How Is Fast Casual Holding Up in the Rebounding Economy?

The dining industry is in constant flux, but there still may be one or two companies that are solid investments.

May 12, 2014 at 2:58PM

Traffic and same-store sales at many well-known casual-dining brands, including Darden Restaurants' (NYSE:DRI) Olive Garden, are declining for reasons besides general economic conditions and a bad winter. The fast-casual sector of the restaurant business is creating problems for casual-dining restaurants. Customers are simply finding the improvement in quality attractive.

What's happening to casual dining?
The fast-casual model was first introduced by Chipotle Mexican Grill (NYSE:CMG). The fact that customers can choose exactly what they want to eat and then watch their meal being put together has proven to be a very successful model. Customers also like the quick meals delivered without a waiter.

But some casual-dining chains are not taking this lying down. Instead, they are fighting back in their own fashion. For instance, Olive Garden has completely overhauled its menu and added lighter items, including a hamburger for lunch and a pasta section. On the other hand, Hard Rock Cafe has cut its menu while adding items such as more fashionable salads and smoked foods.

Bloomin Brands (NASDAQ:BLMN) is another major player in the casual-dining space. While Darden is looking to spin off its Red Lobster brand to improve operations, Bloomin Brands wants to expand internationally. Last year it acquired a 90% stake in its Brazil Outback Steakhouses, and it's looking to increase its presence in China and Mexico.

Can fast casual turn itself around?
Not so long ago, casual-dining chains were as popular as fast-casual chains today. Because of the demand from the baby boomer generation, many chains followed the same successful format of opening as many new restaurants as quickly as possible. To support this breakneck growth, they developed extremely efficient systems to rationalize all their operations such as purchasing and marketing. Unfortunately, this attempt at consistency also meant little differentiation and provided an institutional look which may have been suitable in the 20th century but no longer works.

However, the overall situation is much more complex than too many restaurants being run by brands with no visible differentiation from one another. The entire restaurant industry has changed drastically with fragmented and intensified competition.

But the casual-dining chains do have their advantages in terms of location and an established presence in the market. What they need to do is realize that their business model of consistency no longer works. They need an approach that is much more local and customizable. Meanwhile, the fast-casual restaurant chains should realize that their businesses might be maturing. This is especially true in segments such as hamburgers and pizzas.

Chipotle has crippled casual dining
If we take a closer look at one of the largest publicly held casual-dining chains, Darden Restaurants, you'll see just how much the industry is struggling. Darden has been hit by the decline in sales at Red Lobster and Olive Garden. Earnings per share last quarter declined by more than 40% over the previous year. The EPS of fiscal 2014 is likely to decline year on year by 15% to 20%. Though the company could benefit from acquisitions, investors are advised to stay away for the moment.

How shares stack up
Darden trades at a P/E of less than 18 based on next year's earnings estimates. And Bloomin Brands trades at a 15 P/E. Both are still well below the P/E of 32 for Chipotle. However, on the positive side, Chipotle doesn't carry any debt. But Bloomin Brands' debt-to-equity ratio is 280%, while Darden Restaurants' is 130%.

Bottom line
Chipotle is still a very compelling investment in an economy where individuals are flocking to natural and organic foods. While the likes of Darden and Bloomin Brands might appear to be value plays with low P/E ratios, they may well turn out to be value traps. It'll take a lot for the casual-dining companies to reinvent themselves. For investors looking to play the restaurant industry, Chipotle is worth a closer look.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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