Is the Restaurant Industry Doomed?

When a craving for a Panera Bread Caesar salad strikes, I have my choice of five restaurants within 10 minutes of my Pittsburgh home.

Convenient? Absolutely.

More importantly though, it exemplifies the extent to which the restaurant industry overexpanded throughout the past two decades. According to the National Restaurant Association, the number of restaurants and bars has grown from 361,000 to 537,000 since 1990.

Consumers' access to easy credit and businesses' generous expense accounts supported the heady growth. Restaurant chains found themselves caught up in frenzied spending, but the trend was unsustainable. Like the housing market, the restaurant industry has overbuilt. Without credit cards, consumers can't afford to eat out as often. And recessionary times have required corporations to slash extraneous expenses -- particularly food -- from their budgets.

Food, food everywhere
Simply put, there are too many places to eat. The ratio of restaurants to people has widened dramatically. Since 1990, population in the U.S. grew just 23%, in comparison to the 49% growth in restaurants noted above.

Faced with rapidly waning demand, food establishments are taking desperate measures to stay in the game. Starbucks (Nasdaq: SBUX  ) , known for its premium-priced offerings, is touting breakfast combos. Denny's is downright giving away meals to lure cash-strapped diners. Still others, like Panera (Nasdaq: PNRA  ) , are increasing menu prices to help sustain the revenue growth to which their shareholders have grown accustomed.

These tactics may be effective in the short run. Eventually, though, supply and demand will be forced into equilibrium.

Too tasty to fail?
Absent some initiative that makes restaurants eligible for government bailouts, you can expect to see the restaurant industry experience some failures. Several chains have already been forced to start closing underperforming locations. Some establishments will be forced out of business all together.

Investors are sitting on pins and needles wondering which firms will emerge as winners from the large pool of contenders. Hot grower Chipotle (NYSE: CMG  ) (NYSE: CMG-B  ) , which sold for nearly 100 times earnings at the end of 2007, is priced at just 30 times trailing earnings today. Trendy health food juice bar Jamba Juice (Nasdaq: JMBA  ) has lost 80% of its value over the past year. Bennigan's has already filed for Chapter 7 bankruptcy.

Food for thought
Investors must purchase restaurant stocks with the utmost caution. Attractive menu prices that provided meals a step above fast food drew middle-class families to casual-dining locations in droves over the past several years. Just about any restaurant could grow just by expanding into new locations.

Times have changed. In the current market, restaurants will achieve growth via market share gains. Those that lack a distinct competitive advantage that adds value to the dining experience -- such as superior customer service or unique dishes -- will struggle to survive.

The challenge is especially strong for middle-tier restaurants. Upscale establishments such as Morton's Restaurant Group and McCormick & Schmick's may be struggling through the recession, but they at least offer unique experiences and ambiance that allow them to stand out. They also don't line every suburban strip mall.

For investors with an appetite for attractive valuations, I advise sticking to chains that have robust business models that thrive in any kind of economic environment, and have a proven ability to stand out above their competitors. McDonald's (NYSE: MCD  ) , for example, has remained successful by evolving its menu to meet consumers' changing tastes. Management understands what sets the Golden Arches apart from other fast-food joints, and it relentlessly focuses on maintaining that edge.

Similarly, Buffalo Wild Wings (Nasdaq: BWLD  ) has done a great job of differentiating itself from its rivals. Its success is largely due to its ability to think outside the box, and it has created a special social atmosphere for families by playing cartoons on its televisions, as well as sports.

Like any other sector that is currently wringing out the excess, there will be a few strong winners that will prevail in the casual-dining sector. There will also be an abundance of failure. Restaurants that lack a distinct competitive advantage and healthy financials face the greatest risk of getting eaten alive.

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Starbucks has been recommended by Motley Fool Inside Value and Stock Advisor. Chipotle is a Rule Breakers selection. Try any of our Foolish newsletters today, free for 30 days. The Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, and Starbucks.

Fool contributor Kristin Graham owns shares of Starbucks. The Fool's disclosure policy likes to go fishing on Thursday afternoons.


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  • Report this Comment On April 14, 2009, at 4:23 PM, GetStirredUpRoth wrote:

    It's not all gloom and doom...Just today, we posted a very upbeat story on our client, Chop't Creative Salad Company, which is thriving in today's economic climate. Story can be found at http://tinyurl.com/dhl9g9

  • Report this Comment On April 16, 2009, at 7:55 AM, haroldsinn wrote:

    to ms. graham...please try harolds inn in hopewell twp..we are 6 minutes from the airport and celebrating 49 years ..and yes , the explosion of restaurants has been daunting.. every day we must focus on our uniqueness and be excellent..my dear father always said competition is good , it makes you better..while it certainly keeps us on our toes , a little less would be great !!! he would marvel at the new marketing strategies we use, such as email blasts and loyal rewards clubs..sometimes , i long for the cigar box we kept the money in , but what a wonderful journey this has been!

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