The U.S. restaurant space had a dismal run over the past few quarters in spite of economic growth, lower energy prices and higher income. Consumers increased their spending only modestly on dining out, with the situation taking a turn for the worse, thanks to higher health care costs and tightened credit availability. As a result, traffic has been weak and same-store sales growth has been dull.

In fact, the first quarter of 2017 marked the fifth consecutive quarter of negative comparable sales (comps) for the restaurant industry as a whole, making the mood somber. This is further reflected in the industry’s stock-price performance. Over the past year, the stock-price performance of the Zacks classified Retail-Restaurants industry compared unfavorably with the broader S&P 500 index. While the industry stocks gained a mere 2.2%, the broader index was up 13.4%.

Despite the loud buzz about the restaurant industry hitting recession, it is to be noted that sustained strength in the labor market on the back of a steady rise in wages will likely encourage consumers to dine out more. Restaurateurs are undertaking various sales building and digital initiatives to drive traffic and comps. Also, they are increasingly adapting to the changing tastes and preferences of their consumers to entice them once again.

Increased focus on refranchising bodes well while remodeling efforts should enhance guest experience. Moving ahead, the restaurant industry is thus positioned to get its mojo back.

What’s Spooking the Restaurant Industry?

Restaurants have been witnessing solid sales growth ever since the Great Recession and 2016 wasn’t any exception. Moreover, in its 2017 Restaurant Industry Forecast, the National Restaurant Association revealed that it expects sales in the restaurant industry to reach $799 billion. So, then what’s really bothering 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 continues to be limited. 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. In fact, the 2.4% fall in Q4 was the worst experienced by restaurants in over five years. Also, same-store sales declined 1.6% in the first quarter 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 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.

What Can Possibly Drive Growth?

Nevertheless, some of the big names like McDonald's Corp. (MCD Quick QuoteMCD - Free Report) , Domino's Pizza, Inc. (DPZ Quick QuoteDPZ - Free Report) , The Wendy's Company (WEN Quick QuoteWEN - Free Report) , Papa John's International Inc. (PZZA Quick QuotePZZA - Free Report) , Darden Restaurants, Inc. (DRI Quick QuoteDRI - Free Report) and Restaurant Brands International, Inc. (QSR Quick QuoteQSR - 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, Domino's and Papa John's carry a Zacks Rank #3 (Hold), Darden holds a Zacks Rank #2 (Buy). Restaurant Brands sports a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank 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 20+14. This trend is also far more stable and will continue to lift the sector once the current weakness subsides.

Wave of Consolidation

Consolidation is the name of the game to survive the prevailing restaurant recession. Evidently, though it’s just the fourth month of the year, we have already witnessed four noteworthy M&A activities in the restaurant space.

Notably, another vital rationale behind these consolidations is rising labor expenses and other costs. Now that the Affordable Care Act is here to stay, restaurateurs could be looking to increase scale of operations so as to benefit from economies of scale.Additionally, consolidation is convenient for overseas expansion.

In the first week of April, Panera Bread Company inked a definitive merger agreement with JAB Holdings Company. Per the agreement, JAB Holdings will acquire Panera for $315 per share in cash, in a transaction valued at roughly $7.5 billion, including $340 million in net debt.

In March, Darden, the portfolio of which includes the likes of Olive Garden and Longhorn Steakhouse chains, announced the acquisition of the casual dining chain, Cheddars Scratch Kitchen, in an all-cash deal worth $780 million.

Notably, in February, Restaurant Brands,the parent company of Burger King and Tim Hortons, purchased Popeyes Louisiana Kitchen for $79.00 per share in cash, or $1.8 billion. But before that, in order to drive continued long-term growth, Bob Evans Farms, Inc. announced a definitive agreement to dispose of Bob Evans Restaurants to an affiliate of Golden Gate Capital, in January. At the same time, the company announced the acquisition of Pineland Farms Potato Company for $115 million.

The bringing together of assets, management, personnel and other resources of the two organizations helps in creating sizeable near- and long-term synergies by expanding scale and diversifying the reach of operations.

Thus, given the benefits, weexpect to see more M&A activity in the restaurant space in the near future.

Valuation Looks a Bit Stretched

Going by the P/E (price to earnings per share) valuation metric, which is one of the most commonly used metric for the space, 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 25.9X, which compares unfavorably with what it saw in the last five years. The ratio is higher than the median value of 25X and toward its high of 26.40 over this period.

Moreover, this level compares unfavorably with the market at large, as the S&P 500 index is currently trading at a trailing PE multiple of 20.5X.

Overall, the valuation of the industry from a P/E perspective looks not so attractive when compared with its own 5-year history. This will likely limit further stock market gains.

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 #153 (Bottom 42%).

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

The ranking is available on the Zacks Industry Rank page.

Prediction for Q1 Earnings Season

Our Earnings Preview report paints a not so encouraging picture for the S&P 500 members of the broader Retail-Wholesale sector – one of the 16 Zacks sectors including railroads – in the Q1 earnings season. High costs and a choppy sales environment are likely to hurt the bottom and top line of restaurants, respectively, this earnings cycle. According to the report, earnings for the sector are projected to decline 4.8% year over year. The picture is a lot better with respect to the top line, which is expected to expand 3.3%.

A Glimpse at Beats & Misses in the Sector

Among the companies in our coverage universe, behemoths like McDonald's and Chipotle Mexican Grill, Inc. (CMG Quick QuoteCMG - Free Report) reported better-than-expected earnings and revenues for the quarter.

Meanwhile, Panera Bread reported mixed results for the first quarter of 2017, wherein though earnings failed to beat the consensus mark, revenues surpassed the same. Brinker International, Inc. (EAT Quick QuoteEAT - Free Report) alsoo reported mixed results as earnings beat the Zacks Consensus Estimate, while revenues disappointed expectations.

Bottom Line

The restaurant industry hit a rough patch in 2016, but things are looking up in 2017 as the economy remains robust on the back of growing income and solid employment numbers. Consumer spending has also been in fine fettle of late, although sluggish spending trends in the restaurant space and slowing comps growth make it hard to bank on a strong revival.

Nevertheless, the restaurant deal frenzy is likely to generate revenue growth and counter traffic fall. 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 ahead 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 ahead, 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.