Let's begin this piece with a little bit of Austrian School economics.
Restaurants and their place in the structure of production
Austrian economics sees the capitalist economic structure as proceeding from nature given factors of land mixed with labor to successive layers of capitalists and finally to the consumer. The more modern and sophisticated the economy, the "longer" the structure of production gets. Since any economy must necessarily start from given land and labor factors and end ultimately at consumption, what is in fact "lengthening" as an economy develops is the chain of capitalists in between the two ends.
To picture this lengthening process in the most basic sense, it is helpful first to conceive of the most basic economy imaginable, the so-called "Crusoe" economy of one man isolated on an island, as Professor Murray Rothbard put it in his book, "Man, Economy, and State". All he has is nature-given land and his own labor. The most immediate thing he can do to satisfy his desires is, say, pick fruit with his own hands. The tree is given land/nature, his picking is his own labor, and this proceeds directly to consumption. The structure of production here is the shortest it can possibly be, directly from land to consumption with nothing but labor (picking) in between.
Let's say that Crusoe wants to be able to pick more fruit. After all, there's only so much he can pick with his bare hands. So he takes his labor, some nature-given factors like a branch and some twigs, combines it with labor and time, and builds for himself a fruit-picking instrument. Crusoe now has "capital" that enables him to pick more fruit with less labor. His structure of production has "lengthened" because the distance from nature-given factors to consumption has grown from simply picking fruit directly, to building capital (the fruit-picking instrument) and then picking the fruit with the capital. His economy, his ability to consume, has developed.
The crucial thing to understand here is that building the capital took time. During that time, Crusoe could not pick fruit. He had to withhold consumption (AKA save/invest) in order to build the fruit-picker. However, due to that withheld consumption, he is now able to consume more than he otherwise would. What Crusoe did here was a one-man interest rate transaction. He gave up present goods (decided to have less hand-picked fruit now) for future goods (more capital-picked fruit later) and earned the interest (extra fruit) on his investment.
He also took a risk in building the capital, as all capitalists are essentially risk-takers. Perhaps it would have failed and Crusoe would have gained nothing. But because he took a risk and invested, he reaped the interest in his withheld consumption.
Let's move up a few more steps now to a modern economy. In a modern economy, there are huge machines that plow, plant, fertilize, pick fruit, enormous distributors that use ships and trucks to transport across land and water, etc. Each one of the parts to each of these pieces of capital involved here is made in a different factory somewhere by hundreds of different capitalists in different layers of production all around the world. As the economy becomes more specialized, the structure of production gets longer and longer, and each capitalist can manufacture what he specializes in best and most efficiently (perhaps the widget of a transcontinental boat used to transport apples). All the parts to all the capital eventually come together, the fruit is picked after being grown in the most productive manner, transported somewhere by yet more capital, and finally the fruit is sold to the consumer for money, which only then travels back up the stages of production. Every stage earns its interest with respect to how long it took for the final product to reach the consumer.
The structure of production here is enormous. It would be difficult to count the number of layers of capitalists involved here between land and final consumer. What we do know, however, is that the further away from consumption, the more time it takes to eventually reach the consumption stage, when revenues are finally received. This means that the closer you get to original nature-given factors, or in other words the higher you go up the structure of production, the longer must be the period of withheld consumption, meaning the higher the level of savings must be, and therefore the higher the interest paid to that level on that savings.
Because the highest order capitalists are waiting the longest until the final product is sold, they must therefore receive the highest profit margins. On the extreme other end is the consumer who receives zero profit because he's the one consuming instantaneously. He buys the fruit, waits zero time, eats it, and nothing is left, no interest-based profits at all. In between are the capitalists with varying levels of interest-based profits.
What does this have to do with restaurants and how you can use this information to make investment decisions?
Restaurant chains are at the very bottom of the structure of production, immediately before the end consumer. This means that the interest they earn, their profit margins at any given time, are extremely thin, but quite predictable as to what they should ideally be at maximum efficiency. Why are they so predictable? Because, in almost all cases, we know exactly where a restaurant is in the production structure, and it scarcely ever moves. It's at the end, period. This means that all successful restaurants should have the same basic profit margins, which are anywhere from ½ to 2%.
