This article evaluates four factors that have the potential to drastically alter the restaurant/food service industry and how those factors affect four specific firms: Darden (NYSE:DRI), Brinker Intl. (NYSE:EAT), Buffalo Wild Wings (NASDAQ:BWLD) and Chipotle Mexican Grill (NYSE:CMG). An attempt to quantify each factor in isolation is made, along with designations for "winners" and "losers." The first factor primarily impacts the balance sheet, and secondarily, the income statement and statement of cash flows with possible credit ramifications. The final three factors influence the income and cash flow statements.
1. Proposed Change in Lease Accounting
The FASB and IASB are proposing new standards for lease accounting, dividing leases into Type A and Type B (most land and buildings) rather than the traditional "capital vs. operating" classifications. If finalized as currently contemplated, these changes would pull most operating leases, with the exception of leases under 12 months, including all renewal terms, onto the balance sheet, increasing assets and liabilities. This change is not unique to the food service industry, but will affect all industries that have significant capital leases. Firms will have to re-evaluate buy vs. lease decisions for certain assets. Note that pre-existing leases are not expected to be grandfathered in.
Additionally, instead of expensing the rent of an operating lease as an "operating expense," Type A leases (most equipment would fall under this type), the expense would 1. amortize the asset and 2. have an interest expense component, with most being front-loaded, more expense recognized than the actual cash payment. With this change, EBITDA and CFO improve and Debt-to-Equity, Interest Expense and CFF deteriorate.
While we shouldn't bother getting bogged down in the minutia, especially since the final standards have not been issued and firms can prepare for this change, a high-level comparison of a firm's Debt-to-Equity Ratios pre- and post-standard is warranted. The method used to calculate the "post-standard" ratio, simply adding the operating lease obligations listed in the latest 10k, is quite unrefined due to the lack of available data and the unknown application of the standard upon every lease. However, it does paint a picture of how the new standard will alter a firm's balance sheets.
We all know that the operating leases were present, if you read the full financial statements. But now a firm's ratios are dramatically changed. Will certain firms automatically be in violation of their debt covenants, based on the D/E or Times Interest Earned Ratios? Will banks impose different lending standards upon new debt issues and/or lines of credit? The uncertainty begs caution.
DRI "noncancelable operating leases"
BWLD "noncancelable operating leases and commitments for restaurants under development"
CMG "future minimum payment required under operating leases"
EAT "future minimum payment required under operating leases"
Numbers in thousands, EAT, BWLD, CMG; Numbers in millions, DRI
Winner: We see that DRI is the least-affected firm. It owns or operates most of its restaurants under capital leases, and investors are looking for ways to unlock the value of these assets. In DRI's case, will the theoretical credit ratings of a DRI split still hold?
Losers: Even though CMG and BWLD have the lowest D/E overall, before and after the proposed change, they have significant operating leases compared to assets owned or leased via a capital lease. On a percent basis, the balance sheets of CMG (D/E increase of 597%) and BWLD (D/E increase of 250%) deteriorate the most.
2. Affordable Care Act - Health Insurance Requirement
The ACA will affect the restaurant industry more than other industries.
Food service establishments commonly employ many part-time and occasional seasonal workers. Additionally, turnover in this industry is high. Even if they do not work full-time, 30 hours/week, there is a cost associated with the recurring required paperwork per the ACA. If the firm chooses to cut hours to under 30 per week, there will be implicit and explicit costs associated with maintaining a larger staff.
Let's say it is impossible to cut certain workers' hours under 30 per week and a restaurant will be offering individual policies to its employees. Here is where the restaurant industry runs into another problem, the 9.5%. If a company offers health coverage and the individual's required contribution for his or herself (only) exceeds 9.5% of household income, that person is eligible for the exchange, since the employer is not offering the proper coverage. Wages are low in this industry, so a full-time person (30 hours) making the current minimum wage ($7.25) working 50 weeks/year makes $10,875. 9.5% of $10,875 is $1033. The employee must pay $1033 or less for their annual health insurance premium.
Firms may be hit with the "strong" penalty, "weak" penalty for offering "skinny coverage" or just forced to pay more for health insurance for their employees. The penalties are not tax-deductible. Although costs will increase, it is impossible to quantify the additional expense.
Winners: No one
Losers: Everyone, especially those with a larger workforce, since the paperwork and penalties become greater as the workforce grows.
Consolation Prize: BWLD, EAT and other firms with a franchise model. Firms with a franchise model are not responsible for the cost of health insurance of a franchisee's employees.
3. Affordable Care Act - Menu Labeling
Another part of the ACA that will affect the restaurant industry more than others is the requirement of menu labeling. Those companies with 20+ locations will be required to place caloric (and yet to be determined) other information, besides regular menu items. If this is such a great idea for businesses (on the logic that customers will favor those businesses that have caloric and nutritional information posted on every item), why has no major chain initiated such a policy nationwide? The only menu items restaurants seem to label are the low-calorie options.
