Baird: The Potential Restaurant Winners From A New Tax Bill

President Donald Trump's proposed tax reform appears to be more likely to succeed than not, which has many investors wondering how best to readjust their portfolio. Baird's David Tarantino took a deep dive into the restaurant sector, where there are a handful of potential winners from both the corporate and individual sides of the tax package.

Tax Cuts And Dining Go Hand In Hand

From a historical perspective, there's reason to believe that a potential tax break would benefit the restaurant industry, Tarantino said in the research report. The Knapp-Track casual dining index recorded a 2.3-percent comp gain in the year following former President George W. Bush's 2003 tax changes, which marks an improvement from the 1.1-percent average seen in the full year preceding the tax changes.

Similarly, restaurant comps rose following President Barack Obama's 2011 tax holiday from a prior negative 0.5 percent to 1.4-percent growth in the year following the change.

The analyst's model of how restaurant foot traffic would perform in a theoretical environment fell short of the actual traffic seen during both periods following favorable tax changes, making it logical to conclude that tax cuts have a direct and positive influence on the restaurant industry.

Related Link: Are Restaurants Safe From The Amazon Effect?

No Trade-Ups Seen

Logic dictates that consumers who regularly eat at fast food chains may want to allocate some of their tax savings to "trade up" to higher-ticket dining options, such as fast casual dining, the analyst said. But looking at the prior two tax cuts doesn't support this thesis — opposite holds true, Tarantino said.

The data shows that quick service restaurant chains see an uptick in demand following tax cuts, although other factors — including a strong recovery in consumer confidence exiting the 2001 recession — could have contributed, the analyst said. Nevertheless, the two tax cuts likely had a "more pronounced impact" on discretionary spending among lower-to-middle income consumers.

While consumers who opt for fast food options aren't likely to "trade up," the same logic holds true for casual chain diners, who won't be opting for more expensive fine dining options.

Corporate Tax Rates

Restaurant chains could emerge winners on two fronts, the analyst said. First, consumers are left with more money in their pockets to spend on dining options. Second, the corporate side of the tax reform plan would see multiple restaurant chains paying a lower rate.

Using a 20-percent tax rate scenario (keeping all else equal), restaurant chains with more exposure to the U.S. would see outsized benefits, according to Baird. On the other hand, large multinational chains that generate a sizable percentage of total sales outside the U.S. would see less of a benefit.

Here's  a summary of companies with the highest tax rate projection for 2018: 

Limited-Service Restaurants

• Habit Restaurants Inc HABT: 41.5 percent.
• El Pollo LoCo Holdings Inc LOCO: 39.5 percent.
• Chipotle Mexican Grill, Inc. CMG: 39.2 percent.
• Potbelly Corp PBPB: 36 percent.
• Jack in the Box Inc. JACK: 38 percent.

Casual Dining

• Buffalo Wild Wings BWLD: 31.3 percent.
• Chuy's Holdings Inc CHUY: 29.5 percent.
• Texas Roadhouse Inc TXRH: 28.5 percent.
• BJ's Restaurants, Inc. BJRI: 27.0 percent.
• Darden Restaurants, Inc. DRI: 25.6 percent.

The Bottom Line

Restaurant investors should be "cautiously optimistic" heading into 2018 and some exposure to the group is "warranted," Tarantino said. 

Baird still projects risk in buying restaurant names that have exhibited weak fundamentals in 2017, he said. 

"Instead, we continue to think the best risk-adjusted approach is to favor companies that have been performing relatively well in the current backdrop (with fundamentals being supported by internal drivers and/or stable business models)." 

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