Tread Carefully in the Quick-Service Restaurant Space

One of the industry sectors that has pretty consistently outperformed the overall market over the past few years has been the Consumer Discretionary sector. According to Investopedia.com, the Consumer Discretionary sector “consists of businesses that sell nonessential goods and services. Companies in this sector include retailers, media companies, consumer services companies, consumer durables and apparel companies, and automobiles and components companies.” From the beginning of 2010 through June 30, the Consumer Discretionary stocks within the S&P 500 index increased 158% compared to the 85% increase for the S&P 500 as a whole. The outperformance is much more pronounced if you go back to the market low of March 9, 2009 (roughly +383% for Consumer Discretionary compared to +205% for the S&P 500), but we wanted to eliminate some of the snap-back effect that was caused by the sector’s underperformance leading up to the market lows.

The sector’s dramatic outperformance is fairly easy to understand. In general, retailers generate a large percentage of their revenue within the United States. Since the US economy is much farther along in its economic recovery, investors have been buying Consumer Discretionary stocks to increase their exposure to this trend. But more specifically, the purchase of retail stocks is one of the best ways to gain exposure to the improving financial condition of the US consumer. Now that the labor market has improved, debt levels have come down, access to credit has improved, and incomes are trending higher, the US consumer is perceived to be a reliable source of growth in the years to come.

One sub-segment of the Consumer Discretionary sector has been especially red-hot: the quick-service restaurants, or QSR’s. Having watched the likes of Domino’s Pizza, Starbuck’s, Chipotle, Papa John’s, and Jack in the Box soar in recent years, we wondered just exactly how well these stocks have done. So we created an index of twelve well-known QSR companies to gauge the performance of these companies compared to both the S&P 500 and the S&P 500 Consumer Discretionary indices. What we found was quite striking. Since the beginning of 2010, the QSR index is up 339% compared to 85% for the S&P 500 and 158% for the S&P 500 Consumer Discretionary sector. The chart below shows the results, with each metric indexed to 100 at the beginning of 2010.

f3ca20f1-78b9-41f8-a563-eb37257c166aSource: Bloomberg and FMW QSR Index, consisting of CMG, DNKN, DPZ, JACK, MCD, NDLS, PNRA, PZZA, SBUX, SONC, WEN and YUM.

Naturally, after seeing the results of this analysis, we wanted to take a look at valuations for the companies in our QSR index. The table below shows P/E multiples for each company, along with the average for the group and the multiples for the S&P 500. Following the huge move for the sector, the stocks are now trading at an average of 30.6x estimated calendar 2015 EPS and 26.7x estimated calendar 2016 EPS. These translate to premiums of 78% and 69%, respectively, compared to the S&P 500! Clearly these stock prices are baking in strong future increases in spending at quick-service restaurants. Is the market right?

1ee49895-1a6a-4acb-8456-ffabf86249ceSource: IBES estimates obtained from http://www.thomsonone.com

Notwithstanding the meteoric rise in QSR stocks, our concerns about the health of the US consumer remain: debt levels remain high; interest rates are heading higher; median household income (adjusted for inflation) is still at 1995 levels; the labor participation rate is at multi-decade lows; and the large majority of consumers are saving far too little for retirement. But perhaps most importantly, the improvements we’ve seen in incomes and wealth have overwhelmingly gone to the well-to-do while the middle class, in large part, continues to struggle. Given these trends, we think the consumer’s newfound sense of frugality, spawned from the financial crisis, will cause savings rates to continue rising toward the post-WWII average of nearly 9% (from about 5% now). Higher savings rates could serve as a drag on economic growth for several years. At the same time, the federal government, which has effectively assumed much of the consumer debt through higher transfer payments, must eventually address the ticking time bomb that is entitlement spending. All of these headwinds would argue for a much more conservative growth outlook for consumer spending in the years to come. If this indeed turns out to be the case, Consumer Discretionary stocks, and QSR stocks more specifically, may have gotten well ahead of themselves.

Note to readers:
With regard to Monday’s Market Commentary on the Greek crisis, we did not intend to offend anyone with the addiction analogy. We can certainly understand how this analogy could be viewed as insensitive and we would like to apologize to anyone who read it this way. This was absolutely not our intent. We have great sympathy for the hardships that the Greek people are currently enduring. We have somewhat less sympathy for the current Greek government and its handling of this situation. The entire situation is very complicated and very sad. Our commentaries are intended to be focused on the markets and the economy. Thank you for reading our commentaries and for providing us with your feedback.

Peace,

Michael