Over the past few quarters, the U.S. restaurant space has not been too enticing for investors. Despite economic growth, somewhat lower energy prices and higher incomes, consumers have increased their spending only modestly on dining out. This is because, along with wage growth, inflation is also on the rise, which translates into lower real income and thus less disposable income. The situation has taken a turn for the worse, thanks to higher health care costs and tightened credit availability in the U.S.

Moreover, as consumers demand high-quality products at lower prices, it is pushing grocery stores to decrease their food prices in order to remain competitive. This is resulting in a bigger gap between food-at-home and food-away-from-home indices.

Thus, same-store sales growth has been dull in a difficult sales environment. Foot traffic also went into retreat, and profits at many chains followed suit. In fact, the second quarter of 2017 marked the sixth consecutive quarter of negative same-store sales (comps) for the restaurant industry as a whole, continuing the somber mood.

This is further reflected in the industry’s stock-price performance. Over the past year, while the industry stocks have gained a mere 4.9%, the broader index is up 11.2%.

However, despite the louder buzz of the so-called restaurant recession, it is to be noted that recent strong gains in the labor market on the back of a steady rise in wages will likely encourage consumers to dine out more and put a check on declining traffic. Restaurateurs are undertaking various sales and digital initiatives to enhance guest experiences and, in turn, drive traffic and comps. Also, they are increasingly adapting to the changing tastes and preferences of their consumers. Moving ahead, the restaurant industry should thus get its mojo back.

What Are the Challenges?

Restaurants have been witnessing solid sales growth ever since the Great Recession and 2016 wasn’t any exception, despite an industry-wide slowdown. Moreover, in its 2017 Restaurant Industry Forecast, the National Restaurant Association revealed that it expects sales in the industry to reach $799 billion, reflecting an increase of 4.3% over estimated sales of $766 billion in 2016. So, then what’s really spooking the industry?

It is to be noted that though this will mark the eighth consecutive year of real growth in restaurant sales, the rate of growth will remain dampened by historical standards. Considerable variances among geographic regions and industry segments are also likely to hamper restaurant sales performance.

Additionally, even though total sales are up, foot traffic at individual restaurants is waning fast. Same-store sales that account for traffic dropped in each of the four quarters of 2016 (0.2%, 0.7%, 1.1% and 2.4%, respectively), per TDn2K’s Black Box Intelligence. Moreover, comps have declined 1.6% and 1%, respectively, in the first two quarters of 2017, highlighting the difficult operating environment currently facing many operators.

We note that the prime reason for such a drop in same-store sales is essentially the increased number of new restaurants amid restricted growth in eating-out budgets. Supply glut and limited demand are thus hampering traffic as well as stock prices for restaurants as instead of generating added sales, each new restaurant is eating up share from other restaurants. This has, in fact, resulted in bankruptcy for many public and private restaurants.

Another major challenge that restaurants are facing of late is an increase in menu prices at a much quicker rate than the prices for food at grocery stores. This is adding to the competitive pressure for restaurants, as preparing food at home has become much more attractive from a cost perspective, resulting in declining footfall.

Additionally, rising labor costs and a complex legislative and regulatory landscape on federal, state and local levels is thwarting business performance and bottom lines.

What Can Possibly Drive Growth?

Nevertheless, some of the big names like McDonald's Corp. (MCD - Free Report) , Yum! Brands, Inc. (YUM - Free Report) , Domino's Pizza, Inc. (DPZ - Free Report) , The Wendy's Company (WEN - Free Report) , Darden Restaurants, Inc. (DRI - Free Report) and Restaurant Brands International, Inc. (QSR - Free Report) seem to be unperturbed by the plight and continue to do well on the back of strong fundamentals and innovative offerings. While McDonald’s, Yum! Brands, Wendy’s, Darden and Restaurant Brands carry a Zacks Rank #3 (Hold), Domino's holds a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

This signifies that all is not lost for the U.S. restaurant space, and investors should thus not shy away from putting money into this space and cash in on the bountiful opportunities.

In fact, long-term trends favoring eating out over eating at home are still in place. Moreover, operators willing to evolve and stand out in a competitive market will continue to reap profits. Thus, restaurants with solid fundamentals and sufficient capacity for innovation will remain compelling bets.

More importantly, long-term factors supporting the sector remain firmly in place. Per the USDA, spending on food outside homes has risen from 10% to 50% of total food purchases over 1904 to 2013. In addition, sales at food services and drinking places have increased more rapidly than retail sales since 2014. This trend is also far more stable and will continue to lift the sector once the current weakness subsides.

Meanwhile, though comps fell in the second quarter of 2017, the period posted the best results for the industry since the second quarter of 2016. Notably, besides improving economic conditions, easy year-over-year comparisons also seem to have aided the results.

Valuation Looks Bit Stretched

Going by the P/E (price to earnings per share) valuation metric, which is one of the most commonly used ratio and best suited for evaluating restaurants, the industry looks a bit expensive at this stage and investors might not want to pay any further premium.

The industry currently has a trailing 12-month P/E ratio of 25.18, which compares unfavorably with what it saw in the last five years. The ratio is higher than the median value of 23.87 and toward its high of 29.37 over this period.

Moreover, this level compares unfavorably with the market at large, as P/E for the S&P 500 stands at about 19.85.

Overall, the valuation of the industry from a P/E perspective looks not so attractive when compared with its own range in the same time period. Moreover, given its higher-than-market positioning, there seems to be little room for upside left.

Zacks Industry Rank

Within the Zacks Industry classification, restaurant companies are grouped in the broader Retail-Wholesalesector (one of the 16 Zacks sectors).

We rank 265 industries into 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by more than twice as much. The Zacks Industry Rank for Retail-Restaurants industryis currently at #225 (Bottom 15%).

The location of the industry suggests that the general outlook for the restaurant space as a whole is leaning toward ‘Negative.’

Earnings Trends

The restaurant industry belongs to the broader Retail-Wholesale sector.

Though a soft consumer spending environment in the U.S. restaurant space along with rising costs are haunting restaurant chains, innovative operators with strong fundamentals are continuing to exhibit strength even in a not-so-favorable environment.

Among the companies in our coverage universe, behemoths like McDonald's and Yum! Brands reported better-than-expected earnings and revenues in the second quarter of 2017.

Meanwhile, Chipotle Mexican Grill, Inc. (CMG - Free Report) reported mixed results for the second quarter of 2017, wherein though earnings beat the consensus, revenues fell short. Meanwhile, Starbucks Corporation (SBUX - Free Report) reported third-quarter fiscal 2017 results, wherein it met analysts’ expectations on earnings but failed to meet on revenues amid persistent declines in U.S. restaurant sales. On the other hand, Buffalo Wild Wings Inc. (BWLD - Free Report) lagged on both fronts in the second quarter.

Bottom Line

Restaurant operators continue to battle margin pressures, a tightening labor market and lingering consumer uncertainties. There might be light at the end of the tunnel, though, as a gradually improving economy on the back of growing income and solid employment numbers are likely to help restaurant-industry sales to continue advancing in 2017.

Thus, despite the challenges, the restaurant industry is expected to sustain its general pace of recovery going forward, albeit at a slower rate, as it grapples with several global economic concerns.

Meanwhile, as always, the restaurant industry is expected to remain hyper-competitive as different names vie for attention from diners to capture market share. Restaurant operators will thus need to differentiate themselves from the competition, keeping in mind price and convenience. Moving forward, it will be critical to stay in consumers’ minds, focus on innovative products, distinctive promotions and viable pricing, articulate the benefits of eating at restaurants instead of home, and at the same time deliver a congenial experience.