John Gordon - August 2024

Restaurants: Context Really Matters

by John Gordon, Principal and Founder, Pacific Management Consulting Group

The restaurant industry, always dynamic, has gotten even more dynamic. A foggy logic seen in the past has now given way to an element of mania in it. The industry survived the Pandemic, but we are still rocking in its aftermath. Tension has spiked in the last 50 to 80 days; no wonder that most stocks are down. But of course, restaurants are always investable, there are things to do no matter the cycle, to get well positioned for the next.

There are so many meaningful issues and contrasts now, that we have to step back and ponder the overall situation. Context really matters in the analysis: the natural reaction of human principals to recite conclusions that support their position, and what is good for them personally. As such, opinions, management systems, data, and courses of action need special review. Not endless cycles of analysis as we are in an ever-changing consumer, but our systems need to be better grounded. Consider the following in real-time:

·       How did Starbucks get the most expansive CEO succession to Howard Schultz so wrong in 2022-2023? Along the way, how did Starbucks over invest in the China market which is now jammed full of lower-priced coffee brands? And how did basic café operations deteriorate such that Starbucks US is known in some quarters as both slow and expensive? 

·       How did the industry pricing machine so overprice over the years even before the effect of commodity and labor inflation really began? To the extent now that we have virtually a worldwide guest obsession with price, on our hands? The industry took routine pricing actions of 3% annually for decades—until about 2019. All of the readers of this newsletter are well-versed in cost recovery and reading sales, traffic, check, and mix.

·       Why is it that the industry hasn’t found a solution even yet to the reality of producing and opening twice as many restaurants per capita versus that of US population growth? We know why it is occurring but no one can address it.

·       Back to the Starbucks/Chipotle shuffle this week, it was reinforced that we as an industry are not producing the grounding for great CEOs. Brian Niccol’s entire supportive  background should be studied to see how he learned and developed. In our universal quest to reduce G&A costs, we have to remember resources must be left for people, to build and maintain a great team.

·       And despite our well-developed restaurant reporting, consensus data, and earnings cycle emphasis, the stock market can get away from us, on certain brands. Consider Dominos (DPZ) which had stellar results but was punished by the market in July.  

Sales, Traffic, Mix, and Profit Trends

Despite fairly strong job growth, usually, our number one sales catalyst, weak consumer sentiment is the talk of almost every restaurant, retailer, and consumer company. While the restaurant standout brands are doing very well, getting sales and traffic gains, covering inflation, and picking up restaurant margins through positive leverage, many are not. A trend seen in Q2 was that sales shortfalls were covered by G&A cost savings. Of course, in a soft market, variable compensation trends like stock payouts and bonuses are expected to be down, aiding the G&A reduction. However, some company-owned and franchise organization structures have been ”hollowed out” for years. This is not good to produce more Brian Niccol(s) over time.

In July, restaurant demand fell off. Spending growth slowed across all income cohorts. The QSR and Pizza sectors registered more declines. The QSR spending declines were despite a price war that is underway throughout the segment. Despite worldwide attention, McDonald’s $5/$6 price combination (varied) seemed to generate very modest traffic gains, 2-3% for a time, that could not be enough to offset the discounting. McDonald’s will talk about the traffic gain as a huge win. Despite new products, discounting, and unbelievable amounts of TV and digital, one very large, nonpublic QSR brand is tracking down 7-9% in SSS and double-digit traffic losses. Fast casual remained positive but down sequentially; recent casual dining trends had a strong decline, to negative month to month.  Store-based spending turned into negative territory; online spending remained positive but sequentially lower. [Source and Hat Tip: Bank of America and the Sara Senatore team].

Costs are said to be “deflationary” but in reality, the rate of increase is down from the late 2022-2023 disaster. Listening to earnings calls, food/commodities are up 2-3, while labor rates are plus 5-6%. So P&L efficiencies are required, along with extremely low price changes. So then restaurant-level margins could be up or down, depending on sales leverage, mix, and efficiencies.

Capital spending (CAPEX) for new units and remodels cost remains much higher than 2019; permitting problems remain. To brick-and-mortar CAPEX, companies including franchisors must fund IT/digital/loyalty OPEX and CAPEX. As a result, buildings have to be more cost-efficient. Many industry operators know this and have made progress, larger legacy units will be a drag.

There is always money to be made in the restaurant business, but we need profitable sales and non-price-driven P&L efficiencies.

Franchise M&A conditions are much slower

I always listen to the quarterly Unbridled discussion forums. Rick Ormsby and team are among the best and have a dramatic QSR practice. They reported recently that while they have some transactions, 2024 is very slow and many franchisees are not selling. Many are hoping for the 2021 level of sales/margins and multiples to return.  Never say never, but we have to accept that the 2021 period is not to be seen again. They noted some unit EBITDA percentages are very low and need to be in the 15% or higher range. That number has been confirmed many times. They noted that EBITDA multiple turns are a full 1.5 turns (150 basis points) lower than in 2021.

The top-tier brands are still doing well, and a 5X multiple is a good number. One recommendation: before a sale transaction, attempt to weed out the very unprofitable units. I’ve found in my engagements there is more review of clusters and individual underperforming units.

Bankruptcy Notes

We all know that restaurant Chapter 11s have risen dramatically and that there are several core reasons. Larger debt amounts and leverage, sales, and unit margin percentage and dollar deterioration, failed acquisitions, and static company guest mix trends to the most unprofitable type are driving reasons. Franchise over-expansion and cannibalization are the reasons also. Franchisors need more brand disclosure metrics so that unit counts are not the only metric seen. 

The impact of private equity companies taking loans or dividends recapitalizations, that stress debt levels are seen. These issues were present in both Red Lobster (selling real estate and a corresponding new rent burden) and Rubio’s (sponsor took a loan). Not all private equity firms do this of course.

There are more to come. For an engagement recently, I identified one public brand that is shaky, one brand holding company, three major franchise brands, and four non-public brands as very risky.  Overall, we need more attention to balance sheets, which are always less visible.

Starbucks and Chipotle: What to do?

The movement of Brian to SBUX and the stock declines at Chipotle speak to the key leader factor. SBUX stock gained the most ever on August 13, CEO announcement day, when Brian’s move was announced. Starbucks requires much more customer segmentation studies than what we have heard. During Laxman’s administration, the quality of earnings call disclosure deteriorated. In the US, the essential tension is between “maintaining the coffee focus” versus new products. In my opinion, since the addressable market, particularly in some age cohorts has changed, new product and concept development is critical. The Starbucks slow and expensive can be fixed.  I know how.

The China question is a key issue for Brian, the Board, and the China division leadership. One reality is that the China market is flooded by lower-cost and expanding brands like Luckin. A coffee price war is underway, per Asia experts.  Should new unit expansion be curtailed? Would it pencil out to refranchise China to a great master franchisee? I can imagine the numbers but no one outside of SBUX has the real numbers and potential. What Starbucks has said recently has little backup and seems dated. This is where context matters.

About the author:

John A. Gordon is a restaurant analyst and management consultant, with long experience in operations, corporate staff (20 years), and via his consulting firm (21 years), Pacific Management Consulting Group. He works in investor advisory, earnings and economics, M&A review, brand organization reviews, and of course, franchising engagements. Call him to talk about your issues, he will have useful and actionable input. He is at (858) 256-0794, email jgordon@pacificmanagementconsultinggroup.com.