Higher ingredient and energy costs in 2010 will force restaurants to pull back on promotions

Restaurants could see their margins squeezed as inflationary pressures return to the commodity markets, especially as the chains find it harder to wean customers off a steady diet of meal deals.

Analysts expect higher ingredient and energy costs for restaurants in 2010, with inflation returning to normal levels after a year when costs increases moderated and, for some items, fell from year-ago levels. That could make it harder for chains to continue with the aggressive stream of coupons, buy-one- get-one-free offers and other promotions to bring customers into their doors.

"There's no sign of a pullback yet on discounting," Barclays Capital analyst Jeffrey Bernstein said in an interview. But, "if you see a return to inflation in 2010, it'll prove more challenging to offer these deals."

Consumers are responding to those deals, said Morgan Keegan & Co. restaurant analyst Robert Derrington, who believes that Brinker International Inc.'s (EAT) Chili's Grill & Bar deal offering 10 items for $7 or less is putting more customers in its seats.

But as ingredient costs rise, restaurants may find it harder to raise menu prices to protect their profit margins, especially since consumers have grown accustomed to deals. Derrington termed the casual-dining environment as a competitive "flea-market" for consumers, who are going out to eat when they get coupons or see a good deal advertised on television.

"Consumers are being extremely frugal," Derrington said.

With aggressive menu price increases no longer in their arsenal, restaurants may face margin pressures in 2010, when most chains will see their current purchasing contracts expire and they encounter a pricier market for their basket of goods.
The challenge could damp the rally that casual-dining stocks have had so far this year, with some chains bouncing off multiyear lows to post big gains.

Ruby Tuesday Inc. (RT) shares have increased more than seven-fold to $6.26 in recent trading since hitting a 52-week low of 85 cents in early March. Other chains with dramatic gains include Applebee's and IHOP owner DineEquity Inc. ( DIN), whose shares were recently at $29.86, up roughly six times from their low in February, and O'Charley's Inc. (CHUX), whose shares traded recently at $8.19, up more than 300% this year.

Casual dining giants Brinker and Darden Restaurants Inc. (DRI), owner of Olive Garden and Red Lobster, are also up 53% and 19% so far in 2009.

Higher costs should hit casual dining chains that operate most of their locations themselves rather than those that sell franchises, since they bear all the costs. Bernstein cited Cheesecake Factory Inc. (CAKE) and P.F. Chang's China Bistro Inc. (PFCB) as two facing such exposure.

Some think that those restaurants that have offered big time discounts have shot themselves in the foot, as their customers will come to expect lower-priced food.
"When the economy turns, those that were in the promotional business will suffer more than most," Larry H. Lattig, senior managing director at Mesirow Financial Consulting LLC, said at last week's Nasdaq OMX conference on the food and restaurant industry.