A Sector to Short

When you consider that an excessive amount of restaurants were built during the real estate bubble, the restaurant business is tougher than usual right now. With the hoped-for prospect of 20–30% returns on capital invested in new restaurants, many restaurateurs expanded their footprint. The problem, however, is that too many restaurants followed this strategy, thereby laying the foundation for disappointing returns.

The restaurant business has never been easy. Guests are demanding and not very loyal. If they have a bad experience, many do not return. Store-level sales and expenses like rent, employees, food and utilities can be hard to manage. Higher costs cannot easily be passed on to customers. Profit margins are unattractive and uncertain.

Restaurant chains must now fight aggressively for lower levels of foot traffic — traffic that’s no longer artificially inflated, as it was during the days of easy consumer credit and loose discretionary spending. Households are tightening budgets. This is a trend that will last beyond the official end of the recession. At the top of most budget plans is cutting the number of meals out.

This long-term trend — the supply/demand imbalance in restaurants — is working against the shareholders of mediocre restaurant businesses, particularly those caught between quick, casual restaurant concepts on the high end and fast-food joints on the low end.

The Daily Reckoning