Why Casual Fast-Food Dining Chains Look Like Attractive Investments

The fiscal third-quarter earnings season is coming to an end. As expected, consumer-discretionary companies showed weakness. Restaurant chains also struggled as cash-strapped consumers curtailed discretionary spending with the backdrop of an unstable labor market and higher payroll taxes.

As leading casual-dining chains continued to struggle due to lower customer traffic, rising costs and frugal consumer spending, results from fast-food chains were mixed. In the traditional fast-food category, McDonald's (NYSE: MCD  ) managed to beat analysts' expectation in the latest quarter. Sales in October showed slight improvement in the U.S. and Europe. However, weakness in the Asia Pacific region is a cause for concern. McDonald's projections for the fiscal fourth quarter are also uninspiring.

McDonald's blames lower customer traffic amid challenging economic environment for a downbeat outlook. As a result, the world's largest fast-food chain introduced several low-priced items to its menu. However, analysts believe that the company is not swift enough to match rival burger chains' responses to the changing tastes of customers.

Burger King Worldwide's (NYSE: BKW  ) profit in the latest quarter soared, mainly due to refranchising, which helped slash overhead costs. The introduction of 'Satisfries', a reduced-calories-low-fat version of French Fries, also helped, but it remains to be seen whether or not the chain will be able to sustain the same growth momentum in coming quarters. 

On the brighter side, though, the casual fast-food chains have been witnessing steady growth. Casual fast food chains, perceived to offer healthier meals, comfortably outpaced the traditional fast-food and casual-dining chains. According to Technomica, a research and consulting firm, sales at casual fast-food chains climbed about 13% last year, which was more than double the sales-growth at traditional fast-food chains. During the same period, sales at full-service casual dining chains showed a meager 2% growth.

Chipotle Mexican Grill (NYSE: CMG  ) , popular for its burritos and tacos, outperformed the casual-fast food industry by posting revenue growth of 20.3% in fiscal year 2012, ended Dec. 31. Sales were driven both by new store openings and higher comparable-store-sales. Comparable-store-sales, a key gauge of a retail chain's performance, showed positive growth in last three quarters of the current fiscal year.

Chipotle's low-priced menu, the fresh ingredients its uses, and the choice for customers to customize their orders are the key factors behind increasing customer traffic at its stores.

Buffalo Wild Wings (NASDAQ: BWLD  ) recently posted a 67% jump in fiscal third quarter net income as consumers munched more chicken wings and gulped more beer in its sports-themed restaurants. The chain, which serves chicken wings in more than a dozen varieties of sauces and seasonings, also offers a good collection of imported and domestic beers, including craft brews. Revenue in the latest quarter soared almost 28% compared to a year ago. While rising comparable-store-sales is driving up the top-line growth, the lower cost of chicken wings boosted the bottom line in the latest quarter.

Thanks to a bumper corn harvest, the costs for feeding poultry are down sharply, which reduces Buffalo Wild Wings' costs. The company expects the trend will continue in the long-term.

Noodles & Co. (NASDAQ: NDLS  ) , another made-to-order casual fast-food chain offering globally-inspired pasta, noodles, sandwiches and soups, reported a surprise miss on the revenue front in the fiscal third quarter earlier this month. Shares were sharply down a day after the results were announced, despite the company posted an impressive 15.4% revenue growth in the latest quarter. I believe that investors had way too high expectations for the restaurant chain. The company, which made its initial public offering in July, has a very high P/E ratio compared to its peer group.

Looking forward, Noodles & Co also raised its comparable-store-sales guidance for the fiscal year 2013. During the latest conference call, Kevin Reddy, Chairman and Chief Executive Officer of Noodles & Company, highlighted that the company was off to a strong start in the current quarter. Comparable sales at company owned stores are now expected to grow between 3.25% and 3.75% in fiscal 2013.

Factors Favoring Casual Fast Food Chains
Affordability is one of the factors favoring casual fast-food chains. Cautious consumers, in the backdrop of challenging macroeconomic environment, are not only avoiding eating at expensive restaurant chains but are also getting choosy when it comes to the menu.

For example, consumers now prefer eating chicken as opposed to higher-priced beef. Lower-priced chicken is encouraging fast-food casual chains to expand the number of chicken items on their menus.

Another factor favoring casual fast-food chains is economic uncertainty and declining consumer sentiment. The Conference Board's consumer sentiment index fell to its lowest level since August 2011 in October. The Thomson Reuters/ University of Michigan's overall consumer sentiment index plunged to 73.2 in October from 77.5 in September, the lowest reading recorded since December 2012. The sentiment continued to remain weak in November. Thomson Reuters' preliminary reading on the overall consumer sentiment slipped to a near-two year low of 72.0 in November. 

Both surveys suggested that fiscal-policy stalemate in Washington and the subsequent government shutdown raised fears among consumers that the U.S. economy could slow, knocking down sentiment. Adding to the woes are concerns over when the Federal Reserve might pullback its economic stimulating measures (quantitative easing). Impending economic uncertainty means that the consumer will continue to spend thriftily and look for cheaper dining/lunching options instead of fine dining.

Finally, there is an increasing demand for healthier ingredients. There is growing perception among consumers that having fresh vegetables on their plates is healthy. According to Technomic, about 65% of consumers now agree that it is essential to have a nutritive diet, up from 57% three year ago. Not surprisingly, McDonald's recently pledged that it will soon start offering customers an option to choose any one among salad, vegetables or fruit over French Fries.

The bottom line
Although both macroeconomic indicators and recent earnings results from the U.S. restaurant industry suggest that consumers remain thrifty, the casual fast-food business holds lots of promise. Lower prices, healthier ingredients and customizable menus are the key factors luring cautious and cash-strapped consumers to casual fast-food chains. The growth rate in the casual fast-food sector comfortably outpaced last year, and the trend is expected to continue. Technomic estimates that the casual fast-food chains will grow at 10% compound annual growth rate (CAGR), on average, between 2012 and 2017, while limited service restaurant chains are expected to grow at 4.5% CAGR in the same period. Therefore, the casual fast-food sector looks like a better bet in the restaurant industry. 

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