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Restaurants: Battling Soft Conditions
by John Gordon, Principal and Founder, Pacific Management Consulting Group
Q3 Earnings Season has almost kicked off, with Domino’s (DPZ) reporting last week. Their revenue was a tad soft (US SSS minus .6%, but costs were lower and both corporate store, supply chain, and franchisee margins were higher. Thank you CEO Russ Weiner for reporting US franchisee EBITDA, up to $155K from $139K. DPZ is also introducing new products as they should (pepperoni cheesy bread, for example).
Current business conditions are unfortunately not better. We got a very good jobs report in September, <1> which ordinarily is great for consumer discretionary segments such as us, but a negative, depressed consumer mood is present. Student loan repayments have begun, the auto worker strikes have not been resolved, and the US House Speaker situation/government funding situation looms in about 30 days. Restaurant softness via credit card reporting portals (hat tip, Sara Senatore, Bank of America) has been evident for some time. The softness in the upper-end steakhouse segment (STKS and the upper-end Darden (DRI) brands is also evident.
A suggestion for restaurant earnings calls. These calls are high-tension, legal disclosures. They will be scripted; companies will not go out of their way to air every issue, but they must follow US Securities law. In my earlier corporate staff life, I helped prepare earnings call presentations, now I study them for clients.
On any given restaurant earnings call, more security analysts with questions are backed up on the line than time allows typically. So not everything gets asked.
I’ve noted over time that there are two central visibility gaps in restaurant coverage:
One. Lack of linkage to the balance sheet. On calls, there always is more discussion and focus on the income statement. It is easier to understand. But the funds flow to the balance sheet and capital spending visibility linkages are harder to see and understand. Seeing the return on capital projects v. dividends/buybacks. What is the proper amount of CAPEX and how to fund it? Debt v. equity? This is where the key ROIC metric comes from. That is a question with Dutch BROS (BROS) currently.
Two. Franchisor reporting of franchisee operating results. For decades, virtually all publicly traded franchisors have not reported substantive financial results of the franchise brand's consolidated units in their portfolio. They would incorporate any company-owned unit's numeric results in their 10-K/Q totals of course. They would report same-store sales and would report units open/closed. And of course, they would provide color on initiatives being worked on. They would talk about franchisor revenue, G&A expense, cash position, and new unit expansion. That’s about it. But I would reasonably opine that’s not a very good disclosure for today’s debt service and stock multiples currently in place for franchise brands.
As a corporate staff financial FP&A veteran, I understand the difficulties. Franchisors do have franchisee numbers, although some get submitted late. As a way to begin forward progress, here is a suggested starting point: in their earnings calls, restaurant brands can define “what characteristics does a healthy franchisee base take in our system that we expect and how would we define current variance from that expectation”.
This would be much more than what is being done now and would inject some meaning into the franchise reporting process.
Food Commodities: A 2024 Look
I had the opportunity to dial into the excellent DatumFS (David Maloni, Principal and Founder) State of the Supply Chain Webinar on October 10. They noted erratic weather has taken a toll on crop supplies. Both US milk cow and cattle herd numbers are declining. Look for ground beef relief but chicken inflation in 2024. Please see more at www.DatumFS.com.
The legislative mess in California will have real negative consequences for “fast food” operators and will pose a threat elsewhere. Where it started.
Over the last three years, a series of extraordinary political developments in California involving the SEIU California labor union, certain Democratic members of the California Legislature, Governor Newsom, SEIU President Mary Kay Henry and finally at the end, the IFA and the National Restaurant Association have conspired to create a hellish CA minimum wage outcome for fast food restaurants, mostly franchisees.
Depending on who is reading it, the minimum wage will jump to $20 (and the maximum minimum jumps to $22) in 2024. That is a full $4 /higher than the base state minimum wage schedule before “fast food restaurants” were targeted. Interestingly, some fast casuals, all casual diners, and fine diners were NOT targeted.
The financial and employment implications are obvious: of course, restaurant operating breakevens will shoot up with the higher labor costs and labor hours will be cut. I’ve already told my clients to be extremely cautious and postpone new unit CAPEX in California until other financial cost pressures, such as interest rates ease.
This is an amazing tale. Originally, two California women labor leaders used fast food workers as a pretext to introduce legislation to “protect” fast food workers. The bill was a way to allow SEIU to take control of parts of the California government to make it easier to unionize state workers. While that aspect failed, the wage hike was hiked again and a bureaucratic fast food wage council was added.
The two women both served in the legislative and were highly educated. They only served in political positions and never had business experience. One, Lorena Gonzales, was a State Assemblymember and introduced AB-257, the first bill SEIU wrote. The SEIU Chief Lobbyist, Tia Orr, first wrote it with the help of SEIU HQ. Gonzales was the most anti-franchisee and franchisor, believing the negative surveys and audit reports about employee mistreatment.
The SEIU “whipped” other Democratic members into supporting the AB257 bill. And the Governor signed it after almost 100 revisions. A similar cycle emerged in 2023, as SEIU reintroduced a “corrective bill”.
Ultimately the Governor signed off on that final bill that jumped fast food minimum wage $4/hour from the prior wage schedule. A strange Wage Council will make a recommendation to the legislature for a final review of wages and work conditions improvements.
Finally, we note that a $4 minimum wage increase is a 25% reset. I am very surprised that the Governor, who has owned restaurants and bars in the past and still owns a winery, would not insist on a graduated implementation period.
The SEIU President has said that they hope to use this California fast food model in other states. I would watch New York and Illinois.
About the author:
John A. Gordon is a long-time restaurant industry veteran, with 20 years of corporate finance FP&A experience and 21 years via his founded restaurant analysis and advisory firm, Pacific Management Consulting Group. John works on complex projects for investors, company operators, and special investigations/legal clients, among others. Contacts:(858)874-6626,email: jgordon@pacificmanagementconsultinggroup.com.
<1> New York Times, October 6 2023.