Restaurants are struggling as price increases backfire. But these chains are feeling pretty good.

By Bill Peters

'We see guests trade down from traditional full-service chain dining, trade up from fast food and trade over from legacy fast-casual players,' Cava CEO says

Following a steep rise in food prices, big restaurant chains like McDonald's Corp. and Starbucks Corp. this year have warned of a more circumspect customer. But not everyone in the industry is seeing it.

Even as those bellwethers try to throw more value meals, or a new CEO, at the problem, shares of fast-casual chains - those that try to split the difference between fast food and, say, Applebee's - are rallying this year, as more upper-income diners and others come to view their combination of faster service and better-than-fast-food ingredients as an affordable luxury.

A lot could still go wrong, as worries about the consumer endure and stock gains reach their ceiling. But for now, shares of Mediterranean-restaurant chain Cava Group Inc. (CAVA) are up 175.6% so far this year. Sweetgreen Inc. (SG), which serves salads and grain bowls, is up 186% year to date.

Elsewhere, burger chain Shake Shack Inc. (SHAK) is up 41.2%. And Chipotle Mexican Grill Inc. (CMG) is up 21.9%.

The gains for those names come as dining out has gotten much more expensive. Both higher- and lower-end restaurants have raised prices to test consumer demand or cover higher wages for workers, as well as higher costs for the food they serve.

At times, that has pushed sales figures higher. But in the process, William Blair analyst Sharon Zackfia said, the difference in price between the high end and the low end has narrowed.

"Fast food was pretty liberal with their price increases over the past two to three years," she told MarketWatch. "And potentially, they've been liberal with the price increases without giving much more to the consumer."

She noted that Chipotle and Cava, which went public last year, have seen strong demand from all income levels. Chipotle last month said more people across low-, middle- and high-income tiers were stopping in. And Cava, during its earnings call this month, said "the lowest-income strata has the highest level of sales."

Brett Schulman, Cava's co-founder and chief executive, said during that call that traditional fast-food chains are currently living with the perception that they're too expensive. Even as those chains cast themselves into the current discounting fray, he said "value" for many customers goes beyond the price.

"It's meeting the moment for the modern consumer and positions us at the nexus of consumer convergence, where we see guests trade down from traditional, full-service chain dining, trade up from fast food and trade over from legacy fast-casual players," he said.

Other things working for Cava include its recent launch of Mediterranean steak, which Zackfia said has helped attract more dinner orders and more male customers. Even as Cava expands, same-store sales jumped 14.4% during the most recent quarter, and free cash flow turned positive. And after Cava's 2018 acquisition of Zoe's Kitchen established it as a leader - at least within the narrower space of Mediterranean fast casual - Zackfia said some investors who missed out on the start of Chipotle's run nearly two decades ago might be looking for make up for lost gains.

Still, Cava shares fell on Tuesday, after the company disclosed that executives sold off thousands of shares. Zackfia brushed of the concerns, pointing to the company's plans to have more than 1,000 U.S. restaurants by 2032.

Elsewhere, adding steak to the menu at Sweetgreen, while raising some questions about its environmental aims, has helped demand. And as employees demand higher pay, investors - perhaps not surprisingly - have also taken to the company's efforts to bring in more robotics and automation into its kitchens. Its efforts to venture outside of large cities, into the suburbs, have shown signs of paying off. During its second quarter, same-store sales rose 9%.

"Our results continue to show that our brand's relevancy extends far beyond our current footprint, with considerable whitespace in both new and existing markets," Jonathan Neman, Sweetgreen's co-founder and chief executive, said on the company's earnings call this month.

Shake Shack, meanwhile, has faced concerns that discounting from the likes of McDonald's and Burger King could dent sales. While the company on Tuesday said it would close nine locations that were either underperforming or hurting other Shake Shack stores, Raymond James analysts downplayed the news, saying they didn't expect the move to have a "material impact" on financials.

In June, those analysts also downplayed the impact from the so-called "burger wars," as Shake Shack's fast-food rivals cut prices.

"While we acknowledge the limited-service burger overlap, we believe these concerns could be overdone given Shake Shack's 1) premium/quality positioning, 2) higher/lower mix of upper/lower-income consumers relative to quick service, and 3) more conservative menu pricing during the pandemic and strong value proposition relative to peers," the analysts said.

BTIG analyst Peter Saleh, in a note on Monday, said Shake Shack was on its way to putting up positive free cash flow this year - the first time it has done so in seven years. And Zackfia said there wasn't as much overlap with other burger chains, which rely far more on drive-thrus, as some might think. She argued that once a person gets out of their car to go eat, the competitive dynamics for restaurants change.

Still, analysts at Piper Sandler, in a note this month, said the stock prices for fast-casual names were getting close to running their course.

"While we are not negative per se, from a research analyst and stock-selection picking perspective, we think the risk-rewards for several names in the sector are becoming more balanced; whereas previously this had been the area of our coverage where we've been the most positive overall this year," they said.

Then there are difficulties at the fast-casual chains themselves. Complaints on social media over smaller serving sizes at some Chipotle locations made their way to the company's earnings call last month, leading executives to retrain some staff. And Zackfia said customers' expectations have only risen.

"If I have a bad experience at a restaurant, I'm probably going to go to Yelp and tell everybody I know about my bad experience," she said. "But if I have a good experience, I may just take that for granted."

-Bill Peters

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08-31-24 0752ET

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