The research on "Full service"-type eateries is fairly thin. The vast majority is laboratory-focused, or conducted in cafeterias or other irrelevant (for our purposes) eateries. A conglomeration of studies is published by RFJW foundation. Let's look at some takeaways.
a. Purchase intentions are changed; Fewer calories are purchased
The majority of the research is focused on the question of the healthy eating choices of consumers. In almost all studies, consumers purchase fewer calories. So, for places like Starbucks (NASDAQ:SBUX), this doesn't matter. If the consumer uses skim milk instead of whole milk, or buys nonfat chips instead of the full-fat variety, it is revenue-neutral. For places such as Chipotle, this might even be great news, since consumers are still charged one price, but load up their burrito with fewer items. But for full service restaurants, this might not be such a good thing. Is the consumer forgoing an appetizer or dessert that would have otherwise been purchased, splitting an individual entrée or ordering water in place of soda? The studies are silent or nonexistent in the casual dining industry.
b. Timing of the effect
There is some evidence that the effect is not immediate. Lower caloric purchases were noted 18 months after menu labeling implementation, according to Krieger, Chan, Saelens, Solet and Fleming. The cause was not established. Given this tidbit, the lack of an immediate impact in the first quarter after labeling on sales does not mean that there will be no subsequent negative impact.
c. Revenue declined 2% and 4% in the only comparable study
A study done by Ellison, Davis and Lusk looked at caloric and menu labeling and revenue at a full service restaurant. Previous studies examine college or work cafeterias, and do not capture the data we are seeking. Among other things that Ellison, et al found was that depending on the type of label, calorie (2%) or calorie and symbol (4%), revenue declined.
So, let's take a hypothetical look at what the previous year's earnings would have looked like if the FDA comes down hard on the restaurant industry, requiring labeling with symbols, and the results obtained by Ellison, Davis and Lusk are predictive.
|Percent Decline in Net Income, after 4% decline in sales|
Assumptions: 4% decline in sales, 3.5% decline in Cost of Sales, 3% decline in Labor & Restaurant Expenses, all other costs remain the same, except income tax, which remains at same percent. Why not a mirrored 4% decline in "variable costs"? Even though cost of sales, labor and restaurant expenses are variable, they are not 100% variable
Winners: CMG and other restaurants with similar pricing structures.
Losers: Everyone else.
4. Renewed Emphasis on Raising the Minimum Wage
With the renewed minimum wage push, the restaurant industry bears significant risk. These firms rely on low-wage labor. There are two minimum wages that the industry has to be concerned about - the minimum wage, currently $7.25/hr, and the tipped employee minimum wage, currently $2.13/hr. Let's say that the minimum wage gets pushed up to $10, either through the normal legislative routes or one of the up and coming "backdoor routes to legislation," by an executive order or by a decree of the National Labor Relation Board. According to the 10ks, hourly restaurant employees make up 90%-95% of employees. Are all these employees paid $10 or less? No. But a lot are.
Tied to this increase in the minimum wage is an increase in the tipped employee minimum wage to 75% of the minimum wage. There are 6 states that have higher state minimum wage for tipped employees, which represent about 10% of BWLD and DRI company-owned stores. For the remainder, the average tipped employee will receive a 230% pay raise, with most receiving over a 350% pay raise. The increase in the minimum wage will affect all food service restaurants, but those with full service models will be affected even more so because of the dramatic increase in the tipped employee minimum wage.
|Current Restaurant Labor Cost||Increase in Tipped Labor||Increase in Non-tipped Labor||Total Labor||Current % Labor/Sales||Post Increase % Labor Sales|
|10k Data Used|
|Estimates Used, as a % of Restaurant Labor|
|Tipped Employees||20%||*Only 90% of Stores affected|
|Non-tipped Increase||25%||Assumes Average Rate of $8/hr|
|Chipotle Estimate||35%||Assumes Average Rate of $8/hr|
Winners: No one
Consolation Prize: CMG and other stores whose labor will only increase slightly.
Losers: Full service restaurants
If there is a minimum wage increase, full service restaurants such as DRI, EAT and BWLD will have to drastically change the way they conduct business through the utilization of technology like EAT, or to a service model similar to CMG. It will take time for Americans to adapt to the restaurant model currently present in other countries, where the price includes the server's earnings and very little gratuity is expected.
The food service industry is vulnerable to new regulations and accounting changes. Given that all four firms are trading at P/Es higher than the S&P average, caution is in order for investors with a longer-term horizon. Out of the four firms compared, CMG will have the easiest time adapting to changes. Its service model is the most adaptable to the new menu regulations and may even help its cost of goods sold. If the minimum wage is increased, CMG will feel the pain least, since it does not employ tipped employees. On a per store basis, it has fewer employees to raise its healthcare costs and/or penalties. Moreover, even though CMG's balance sheet will look dramatically different after the lease accounting standard changes, it won't look awful.
|P/E as of writing submission|
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.