Bright Slice in Bleak Sector

Despite cheap gas and an improving employment picture, including increasing wages, the restaurant sector has been under serious pressure as of late. In fact, this quarter average comparable sales for the entire restaurant sector dipped into negative territory – the first decline since the first quarter of 2009.

The list of food and beverage chains reporting lower than expected results for Q2 is long and covers wide cross section of price points and categories. Starbucks (SBUX), McDonald’s (MCD), Chipotle (CMG), Noodles (NDLS), Chuy’s Holdings (CHUY), Sonic (SONC), Dave & Buster’s Entertainment (PLAY), Red Robin Gourmet Burgers (RRGB), Ruth (RUTH) and Texas Roadhouse (TXRH) have all missed on top or bottom line and many cases both.

All told, 17 of the 19 restaurant chains that reported second-quarter results thus far said sales fell from a year ago and 50 of the 55 publicly-traded restaurant stocks with a market cap of over $50M are in negative territory for the past two week period.

Same-store sales growth in the restaurant sector fell 1.1% in June, according to Black Box Intelligence. Same-store traffic was down 3.5% Y/Y during the month and 3.0% for all of Q2. This trend has actually been developing for a while.

Restaurant sales images 8.05.16

There is, however, one stand-out in the restaurant sector: pizza. Domino’s Pizza (DPZ) and Papa John’s (PZZA) are the only two restaurant chains in the Bloomberg Intelligence restaurant index who reported earnings results which showed a growth in sales during the second quarter compared to a year ago.

Domino’s said sales at established U.S. locations rose nearly 10 percent, marking the ninth consecutive quarter of growth above 5 percent. Papa John’s posted a 7% increase in same store sales and Shares of both are up over 10% over the last few weeks.

Some other names in the sector that have posted solid numbers and seen their stocks move higher include Noble Roman (NROM) and Pizza Inn (RAVE). One notable loser is Papa Murphy’s (FRSH) whose shares tanked 10% on Thursday following disappointing results. The stock has cratered some 75% in the past 52-weeks so clearly it has some company specific issues.

The trend suggests consumers are opting for at-home delivery over casual dining out. The ease of delivery also fits the lifestyle of many millennials; sitting on a couch, streaming entertainment and reaching to their smartphones to tap an app to have the world brought to their doorstep. Amazon’s voice-controlled Echo can understand a pizza order and relay the information to Domino’s.

Working parents might also be opting for take-out and delivery and pizza also represents one of the better values. Large pies with some type of side, which can feed a family four, can be had for under $10 from both Dominoes and Papa John’s. Some analysts and CEO’s such as Starbucks’ Howard Shultz have also cited civil unrest and terror as a keeping people at home and decline in foot traffic especially in malls.

Lean Production

Ironically one of the items that should be bolstering restaurant sales is the uptick in wages, is actually hurting their profitability, especially at fast food which has been forced to pay workers upwards of $10 per hour. Wages are the number one input cost and several chains such as Wendy’s (WEN) and Fiesta Grill (FRGI)

Pizza places, particularly those that emphasize deliver and take-out, given their limited and simply menus can run leaner more cost efficient operations. The average Domino’s requires just one third of the square footage and half the number of employees as a typical McDonalds.

From a technical standpoint Domino’s chart has been building a nice bullish flag as rice consolidates above support after the July 21st earnings induced gap up.

DPZ Chart 8.05.16

I’m eye a call spread that will capture the next leg up in next month or two. Specifically;

  • Buy the September 145 Calls and Sell the September 155 Calls for a $3.75 Net Debit

Here is what the risk graph of spread looks like:

DPZ risk graph 8.05.16

Domino’s stock is trading at a multiple of 32 times forward earnings, above its 5-year average of 28x and a premium to some of its restaurant peers. But with pickings slim for growth elsewhere in the restaurant industry, pizza may still be one of the best choices on the menu.

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— Steve Smith

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About the Author: Steve Smith