Financial, political risk hit restaurants, but good news for fast-food delivery

The increasing belief that the US is about to go into recession has led Stifel Nicholaus analyst, Paul Westra to downgrade 11 restaurants, stating that falling restaurant sales are the "canary that lays the recessionary egg," since historically, restaurants have led the stock market lower ahead of previous financial crises. Westra also believes recovery for the restaurant industry will be much more muted than previously. On another note, what has appeared bad for sit-down restaurants has been good for restaurant delivery companies, as political turmoil and economic concerns have resulted in more Americans ordering in; for instance, KeyBanc analyst Chris O'Cull has raised his rating on shares of pizza delivery firm, Papa John's.

The belief that a recession will hit the U.S. in the coming months prompted a Stifel Nicolaus analyst to turn “decidedly bearish” on restaurant stocks Tuesday, because they have led the stock market lower ahead of previous economic downturns.

Analyst Paul Westra downgraded 11 restaurants, including Chipotle Mexican Grill Inc. CMG, +0.86% , Darden Restaurants Inc. DRI, +1.10% , Panera Bread Co. US:PNRA, Cheesecake Factory Inc. CAKE, +1.95% and BJ’s Restaurants Inc. BJRI, -0.03% to sell ratings, an unusual grade for the sector. Westra said “we confidently believe” that a recent Stifel survey showing restaurant-industry sales decelerating “simultaneously” across all categories “is a harbinger to a U.S. recession in 2017.”

“‘A prospective 2017 U.S. recession could be the worst ever for restaurants.’” — Paul Westra, Stifel Nicolaus

What makes Westra even more bearish on the group is a belief that the eventual recovery will be much more muted than usual. Restaurants usually reap “windfall profits” from the decline in food labor costs in the year following a recession, but that decline has already occurred starting in 2015. In addition, Westra said prospects for minimum-wage increases will fuel wage-cost inflation in 2018.

“A prospective 2017 U.S. recession could be the worst ever for restaurants,” Westra wrote in a note to clients.

Here are the rating and stock-price-target changes Westra made:

Company Ticker New ratings Old rating New stock target Old stock target Chipotle Mexican Grill CMG Sell Hold $215 N/A Darden Restaurants DRI Sell Hold $53 N/A Panera Bread PNRA Sell Hold $175 N/A Cheesecake Factory CAKE Sell Buy $43 $65 BJ’s Restaurants BJRI Sell Buy $35 $52 Chuy’s CHUY Hold Buy N/A $42 Del Frisco’s DFRG Hold Buy N/A $23 El Pollo Loco LOCO Hold Buy N/A $17 Dave & Buster’s PLAY Hold Buy N/A $50 Texas Roadhouse TXRH Hold Buy N/A $50 Zoe’s Kitchen ZOES Hold Buy N/A $52 Source: Stifel, Nicolaus & Co.

Stifel Nicolaus said that of all the companies its analysts rate, only 3% are rated sell, while 49% are rated buy, 42% are rated hold and 6% are rated suspended.

Westra said restaurant stocks have dropped by an average of 23% in the three to six months before the start of the past three recessions, while the S&P 500 index SPX, +0.43% has declined 10%.

Among the downgraded stocks that were most active Tuesday, Chipotle dropped 2.4%, Darden Restaurants slumped 3.3%, Cheesecake Factory Inc. shed 4.6%, Texas Roadhouse Inc. fell 6.3% and Dave & Buster’s Entertainment Inc. slid 3.4%. Chuy’s stock was the biggest loser, tumbling 11%.

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Coincidentally, analyst Andy Barish at Jefferies also downgraded multiple restaurant chains Tuesday, saying he was “calling the top of the restaurant cycle” after an “extensive” study suggested that the “industry has at least 18 months of challenges ahead” in terms of softer same-store sales and higher labor costs.

He downgraded Texas Roadhouse to underperform from hold, and Fiesta Restaurant Group Inc. FRGI, +0.53% , Noodles & Co. NDLS, -0.15% , Red Robin Gourmet Burgers Inc. RRGB, -0.08% and Ruth’s Hospitality Group Inc. RUTH, +0.05% to hold from buy.

Barish isn’t nearly as bearish on the group as Stifel’s Westra, however, saying that he recommends investors “wait for lower valuations” but then buy the group broadly.

In contrast, Westra didn’t just turn “decidedly bearish” because he expects the group to miss second-quarter same-store-sales expectations. He thinks that including the pre-recessionary slowdown, the industry is in for at least two years of sales “pain.”

“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,’ ” Westra wrote.