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Morningstar | Predictions for the Restaurant Industry Heading Into 2019

In many ways, restaurants find themselves in a similar position that retailers did a decade ago, with Amazon's integration of Whole Foods and other physical retail initiatives likely triggering a ripple effect across the grocery store industry, mobile technologies evolving consumer views on convenience and experience, and delivery and other off-premises solutions gaining widespread consumer adoption. Like the retail industry, we don't expect all participants to survive, but for those that recognize these trends and make necessary operational and technology changes, it can help to build an economic moat and lead to a multiyear period of market share gains.

We've heard the argument that the industry is overstored for several years, and to some extent this is true. Some private equity sponsors aggressively pushed operators to expand without focusing on in-restaurant measures designed to improve convenience or in-store experience. As these in-store operational and technology improvements take center stage the next few years and off-premises opportunities become more accessible, we expect restaurant unit counts to contract. However, we still see meaningful unit growth opportunities for those chains that understand their consumers' priorities and adjust their business models and restaurant layouts accordingly.

Restaurant industry valuations have come in after reaching peak multiples in 2017. While some of the contraction was warranted given the end of the refranchising trade and expectations of a turbulent environment as online grocery begins to gain mainstream adoption, we believe there is still a place in investors' portfolios for wide-moat restaurant companies like McDonald's and Starbucks that understand where technology is heading and make necessary changes to address evolving consumer expectations regarding restaurants.

Below, we've included 10 predictions for the restaurant industry the next several years:

-- The ripple effect from online grocery will become more pronounced for restaurants. Amazon grabbed a lot of headlines when it announced that it was acquiring Whole Foods in June 2017. To this point, we really haven't seen a meaningful impact on restaurants due to online grocery, as industry traffic was already weak before the announcement (and has only modestly improved since then). However, with Amazon finding ways to bring Prime memberships into its physical stores through discounts at Whole Foods locations (including Prime Day promotions) and other tactics that grocery stores and mass merchants will likely deploy as countermeasures, we expect restaurant guest traffic across all tiers will remain uneven over the back half of 2018 and into 2019.

-- Expect additional restaurant closures and decelerating industry growth. With restaurant operators already dealing with stagnant guest traffic trends and likely to face labor, rent, and food cost inflation in the years to come, Starbucks and Chipotle probably won't be the last to close restaurants in 2018. We expect restaurant unit counts to decrease by 0.6% the next five years in the U.S. with casual dining and smaller quick-service restaurant chains being the hardest hit. This will result in average industry sales growth slowing from 4.0% from 2012-17 to 3.4% from 2017-22.

-- But there is room to grow for concepts that have adapted to evolving consumer preferences. While we expect slowing industry growth trends the next five years, we don't see an outright restaurant recession and see growth opportunities for those chains that continue to adjust to evolving consumer preferences. The blueprint to remaining relevant will differ for each restaurant operator, but we believe the most successful restaurant concepts will be those that identify what consumer need they are satisfying—often boiling down to convenience versus experience—and then structuring their menu, operations, and technologies to best address these demands. With the rise in digital technologies, increasing demand for off-premises restaurant substitutes, and changing consumer attitudes regarding health/wellness and food sourcing, we believe restaurant layouts will look very different five years from now, with transactions per square foot being one of the best benchmarks operators and investors can use to monitor a concept's ability to make necessary changes.

--The recent pullback in restaurant industry valuations has created buying opportunities. After peaking in 2017, restaurant industry valuations have contracted the past two years as refranchising has subsided and restaurants reinvent themselves amid rapidly changing consumer preferences. While the industry strikes us as fairly valued at current levels, we believe there are a handful of restaurant concepts that screen well using our new benchmarks that haven't received enough credit from public or private market investors.

--Starbucks' recovery will be volatile, but there is still a long-term investment case to be made. Of the restaurants we cover, we believe Starbucks will probably garner the most investor scrutiny over the near future, with still-sluggish U.S. sales trends, new sources of competition in China, its recent consumer packaged goods partnership with Nestle, questions about the current executive team, and the potential headline risks associated with Howard Schultz's political aspirations. While each of these risks brings its own set of executional challenges and management changes are possible in the near future, we believe the company is positioned for a comeback through restaurant layout changes (emphasizing convenience at some stores, experience at others) and menu innovations focusing on health/wellness and authenticity.

--Early technology adopters will start to see sustained guest traffic improvements in 2019. There have been several developments on the restaurant technology front the past several years, including new point-of-sale systems, mobile ordering/delivery capabilities, mobile-enhanced loyalty programs, back-of-house solutions (including labor staffing and inventory management), and automation for food preparation processes. Outside of mobile ordering and delivery, these moves haven't had a material impact on sales and profitability thus far, but we anticipate more pronounced contribution in 2019 for those restaurant operators who understand their specific value proposition and have invested in appropriate front- and back-of-house technologies.

-- Delivery and to-go orders will become even more meaningful to restaurants in the years to come. When all is said in done, we believe the rise in delivery/off-premises solutions will go down as one of the most meaningful restaurant industry developments over the past two decades. Each restaurant's approach to delivery and to-go orders will depend on cuisine type, geography, and daypart capabilities, but we believe the incremental transaction per square foot and average ticket increase opportunities make this a worthwhile area of investment. Finding the right partner is key—especially with restaurant delivery aggregators likely to consolidate in the years to come—but we believe those restaurants that have integrated off-premises solutions into their operations will outperform in the years to come.

-- The restaurant tech boom will continue over the next several years. As restaurant valuations have come in and operators increasingly embrace technology to mitigate costs, it's not surprising that we now find ourselves in the early stages of a restaurant technology boom. We're seeing funding for technology solutions across virtually every restaurant function, including discovery, ordering, guest experience, payments, business management and kitchen operations. We've worked with our counterparts at PitchBook to develop a Restaurant Technology Market Map to give restaurant operators and investors a better idea of the different technologies that are being incubated across the broader landscape.

-- Restaurant mergers and acquisitions will accelerate, and we may still see a large strategic deal done before the year is up. With interest rates rising, fewer refranchising opportunities, and restaurant balance sheets already highly leveraged, restaurant M&A slowed in the first half of 2018. However, with valuations coming down across the space, restaurant transactions have reaccelerated the past few months, including First Watch, Bravo Brio, Modern Market, Costa, Zoe's Kitchen, and Sonic. Based on expectations of sluggish traffic and increased cost pressures, we wouldn't be surprised if additional small- to mid-cap restaurant chains escaped public scrutiny and explored potential go-private transactions. We also believe conditions are favorable for a strategic or financial brand consolidator looking to add a new franchised concept.

-- Who will be the next restaurant tech IPO? We're not expecting any significant restaurant industry IPOs to be announced this year or 2019—fast-casual pizza chains Blaze or MOD are likely next in the pipeline, but not until 2020 at best—but with restaurant technology firms starting to gain adoption and consolidate, we're probably not too far from another restaurant technology IPO. Some private companies are likely to sit tight until Uber's (and by extension UberEats) rumored IPO in the second half of 2019, but don't be surprised to see IPO speculation for other restaurant technology firms like Toast (which completed a $115 million Series D transaction in July), Olo, or HotSchedules as we approach 2019.

For benchmarks that investors can use to identify which operators are best positioned to weather upcoming restaurant industry changes, please see our Observer "The Restaurant Industry Is Evolving—Your Key Performance Benchmarks Need to, Too," published on Oct. 2, 2018.