Restaurants 2016 Outlook

RBC Capital Markets, LLC David Palmer (Analyst) Eric Gonzalez (Associate) (212) 905-5998 (212) 905-5970 [email protected] [email protected] December 16, 2015 Restaurants 2016 Outlook The bigger are getting bigger We are forecasting a market cap weighted upside for our restaurant coverage of 13% over the next year: We believe 2016 will look very similar to the way 2015 is ending—with scale advantages (e.g., digital, national advertising of value, etc.) of large chains playing an increasingly important role in fundamental performance. (See pp. 14–26 for a review of our 2015 predictions.) Our base case macro EQUITY RESEARCH backdrop for 2016 includes: (1) fast food industry SSS growth of 2–3% (see p. 33); (2) nearly flat casual dining industry SSS growth (see p. 27); (3) food costs declining and wage costs growing; and (4) diminishing FX headwinds. Our favorite stocks heading into 2016 are YUM, MCD, and WEN. Adjusting price targets and estimates to reflect market share changes and value-creating corporate actions: We increase our price targets for Outperform-rated McDonald’s (to $130 from $125) and Wendy’s (to $12 from $11) and Top Pick Yum Brands (to $90 from $87) to reflect solid domestic outlooks and restructuring actions. We decrease our price targets for Sector Perform-rated Restaurant Brands (to $42 from $44), Darden (to $62 from $74), Bojangles (to $20 from $23), and Noodles (to $12 from $13) partly as a result of our outlook for slower domestic growth. Furthermore, we reiterate our $68 price target on Outperform-rated Starbucks and our F1Q Americas SSS growth estimate of 8% based on results of our consumer panel analysis through November. See pp. 5–7 for a summary of our revisions. Tougher to be smaller in 2016 but not likely overwhelming; we will look for value picks: While the fast food industry is large (79% of US restaurant traffic), the at-home market is 4x larger than restaurants in number of occasions (81% of meals are prepared at home). As food prices decrease, supermarkets pass those prices through, which can be a drag on restaurant industry growth (at-home food inflation 60% correlated to fast food same store sales growth). While this is usually negative for larger chains, nationally advertised value tiers may offset slower industry growth with share gains. However, economic conditions are constructive to industry trends. Thus, we will be looking for chains that show surprising sales resiliency at what might be more reasonable valuations. See Appendix for commodity forecasts. Digital, breakfast, and value making it better to be bigger: Casual dining industry same store sales (SSS) trends have drifted from 2% in 1Q to flat thus far in 4Q. In contrast, SSS trends for fast food have accelerated to more than 3.5% in 4Q (vs. 2.5–3% for the year), with some larger chains driving industry improvement. The biggest acceleration has come from Outperform-rated McDonald’s, Wendy’s, and Starbucks. For Starbucks, our consumer panel research suggests that its digital platform along with food attachment has provided a boost to sales and the multiple—and we believe SSS growth has reached double digits in early 4Q. For McDonald’s, All-Day Breakfast (ADB) has provided the direct benefit of high-margin sales growth in the US (and should contribute to upside to 4Q consensus). In addition, ADB has helped McDonald’s system to unite behind nationally advertised value in 2016. Being more like 3G should continue to bolster YUM, WEN, and MCD in 2016: While Yum Brands, Wendy’s, and McDonald’s are at various stages of announced restructuring, we believe upside remains for all three from future overhead reduction and leveraged recapitalizations. For Yum Brands, we believe the market has yet to fully appreciate the EPS upside from the restructuring and we increase our EPS estimates and raise our price target to $90 from $87 (see p. 9). Best execution upside—Dunkin’ and Brinker: 2015 has perhaps shown us that not all digital platforms are created equal. As we head into 2016, we will watch the sales trends of Sector Perform-rated Brinker’s Chili’s chain and Outperform-rated Dunkin' Brands’ Dunkin' Donuts. Both chains seem to have an opportunity to participate with protein-oriented value, which may better leverage national advertising scale. And each may find ways to better leverage digital platforms. We will closely observe both companies since even a 2pp improvement in SSS could lead to substantial stock upside. Priced as of prior trading day's market close, EST (unless otherwise noted). All values in USD unless otherwise noted. For Required Conflicts Disclosures, see Page 56. Restaurants 2016 Outlook Table of contents Key points ............................................................................................................................ 3 Summarizing our predictions for 2016 ....................................................................................... 4 Price target and estimate revisions ...................................................................................... 5 Most preferred names in 2016 ............................................................................................. 8 Yum! Brands (YUM; Top Pick; $90 price target) ......................................................................... 8 McDonald’s (MCD; Outperform; $130 price target) ................................................................ 11 Wendy’s (WEN; Outperform; $12 price target) ....................................................................... 11 Reviewing the last year ...................................................................................................... 13 Casual dining outlook ......................................................................................................... 26 Base case calls for another year of flat trends ......................................................................... 26 Texas Roadhouse (TXRH; Sector Perform; $41 price target) .................................................... 29 Brinker (EAT; Sector Perform; $52 price target) ...................................................................... 30 Darden (DRI; Sector Perform; $62 price target) ....................................................................... 30 Fast food outlook ............................................................................................................... 32 Fast food outperformance likely to continue in 2016 .............................................................. 32 Input cost outlook .............................................................................................................. 35 Food costs ................................................................................................................................ 35 Labor ........................................................................................................................................ 37 Restaurant themes to watch in 2016 .................................................................................. 39 Big chains and the need for (food) value ................................................................................. 39 Business and financial structure .............................................................................................. 44 Other notable themes in restaurants ................................................................................. 46 The changing fast food world ................................................................................................... 46 Assessing and fixing consumer issues in traditional fast food ................................................. 46 The US consumer is not looking to big brands or TV for the truth .......................................... 48 Appendix ............................................................................................................................ 50 December 16, 2015 2 Restaurants 2016 Outlook Key points We are forecasting a market cap weighted upside for our restaurant coverage of 13% over the next year: After a year of underperformance in 2014, large cap names such as Starbucks (Outperform) and McDonald’s (Outperform) drove the lion’s share of upside for our RBC restaurant coverage universe (up 23% year-to-date on a market cap weighted basis vs. 21% for the broader sector and -1% for the S&P 500). We believe 2016 will look very similar to the way 2015 is ending—with scale advantages (e.g., digital, national advertising of value, etc.) of large chains playing an increasingly important role in fundamental performance. In addition, we believe upcoming business, cost, and financial structure changes at McDonald’s and Yum! Brands will continue to boost those stocks in 2016. Our base case macro backdrop for 2016 includes: (1) fast food industry SSS growth remaining in the 2–3% range; (2) casual dining industry SSS growth remaining nearly flat; (3) food costs declining and wage costs growing; and (4) diminishing currency headwinds (assuming constant currencies). Our favorite stocks are Yum! Brands, McDonald’s, and Wendy’s. Adjusting price targets and estimates to reflect market share changes and value-creating corporate actions: With this report, we are tweaking our estimates for several of the companies in our restaurant coverage universe. We are increasing our price targets for Outperform-rated McDonald’s (to $130 from $125) and Wendy’s (to $12 from $11) and Top Pick Yum! Brands (to $90 from $87) to reflect solid domestic outlooks and restructuring

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