Is the Restaurant Industry Doomed?

Convenient? Absolutely.

More importantly though, it exemplifies the extent to which the
restaurant industry overexpanded throughout the past two decades.
According to the National Restaurant Association, the number of
restaurants and bars has grown from 361,000 to 537,000 since 1990.

Consumers' access to easy credit and businesses' generous expense
accounts supported the heady growth. Restaurant chains found themselves
caught up in frenzied spending, but the trend was unsustainable. Like
the housing market, the restaurant industry has overbuilt. Without
credit cards, consumers can't afford to eat out as often. And
recessionary times have required corporations to slash extraneous
expenses -- particularly food -- from their budgets.

Food, food everywhere
Simply put, there are too
many places to eat. The ratio of restaurants to people has widened
dramatically. Since 1990, population in the U.S. grew just 23%, in
comparison to the 49% growth in restaurants noted above.

Faced with rapidly waning demand, food establishments are taking desperate measures to stay in the game. Starbucks (Nasdaq: SBUX), known for its premium-priced offerings, is touting breakfast combos. Denny's is downright giving away meals to lure cash-strapped diners. Still others, like Panera (Nasdaq: PNRA), are increasing menu prices to help sustain the revenue growth to which their shareholders have grown accustomed.

These tactics may be effective in the short run. Eventually, though, supply and demand will be forced into equilibrium.

Too tasty to fail?
Absent some initiative that
makes restaurants eligible for government bailouts, you can expect to
see the restaurant industry experience some failures. Several chains
have already been forced to start closing underperforming locations.
Some establishments will be forced out of business all together.

Investors are sitting on pins and needles wondering which firms will
emerge as winners from the large pool of contenders. Hot grower Chipotle (NYSE: CMG) (NYSE: CMG-B), which sold for nearly 100 times earnings at the end of 2007, is priced at just 30 times trailing earnings today. Trendy health food juice bar Jamba Juice (Nasdaq: JMBA) has lost 80% of its value over the past year. Bennigan's has already filed for Chapter 7 bankruptcy.

Food for thought
Investors must purchase
restaurant stocks with the utmost caution. Attractive menu prices that
provided meals a step above fast food drew middle-class families to
casual-dining locations in droves over the past several years. Just
about any restaurant could grow just by expanding into new locations.

Times have changed. In the current market, restaurants will achieve
growth via market share gains. Those that lack a distinct competitive
advantage that adds value to the dining experience -- such as superior
customer service or unique dishes -- will struggle to survive.

The challenge is especially strong for middle-tier restaurants. Upscale establishments such as Morton's Restaurant Group and McCormick & Schmick's
may be struggling through the recession, but they at least offer unique
experiences and ambiance that allow them to stand out. They also don't
line every suburban strip mall.

For investors with an appetite for attractive valuations, I advise
sticking to chains that have robust business models that thrive in any
kind of economic environment, and have a proven ability to stand out
above their competitors. McDonald's (NYSE: MCD), for example, has remained successful
by evolving its menu to meet consumers' changing tastes. Management
understands what sets the Golden Arches apart from other fast-food
joints, and it relentlessly focuses on maintaining that edge.

Similarly, Buffalo Wild Wings (Nasdaq: BWLD) has
done a great job of differentiating itself from its rivals. Its success
is largely due to its ability to think outside the box, and it has
created a special social atmosphere for families by playing cartoons on
its televisions, as well as sports.

Like any other sector that is currently wringing out the excess,
there will be a few strong winners that will prevail in the
casual-dining sector. There will also be an abundance of failure.
Restaurants that lack a distinct competitive advantage and healthy
financials face the greatest risk of getting eaten alive.

© 2009 UCLICK, L.L.C.