These small margins are in fact a big advantage to being at the end of the structure of production. While the time period where management is trying to achieve this small profitability can be very precarious, the key to understanding the restaurant industry is this:
Once a chain hits the sweet spot of 1-2% profit margins, it means it has achieved maximum efficiency for its place in the structure of production. After that, it simply becomes a question of expansion and growing revenue.
Put another way, a restaurant consistently operating at 1-2% profitability, even after prolonged losses on the way to stability, is safer than, say, a durable goods manufacturer higher up the production chain operating at a consistent 10% margin when its competitors are operating at 20%. For one thing, it is much more difficult to tell exactly where in the production chain any given durable goods manufacturer is, and therefore what interest it should earn based on its distance from the end consumer, and therefore what its profit margins should be at maximum efficiency. Depending on who the firm is selling to and how close to the consumption stage any given customer of the firm is, it could be functioning as a different order capitalist for any given sale.
Secondly, assuming we know exactly where it is in the production structure, if a firm somewhere in the middle of the production chain is earning 10% profits while its competitors are earning 20%, even though that 10% is much higher than the 1 to 2% earned by a restaurant, the 10% firm will eventually be priced out of the market by more efficient competitors who will be able to undercut it in a free market.
With restaurants, however, an investor knows exactly where his investment is in the production structure at all times, and therefore knows to a much more exact extent how much it should be making in profit. Once it hits that margin, it is a sign that the company is at maximum efficiency, and the stock should then benefit.
The question is getting there
Achieving that 1 to 2% profitability for a restaurant chain is the challenging part. For the rest of this article I will focus in on one new prospect with high return potential, and that is Chanticleer Holdings (HOTR), a $16M company trading at $4.25, a minority owner of Hooters of America and an international Hooters franchisee. Chanticleer is getting closer to profitability, cutting its losses quarter by quarter and expanding quickly. It has made three key moves in the last two months, the most recent only two weeks ago. My main thesis is that if Chanticleer can break even by summer of 2014, it will achieve that 1 to 2% profitability by the end of 2014, and from there HOTR will rise significantly, perhaps many-fold. First I will sketch an outline of Chanticleer's current cash position and then go through each of the three recent developments and analyze how they may affect its profitability in upcoming quarters.
Chanticleer's cash position
The first thing to notice about Chanticleer's income statement is that its operating loss has been shrinking for 3 consecutive quarters, 25% since Q3 2012, and that this is not due to revenue growth. Chanticleer has not opened any new Hooters restaurants since Q3 2012, so dramatic revenue growth should not be expected. Rather, its revenues are remaining more or less seasonally constant, while its cost of revenue and administrative payments are proportionally shrinking. In short, it is becoming more efficient.
With the number of restaurants currently in operation, there is little to no chance Chanticleer can break into profitability given the economies of scale required for a restaurant chain to be net positive. But the fact that operating costs are shrinking to the extent that they are indicates that when Chanticleer does expand, management has proven that it can tighten up operations.
In a recent interview with the Charlotte Observer, Chanticleer CEO Mike Pruitt estimated that the company would need 10 to 12 restaurants in order to be profitable. It currently has four up and running in South Africa, one in Hungary, and one in Australia, for a total of 6. If he's right and 10 to 12 will do it, then Chanticleer should break even by next summer, given the following:
Move #1 - Acquisition of Hooters in Nottingham, UK
On August 2, Chanticleer signed a binding letter of intent to acquire the Hooters restaurant in Nottingham, UK, for $3.15M. This included a $200,000 down payment towards the purchase. The full purchase must be made by September 30 according to financing terms, meaning the Nottingham revenue stream will be added to Chanticleer on its next earnings statement. The Nottingham location was previously owned by another private Hooters franchisee and has been in operation for 13 years.
