This article originally appeared on Mountain Vision.
The restaurant business was one of the few economic sectors to remain relatively unscathed by the 2008 recession. When most investors and business owners were feeling the sting of the economic crisis and the painfully slow recovery thereafter, Americans kept spending a significant portion of their shrinking pay checks on eating out. That shielded the restaurant industry from the effects of the recession.
Eating out, after all, is a common, long-standing spending pattern in the US, with the average American eating out 3 times a week and the average household spending 42% of its food budget in restaurants, according to figures from the US Bureau of Labor Statistics. The restaurant industry itself represents a considerable force in the US economy, with 14.4 million employees, or 1 out of 10 Americans, and industry sales of 745.61 billion USD in 2015, according to the National Restaurant Association. Today, the restaurants’ share of the food dollar stands at 47%, a long way from their 25% share in 1955.
The canary in the coal mine
When one considers the size of the US restaurant sector and the big role food spending plays in a consumer-driven economy, it is no wonder that economists and analysts have long studied its performance in relation to the wider economic environment. They have identified downturns in the industry as a historically significant indicator of overall economic weakness and a possible harbinger of a recession. Restaurant sales are considered to be a reliable measure of the real economy’s robustness, or lack thereof, as they provide a direct insight into shifting spending habits, and often reflect the financial pressures on the average consumer’s real disposable income.
Especially in the US, where eating out expenses are closely correlated with job growth, as seen in the chart below, and where even low-income households spend a significant amount on away-from-home meals, a decline in the restaurant sector may be a signal of things “not going according to the plan”. Since US economic growth relies heavily on consumer spending, a slowdown in restaurant spending translates into slowing growth, or even a looming recession.
The sector’s strong performance in previous years was widely attributed to the Millennials’ obsession with experiential consumption, as opposed to conventional, material spending. The rise of foodie-ism, of specialty cuisine restaurants and of fully customizable offerings, was also used to justify largely optimistic projections of the sector’s growth. Despite this, the National Restaurant Association’s Restaurant Performance Index (RPI), a monthly composite index which reflects the health and the outlook for the U.S. restaurant industry, revealed a worrying trend that demolished these great expectations. The RPI, which tracks restaurants’ same-store sales, traffic, labor, and capital expenditures, uses the level of 100 to indicate a steady state, while any value above this is considered to indicate the sector’s expansion, and, conversely, values below 100 signal contraction. Starting in December, the RPI fell to 99.7, from 101.3 in November. After a short positive interlude, in its latest update in July, the index declined again for the second consecutive month. It is worth mentioning, that since the beginning of 2003, the first time the RPI entered below-100 territory was in the late-summer of 2007, shortly before the great recession.
Restaurants across the US have been struggling to adapt and to keep up with numerous changes and hurdles, both in their consumer base and the regulatory environment. One of the most commonly cited problems faced by the industry, is the increase in labor costs. The widespread and much-publicized demand for a legislated increase of the minimum wage, as well as stricter overtime regulations, are putting pressure on profit margins. As more states are expected to adopt these new laws, the impact will be significant, in an industry where out of the 14.4 million employees, 7.1 million work for minimum wage.
Efforts to attract Millennial customers, and to keep them, which has proven even more challenging, have also affected production costs. According to a report by Morgan Stanley, the 18-to-33 year olds prefer companies with a record of “good social ethics”, while 53% of them go out to eat at least once a week, compared with 43% for the general population. Another study by the Hartman Group, a consumer research firm, revealed that 40% of this demographic group order a different dish every time they visit a restaurant, while they are twice as likely as Baby Boomers to eat foods that are certified organic and 80% of them want to know details about how and where their food is grown. Additionally, they also like customizable food options, and “the 87,000 possible drink combinations that can be had at a single Starbucks unit, are seen as a need, not a luxury.”
Increased public awareness and media scrutiny regarding food production processes, industry practices and ethics have also contributed to the sector’s concerns. Chipotle’s case was a worst-nightmare-scenario for many in the restaurant business, as the company lost over $11 billion in market capitalization after a series of food safety scares from July through December of last year.
The list of factors that industry insiders and CEOs blame for poor results is long and sometimes surprising: Recently, Wendy’s CEO Todd Penegor, explaining the decline in the company’s earnings, said that the presidential election, and the sense of political and economic uncertainty it has instilled in consumers, has made them less likely to eat out. As he put it: ”When a consumer is a little uncertain around their future and really trying to figure out what this election cycle really means to them, they’re not as apt to spend as freely as they might have even just a couple of quarters ago”.
The big picture
Even though the short-term challenges and the various localized obstacles have played an important role in aggravating individual companies’ or restaurants’ struggles, the industry-wide downturn suggests a fundamental shift in spending patterns and a larger cause for concern for the wider economy.
Thus, the reason behind this sector-wide decline, could be quite intuitive and straightforward: When money is tight, eating out is one of the first things to go, and Americans are instead opting for packed lunches and eating their dinner at home.
Recently released earnings results have reinforced these concerns. As shown in the chart below, sales stagnated in June, marking the lowest point in sales growth since 2013. 15 of the 16 major chains’ second-quarter earnings either showed that sales were down from last year, or that growth had slowed down from the previous quarter. Ruby Tuesday suffered losses and announced the closure of 95 locations, both McDonalds’ and Burger King missed estimates, Wendy’s and Shake Shack announced disappointing results as well, while troubled Chipotle’s sales still have not recovered, despite a substantial boost in marketing spending. In general, the decline in spending has forced most of these chains to offer high discounts, and to fight for customers with new promotions and free food offers- a strategy that seems to pay off in the short term but raises doubts about its sustainability and its impact on profits.
Paul Westra, a senior analyst at Stifel Financial Corp., has turned “decidedly bearish” and downgraded the entire restaurant sector, according to research notes to clients circulated in July. He warned that his analysis indicated that the sector’s troubles are also a sign of hard economic times ahead. Westra wrote: “The catalyst for the current weak pre-recessionary restaurant spending trend is likely multifaceted – U.S. politics, terrorism, social unrest, global geopolitics, economic uncertainty. But, if history is a guide, we warn investors that restaurant-industry sales tend to be the ‘canary that lays the recessionary egg.” He also pointed out that the sector’s performance this year, particularly in the second quarter, bears striking similarities to trends that emerged in 1990, 2000 and 2007, in the 3-6 month periods that preceded the last three U.S. recessions; a fact that may sound the alarm for what we might expect to see in 2017.
The take-away lesson
Overall, the troubles of the restaurant industry in the US, as an isolated factor, do not necessarily suffice to conclusively determine whether a wider recession indeed lies ahead in coming months. It does however send a signal that the state of the real economy is not as robust as the Federal Reserve or the media currently maintain. In any case, we will continue to monitor developments in the markets, while bearing in mind signs like this, to be in a better position to understand and to anticipate the future direction of the economy and financial markets.