Einstein Noah (NASDAQ: BAGL) is a notable exception).  This helps to explain the poor performance by both Carrols--which owns fast-casual chains Pollo Tropical and Taco Cabana, but also hundreds of Burger King franchises--and Pizza Inn, which is primarily a pizza chain, but is rapidly expanding into the fast-casual market in Texas with its Pie Five concept (build-your-own pizza, ready in five minutes). 

But, wait a minute.  Isn't this downturn good news for the sector?  After all, if fast-casual restaurants have been outperforming both their cheaper (fast-food) and pricier (sit-down) cousins, won't they rebound more quickly from this slowdown?  Should you pick up a few shares?

What's On The Autumn Menu?

It's really a shame that most fast-casual restaurants (like most other restaurants) are privately owned or held.  I'd love to be able to compare local favorites like Potbelly, Fusian (Chipotle:Burritos::Fusian:sushi rolls), and Firehouse Subs with the stocks listed above to get a better sense of the broader sector, since some would argue that Starbucks and Buffalo Wild Wings are technically a coffee shop and a sports bar, respectively. But be that as it may, there are quite a few potential headwinds looming for the restaurant industry:

• Drought-stricken cornfields: Now, you may shrug your shoulders at this.  After all, besides that great corn salsa at Chipotle, corn's not being dished out at many fast-casual chains, right?  Ahem, wrong.  It's on the plates...of the cattle, pigs, and chickens that provide the meat (literally) of the menus.  Because most corn is used for livestock feed, rising corn prices due to crop failures mean those slices of pepperoni on your Pie Five pizza and all those wings swimmin' in Jammin' Jalapeno sauce...even the sour cream on your veggie burrito...gets more expensive and cuts into restaurant profits.
• Slowing same-store sales: While Chipotle's same-store sales grew at a fairly hefty 8% in Q2, analysts were expecting 10% growth, and as a result, 22% of the filling dropped out of that burrito.  For the rest of FY12, Chipotle is only projecting 4-6% same-store sales growth, and they're not alone.  Panera--best in class--projects 6-6.5% same-store sales growth.  Carrols projects 3-5%.  None of this even remotely approaches the 8, 10, 12% increases we've seen in the past.  But at least it isn't the negative growth reported by some of the major sit-down chains!
• Too much competition?  The restaurant industry is a competitive one, and because fast-casual was the hottest pot on the stove, it's the pot a lot of restauranteurs decided to cook in last year.  And last year's concepts are becoming this year's competition.  In a recent article in the Cincinnati Business Courier, Mike Ziegler, brokerage senior vice president at Colliers International in Cincinnati, attributed the explosion of fast-casual restaurants to "deflated property value, cheap borrowing, and the relatively low cost of franchising these chains.“  In other words, will a potential customer cross town to pick up Chipotle when they pass a Currito, a Qdoba, a Burrito Joe's, and a Moe's Southwestern Grill on the way?  (My answer: I would stop at Currito for their mango salsa and tofu or Moe's for their salsa bar...I've never been impressed by Qdoba--owned, btw, by Jack in the Box--or Burrito Joe's)

I doubt things for this sector will improve until we've got the November elections in the rearview mirror, at which point consumers and the market will have a clearer idea of what challenges and solutions may lie ahead for the overall economy.   Therefore, I'm placing CAPScalls of Underperform on CMG, BWLD, TAST, PZZI, and PNRA...but only for the next several weeks.  For Starbucks, however, I'm on the other side of the fence, for the following reasons:

• While milk and cream (and corn syrup!) feature prominently in Starbucks' offerings, with no cheese or meat on the menu (unless they introduce a holiday bacon mochalatte) in most locations, high corn prices should affect Starbucks less than others.
• Expiring patents on K-cup technology by Green Mountain Coffee Roasters (NASDAQ: GMCR) coupled with Starbucks' impending launch of its Verismo rival pod brewer gives Starbucks an excellent growth opportunity.
• Research has already proved that customers wouldn't cross the street to visit a Starbucks, so Starbucks has already had years to strategically locate its stores to take advantage of the best real estate.  When the economic downturn forced some independent stores out of business, Starbucks picked up the slack...and the revenues. 
• With a P/E of about 26, Starbucks is a cheaper buy right now than Panera (at 30) or Chipotle (at 36).

I'm issuing a CAPScall for Starbucks to outperform the market, although I have no plans to initiate any position in the next 72 hours.

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