The acquisition will be financed by a 6% convertible note at a principle of $3M all specifically earmarked for the purchase of the Nottingham Hooters. The full terms can be found here. Under the agreement, Chanticleer will also pay 10% of the net profits from the Nottingham Hooters to the creditors for the life of the restaurant. Whether the deal will ultimately be dilutive depends on whether the notes will be converted to stock or paid in cash. This will be left up to the discretion of the creditors involved.
Chanticleer currently has $3.67M in liquid assets on its balance sheet, which will enable it to finance this new debt for the next two years. The principle $3M is owed at the end of the third year. We do not know the finances of the Nottingham Hooters to date, but we'll find out its net effect on Chanticleer's next earnings statement. Nottingham will bring Chanticleer up to a total of 7 Hooters restaurants.
Move #2 - Acquisition of American Roadside Burgers [ARB]
On August 14, Chanticleer signed a letter of intent to acquire American Roadside Burgers in an equity exchange agreement of 740,000 shares of HOTR, meaning the acquisition will cost Chanticleer nothing out of pocket. ARB can best be described as something of an upscale McDonald's (MCD) with an Americana theme. It is a small chain of 5 restaurants and the deal is closing on September 30, the same day the Nottingham acquisition is scheduled to be completed. This will bring total restaurants up to 12, 7 Hooters, 5 ARB's.
Plans for this acquisition were not hinted at in any of the company's previous filings, so investors have to ask why this is happening now, and why ARB? Pruitt's words as quoted in the Charlotte Observer interview may be able to shine some light here:
"When the Roadside opportunity was brought to me, the people I called were my partner in Australia, my partner in Budapest, my partner in South Africa, and said, "Do you think an upper-end burger concept would work in the parts of the world that you're familiar with?" And with 100 percent, they came back "For sure."
Given the name "American Roadside" and the chain's theme, it seems a natural fit for it to be exported internationally. Taking a parallel from Bloomin Brands' (BLMN) Australian themed Outback Steakhouse, there are currently 771 (page 6) Outback Steakhouses in the US. There are only 6 in Australia, home of the Outback. That's only one more restaurant than American Roadhouse has now. Clearly, Pruitt wants to use ARB in order to expand his international market by sticking with the Hooters Americana theme but taking away a bit of the raunchiness associated with the Hooters brand.
Move #3 - A fifth Hooters Restaurant in South Africa
South Africa is Chanticleer's main market. Revenues from the company's 4 Hooters locations in South Africa accounted for 85%, or $1.43M (page 31), of its total revenues last quarter. On September 3rd, Chanticleer announced plans for a fifth Hooters restaurant in Pretoria, South Africa, to be opened by the end of this year. A fifth restaurant there will be cheaper to operate than breaking into a new country as Chanticleer is already familiar with the territory. Together with a second Australian Hooters joint venture in Townsville planned earlier, this will bring total Chanticleer restaurants up to 14.
The next two earnings statements will be critical
We don't know exactly what cumulative effect the Nottingham, ARB, Pretoria, and Townsville acquisitions will have for Chanticleer's earnings statement, but we will all find out in the next two quarters. Two things are certain. Revenue will go up, and so will interest payments on debt. The most important thing to watch in my opinion will be the operating margins. If these go positive by Q1 2014, then overall profitability is just a question of paying off the debt accrued by this expansion and it will only be a matter of time before that 1 to 2% profit margin is reached. Given HOTR's tiny market cap to date, gains could be disproportionately large if these acquisitions prove successful. Of course if we find out ARB is dead on arrival and the Nottingham Hooters is a mess, the prospects for Chanticleer are nil, but I doubt that creditors would put up $3M without looking carefully at some financial statements first.
Pruitt is already thinking ahead in some interesting directions.
Specifically, he hinted that, along the lines of the ARB acquisition, he is positioning Chanticleer as the go-to franchiser for American restaurant chains seeking to expand internationally. Several companies, he has indicated, have already approached him on this front. In his words:
I haven't done anything to promote that, but I can tell you there's a burger chain in this country that's iconic, that's already approached me. I've had another significant company, a juice company, approach me. So I'm already being approached by concepts.