Whet Your Restaurant Sector Appetite: A 2017 Outlook

Offering its insights into the prospects of the restaurant sector in 2017, Wedbush said in a note on Thursday that the current valuation expansion (13 percent gain since November 8 versus 13 percent gain for the S&P 500) was driven by expectations of potentially lower taxes, lower labor headwinds and an uptick in transactions.

QSR/Fast Casual Winners From Potential Corporate Tax Cut

Analysts Nick Setyan and Colin Radke expect casual and fine dining to benefit far less from the prospects of corporate tax reduction than the quick service restaurant and fast casual categories. The analysts believe corporate tax reduction may be accompanied by an elimination of existing corporate tax credits such as tip credit.

The analysts are of the view that Buffalo Wild Wings BWLD BJ's Restaurants, Inc. BJRI, Denny's Corporation DENN and Chuy's Holdings Inc CHUY are to benefit to the tune of 10 percent in their statutory taxes reduction.

For quick service restaurants and fast casual restaurants — such as Chipotle Mexican Grill, Inc. CMG, Panera Bread Co PNRA, Starbucks Corporation SBUX, Habit Restaurants Inc HABT and Shake Shack Inc SHAK — the tip benefit is seen as about 0 percent.

Comps, Transactions Trend To Improve

Wedbush clarified that the current consensus estimates already assume an improvement in same-store sales growth and transaction trends, starting in the fourth quarter from a third quarter trough. The improvement, according to the firm, will accelerate as 2017 progresses. Following its fourth quarter checks to date, the firm sees no evidence of an inflection point ahead of pre-election expectations.

Margins At Risk

The firm is of the view that the consensus expectations for industry unit-level margin expansion of flattish performance are at risk. Assuming low probability of comp and transaction growth outperformance, wage inflation in line with 2016 and less of tailwind from food costs, the firm sees risk of downward revisions.

Industry Unit Growth To Slow Down

The firm also believes managements might seek to reduce unit growth to alleviate pressure from new unit inefficiencies. According to the firm, restaurants may seek to close underperforming units to highlight the underlying profitability of their businesses. Specifically, the firm believes this rationalization action would benefit small-cap restaurants disproportionately, with Fiesta Restaurant Group Inc FRGI, Noodles & Co NDLS and Kona Grill Inc KONA.

Ratings/Price Targets

• Fiesta Restaurant: Outperform/$32.
• Noodles & Co.: Neutral/$4.50.
• Kona Grill: Outperform/$14.
• BJ's Restaurant: Underperform/$34.
• Buffalo Wild Wings: Neutral/$155.
• Denny's Corp.: Outperform/$14.
• Chuy's Holdings: Outperform/$31.