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Thursday, April 4, 2013 - 10:00
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Thursday, April 4, 2013 - 10:00

Trouble Lies Ahead For This Rallying Sector

Thursday, April 4, 2013 - 10:00am

For families making less than $70,000 a year, the mood is bleak.

Social Security taxes just went up. Gas prices have spiked. The unemployment situation is still iffy at best.

Add it all up and you can see why America's middle class is still feeling insecure about their finances and why they've sharply cut back on non-essential spending.

A January Goldman Sachs survey showed increasing fiscal concern among suburban baby boomers. That should be troubling to many types of businesses. However, when it comes to one particular type of business that's popular with the baby boomer crowd, the numbers are a signal for the astute investor to consider selling.

In this survey, 72% of consumers expected an increase in their taxes. Of that group, 44% are planning to reduce spending, while 28% are not.

And according to Goldman Sachs, one sector is particularly at risk: casual dining.

Companies such as Brinker International (NYSE: EAT), Darden's (NYSE: DRI) and Cracker Barrel (Nasdaq: CBRL) are seeing the effects of slower spending, and the fact that their share prices have been boosted in this bull market should give you pause. These gains can reverse in a hurry if sales trends don't soon improve.

Sure enough, the Knapp-Track Index of monthly restaurant sales showed that same-store sales at casual-dining establishments fell 5.4% in February. That's the biggest monthly year-over-year drop since 2009.

Notably, other restaurant categories such as fast-food and high-end dining are seeing only small same-store sales declines. The upcoming Knapp-Track data for March may actually turn positive, but only because March 2012 sales trends were weak. Don't take a positive reading to mean that this industry's woes are over.

Tired concepts
The especially sharp drops in same-store sales aren't solely due to the beleaguered middle-income U.S. consumer. The companies themselves share some of the blame, as key franchises such as Olive Garden, Ruby Tuesday and Chili's have grown tired in the eyes of consumers.

For example, Olive Garden posted a monthly drop of 9.1% in year-over-year same-store sales in February. That metric has been negative in 17 of the past 22 months.

Longhorn Steaks and Red Lobster had healthier same-store sales trends during the past few years, but each chain has been experiencing negative sales comparisons during the past six months.

Rising costs
These firms also face higher expenses.

First, beef prices are expected to spike this year as farmers cull their herds in the face of the ongoing drought. This initially lowered beef costs -- a lot of cattle were brought to market in late 2012.

Second, the next phases of the Affordable Health Care Act are expected to lead these restaurant chains to offer health insurance to more employees, which is another cost that must be accounted for, and will reduce the bottom line.

In the past 60 days, consensus profit forecasts for Darden have moved 5% to 15% lower (on 2013 and 2014 forecasts, respectively), yet the surging stock market has pushed shares up anyway.

Investors have also boosted shares of Brinker International to an all-time high, even as sales trends remain weak. Despite the recent move to $37, analysts at Merrill Lynch predict shares will fall to $28. They think shares should trade for about 12 times forward earnings, which is a 20% discount to the peer group. "EAT shares merit a discount valuation, in our view, based on the long-term sales record at Chili's and concerns about the risks of aggressive cost cutting," noted Merrill Lynch analysts.

Cracker Barrel also looks frothy
Shares of Cracker Barrel have also traded up sharply, doubling since the summer of 2011.

The company's same-store sales trends have been perkier, (up 3.3% year-over-year in the most recent quarter), and the stock has also been boosted by the agitation of a shareholder activist. Yet it's hard to ignore that shares now trade for about 17 times projected 2013 earnings per share forecasts. That's much higher than the forward multiple of 13.5 this stock has traditionally garnered in the past 10 years, implying that profit-taking lies ahead.

Risks to Consider: A robust drop in the national unemployment rate for the rest of 2013 could provide a meaningful boost to consumer sentiment, though a lack of payroll gains would likely lead to sharp drops for many of these stocks.

Action to Take --> These are the perfect types of stocks you should be selling in this bull market. Their operations remain challenged, their price-to-earnings multiples are getting stretched, and they are faced with rising costs. Although they're among the top performers of 2013, that outperformance appears unlikely to last.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.