Investors see gas prices falling and employment increasing, and they’ve been bidding up consumer stocks, including restaurants.
But valuations for many restaurant companies are now at historically high levels.
Brad Swanson, managing director for investment banking at KeyBanc Capital Markets, said the historical valuation for quick-service restaurants is an enterprise value multiple of 10 times cash flow. For casual-dining concepts, that average is 7.9.
Currently, he said, the average multiple for quick-service restaurants is 14, for casual diners it’s 10.
These valuations put pressure on restaurant companies heading into earnings season, which begins in earnest next week. Those that can’t meet expectations risk getting punished by investors.
“When we saw some of those big numbers in January, investors got a little overly excited that the industry is really breaking out,” said Jefferies analyst Andy Barish. “Industry sales are a little bit better. But it’s going to be hard to justify where these valuations have gone.”
To be sure, restaurants are starting the year on the best footing they’ve been on in the post-recession era. Same-store sales in January were notably strong, according to both Black Box Intelligence and MillerPulse, in part due to weather.
Restaurant sales surpassed grocery sales in March for the first time ever, according to federal data. What’s more, commodity costs are easing for everything that’s not beef, which could set chains up for better profit numbers heading into the year.
There are growing concerns about labor costs, but that tends to impact franchise operators more than franchisors. Many publicly traded restaurant chains are heavily franchised and are thus shielded from such costs.
Gas prices, meanwhile, are $1 a gallon below what they were a year ago, and employment continues to grow, all of which should theoretically make people eat out more often and buy more stuff.
Consumer discretionary stocks, which include restaurants, have easily outpaced the broader markets for years now. The S&P Consumer Discretionary Index is up 20 percent over the prior year, including 5 percent year to date.
But now this has generated concern that prices have grown too rich, and investors’ expectations are too high.
Indeed, Christopher O’Cull, analyst with KeyBanc Capital Markets, said in a recent note that he believes investors’ expectations might be inflated. O’Cull surveyed restaurant investors, 76 percent of whom said restaurant fundamentals were in-line or improved with their expectations for the quarter. Respondents also said 83 percent of companies would either meet or beat earnings expectations for the period.
The results, O’Cull said, were “somewhat surprising” given the slowdown in same-store sales in March.
Companies with high valuations don’t need to do much to knock their valuations down a notch or two.
Consider what happened to Sonic Corp. in March. The drive-in burger chain reported 11.5-percent same-store sales in its quarter ended Feb. 28. The company said earnings doubled and it raised profit projections. And then its stock fell by more than 12 percent — due likely to sales projections that weren’t quite as strong as sales from early this year. Sonic could be “the canary in the coal mine,” Barish said.
Other chains could face similar selloffs if they do anything in their coming earnings reports to disappoint investors. And remember: Same-store sales slowed in February and March, according to both Black Box and MillerPulse. Disappointments might be difficult to avoid.
“You’d think companies would have to report above expectations and guide higher for the year,” Barish said. “But we haven’t seen a lot of that in the category. It leads you to question how long these valuations can be sustained.
“You’re going to have to report a good quarter,” he continued. “You’ll have to hear encouraging news on April, with a positive same-store-sales tone. That’s going to determine the next move in these stocks.”
Of course, stocks today have fallen more than 1 percent through mid-afternoon trading, and the NRN Restaurant Index is down roughly the same, amid a global selloff. Maybe that will ease some valuation pressure this earnings season, but that’s not likely.
Contact Jonathan Maze at [email protected].
Follow him on Twitter at @jonathanmaze
