Although economic data suggests the UK economy has generally not been severely affected by the EU referendum, I expect a ‘restaurant recession’ to take place in 2017/18. The main reason for this is higher inflation caused by Brexit. Already, CPI is 1.8% and is expected to move to 3% or even 4% this year according to various forecasts. In my view, this will cause consumer disposable incomes to drop in real terms, as wage growth is unlikely to match inflation.
Consumers will therefore cut back on non-essentials, such as eating out. The last time a similar situation occurred was during the financial crisis, when many consumers switched dining out for dining in via a takeaway. Therefore, the trading environment for restaurants such as Restaurant Group (LON:RTN) may already be weak, but could deteriorate over the coming months.
At the same time, the company is seeking to make major changes to its strategy. In my opinion, seeking to ‘fix the roof when it’s starting to rain’ may prove challenging, while the company’s valuation appears excessive given other options within the consumer discretionary sector.
Discretionary spending
In my view, one of the most interesting aspects of the financial crisis was the change in consumer spending habits. Goods and services which I had previously thought were discretionary turned out to be staples, and vice versa. For example, it turns out that a daily coffee from Costa or Starbucks is probably fairly high up on most people’s list of products they cannot live without. However, grocery items, while necessary, will be substituted for cheaper alternatives wherever possible when consumer disposable incomes fall in real terms.
However, one sub-sector of the consumer goods industry which always has been and still is discretionary is dining out at restaurants. This can easily be substituted for dining in or cheaper ‘halfway’ options such as a takeaway. In the financial crisis, restaurants experienced an extremely challenging period. For example, in the first half of 2009 consumers in the UK spent £330 million less on dining out than they did in the first half of 2008.
A tough outlook
In my opinion, a similar situation will occur in 2017/18. Weaker sterling is gradually pushing inflation higher, and may continue to do so as the uncertainty regarding Brexit negotiations heightens. Inflation could easily move ahead of wage growth over the next couple of years, since even the Bank of England estimates inflation will reach 2.7% this year. In the last three months, UK wages have grown by only 2.6%. This is likely to leave consumers with less money to spend in real terms on consumer staples and discretionaries. Non-essential items such as dining out could be among the first ‘sacrifices’ made by consumers seeking to make ends meet.
Non-essential items such as dining out could be among the first ‘sacrifices’ made by consumers seeking to make ends meet.
Already, there are signs that a ‘restaurant recession’ is starting to take hold. Results this week from Restaurant Group were disappointing and included a like-for-like (LFL) sales decline of 3.9%. On a reported basis, the company was loss-making. This is taking place at a time when the rate of inflation is 1.8%. It could easily double between now and the end of 2018, or even move higher than that. In such a situation, I feel Restaurant Group and other dining out businesses could suffer.
A changing business
An encouraging part of Restaurant Group’s 2016 results was its strategy to try to improve its financial performance. It has a four-point plan which seeks to improve efficiency and customer service, and enable the company to become more competitive in order to grow. While I feel this strategy is logical and could work in the long run, I also believe it will be tough to implement in what may be an increasingly competitive operating environment.
As mentioned, the challenges facing Restaurant Group are mostly external and so I would expect the company to require investment in pricing in order to shore up sales. This could lead to reduced margins, with the possible alternative being lower sales and higher margins. In my opinion, Restaurant Group is heading into what may become an intensely difficult period from a relatively weak position. Therefore, I believe its risks are relatively high – even when compared to other consumer discretionary stocks which also face a difficult outlook.
If Restaurant Group’s share price included a margin of safety, I think it could be classed as an appealing long-term recovery stock. In an industry where single-digit P/Es are now obtainable for well-known high street consumer goods companies, Restaurant Group’s P/E (on an adjusted basis) of 13 lacks appeal in my view. I don’t think it fully factors in the external environment it already faces, as well as the prospect of deterioration in future months. Further, I would prefer a greater margin of safety given the risks involved in making major changes to its strategy and business.
Uncertain outlook
While I think Restaurant Group could perform well in the long run, I believe it faces significant short-term challenges. Brexit uncertainty may keep sterling pegged back, leading to a higher rate of inflation which surpasses modest wage growth. This may put pressure on disposable incomes, thereby causing a reduction in spending on discretionary items. As the financial crisis showed, dining out could be one of the areas where consumers cut back in order to maintain spending levels on staple items. Therefore, a ‘restaurant recession’ may harm the company’s financial outlook in 2017/18.
At the same time, Restaurant Group is attempting to transform its business. In my opinion, it is doing so at a difficult time owing to the pressures which the restaurant industry already faces. The company made a reported loss in 2016 and while improvement is possible, I believe its valuation is too high given the risks it faces. Therefore, while I’d be happy to buy possible recovery plays within the consumer discretionary sub-sector for potential long-term gains, Restaurant Group offers too much risk and too little reward for me at the moment.