A combination of improving domestic economic fundamentals and low energy costs continues to benefit the restaurant space. But the coast isn’t entirely clear either.

Commodity Cost and Other Costs Drag Down Margins: Food costs account for about one-third of restaurant costs, thus making the industry excessively vulnerable to food cost inflation. Increase in demand for a commodity is always good news for producers. However, it becomes a problem for restaurants when there is inadequate supply of a particular commodity and prices start to rise.

Prices of poultry, eggs and avocados are some of the key ingredients whose prices have touched record highs in the recent past. While a drought in California raised the prices of beef and avocados, the outbreak of avian flu in some states of the U.S raised turkey and egg prices. Unfortunately, the situation is not expected to improve in the near term. While beef prices are expected to jump 5.5% to 6.5%, poultry and egg prices are expected to rise 2.5% to 3.5% and 12.5% to 13.5%, respectively in 2015 per the U.S. Department of Agriculture.

Rising costs hurt the margins of a company. Moreover, as companies try to pass on the costs to customers by increasing menu and product prices, it impacts traffic. Chipotle Mexican Grill, Inc. (CMG - Analyst Report), Buffalo Wild Wings Inc. (BWLD - Analyst Report), Fiesta Restaurant Group, Inc. (FRGI - Snapshot Report) and Shake Shack Inc. (SHAK - Snapshot Report) have already announced price increases for their products in response to rising input costs of key ingredients.

In addition to commodity costs, costs related to initiatives to boost comps and pre-opening and re-imaging expenses are also dampening margins. Also, there has been considerable debate in the recent past over restaurant workers’ wages. Workers at quick-service restaurants claim that their employers' profits have not trickled down to them, thereby forcing strikes demanding wage hikes. These incidents significantly hurt the reputation of companies. They are compelled to make minimum wage increases, which end up hurting margins.

Moreover, the labor market has tightened due to a drop in unemployment rate, higher retirement numbers and a growing portion of people who do not want a job. This is further compelling restaurants to either hike wages or provide benefits to retain or attract employees. Companies like Chipotle, The Cheesecake Factory Inc. (CAKE - Analyst Report), McDonald's Corp. (MCD - Analyst Report) and Domino's Pizza, Inc. (DPZ - Analyst Report) are working on these lines.

Soft Traffic Trend: Though traffic trend has improved sequentially over the past three months, it has remained in the negative. It is a matter of concern for the industry. Per market analysts, people are visiting chain restaurants less often and instead prefer spending more per visit. This is hurting traffic. Moreover, increase in menu prices at times prevents them from dining out. Among the restaurants that are bearing the brunt of soft traffic include BJ's Restaurants, Inc. (BJRI - Analyst Report) and Brinker International, Inc. (EAT - Analyst Report).

Macro & Political Issues/Other Challenges: The restaurant industry is facing difficulties like heightened competition in the U.S. and decelerating growth in Asia. Meanwhile, Greece’s default on its IMF loan would further create problems for the debt-laden Eurozone. Therefore, some restaurant companies like Brinker International, Cheesecake Factory and Papa John's International Inc. (PZZA - Analyst Report) that have significant presence in these regions, are expected to face macro headwinds.

Additionally, restaurants with international presence are vulnerable to political and other issues in the regions in which they operate. The temporary closing of McDonald's restaurants amid allegations of violation of sanitary rules in Russia in the recent past is a case in point.

This was likely the result of the ongoing tension between Russia and the West on the Ukraine issue and had a significant negative impact on the comps of this burger giant. Also, food safety issues among consumers have been hurting comps of a couple of restaurants like McDonald’s and Yum! Brands, Inc. (YUM) that have faced serious allegations over food safety in China.

Currency Headwinds: Fluctuating currency exchange rates are also a concern. Currently, a surging U.S. dollar is reducing the value of overseas sales of companies like Domino's Pizza and McDonald's as these have considerable overseas presence. Meanwhile, McDonald’s and Yum! Brands are also expected to bear the brunt of the devaluation of the Chinese yuan in the form of soft sales, going forward as China is one of their key operating regions.

Affordable Care Act to Hurt Margins: The Affordable Care Act, commonly known as Obamacare, is expected to have an adverse impact on the operators. U.S health care reform as per the Affordable Care Act imposes several new requirements on employer health benefits. The law entails restaurants with 100 or more full-time equivalent employees to offer health care coverage to substantially all full-time employees and their dependents beginning this year.

Meanwhile, it will be applicable for employers with 50 to 99 full-time-equivalent employees in 2016. However, the employers are suffering penalties if they do not follow these rules. In both the scenarios, it will increase the costs for restaurant operators like Darden Restaurants, Inc. (DRI - Analyst Report), Papa John's and The Wendy's Company (WEN - Analyst Report) who are already grappling with the pressure of higher food costs and other costs, thereby hurting margins.

To avoid these austerities, most companies are trying out different labor models like involving more part-timers and cutting work hours, which would hurt margins at the restaurant chains. Meanwhile, some companies are already limiting their hiring, which will eventually increase the unemployment rate.

To Sum Up

Every industry has its own share of problems and so does the restaurant industry. Implementing the right pricing strategy, increasing global presence and focusing on supply chain revenues can offset the negatives to some extent. Let us see how these companies manage to counter the headwinds and register profits in the coming days.

Check out our latest Restaurant Industry Outlook here for more on the current state of affairs from an earnings perspective and the trend for this important sector.