Looking into 2013, there is no doubt that rising food commodity costs will have an effect on restaurants. The effect of the U.S. drought, global economic, currency, weather and supply/demand conditions will have negative margin effects. All of the proteins will be difficult, especially beef and chicken. Coffee and vegetable oil are among the few food groups lower.
The cost effect will be felt in 2013, and beyond. This comes on top of an up/down/up cycle since 2007. Depending on concept, restaurant cost of goods sold is typically 25-35% of revenue, the largest expense. Restaurants might cover moderate levels of food inflation, but if labor or other operating costs rise, and if revenues fall and produces deleverage of fixed costs, a real problem exists.
We think the "low hanging fruit," the easier to implement, plate centered cost savings actions have already been done. Many restaurants have already reacted, in the recessionary 2008-2009 period by trimming portions and prices and by featuring lower cost per pound items and "small plates" in their menu and promotional mix. CKE Restaurants, for example, rolled out turkey burgers, and pork, lobster, chicken and other items have been periodically featured elsewhere. PF Chang's (NASDAQ:PFCB) implemented expansive happy hour food and alcohol offerings.
In 2011, we baselined the private equity owned Real Mex Mexican chains (Chevy's, El Torito) and were embarrassed by how plate portions had eroded smaller over time. No wonder they did Chapter -11 twice and are still closing units.
Many restaurants have already attacked staffing costs mercilessly, such as Darden (NYSE:DRI), which eliminated bussers nationwide, expanded tip credit and is recertifying servers in massive workforce reorganization (and has the class actions lawsuits now pending). Sonic (NASDAQ:SONC) expanded the tip credit, lowered wages for some and rolled out car hops on roller skates to enhance service (and hopefully tips).
What to do? The show must go on of course. Other than price increases, which always has to be considered in relation to competitors and customers, more work on menu mix and the rest of the P&L has to be considered.
These notes are particularly relevant for franchisees who have their brand composing the marketing. Hard questions have to be asked.
More work towards developing store, zone, and regional pricing tiers needed: most U.S. restaurant chains grew out of a 1960s/1970 culture of mass conformity. It is what the newly traveling public demanded in reaction to inconsistent restaurants in the 1940s-1960s. The U.S. today is has a far more diverse population, competition, operating cost and real estate characteristics. Pricing really need not be the same everywhere in every location, either in a DMA or in a region. Ask ABC stores, the famous convenience retailer in Hawaii, how it invented store level pricing. Does a Subway customer expect exactly the same price to the penny for a sub everywhere in a DMA?
Restaurant management systems and today's analytics really are sophisticated enough to handle tiers of pricing. For example, one of Burger King's (BKW) international high volume markets does not use the same lowball price tactics and is not the worse for wear.
Wendy's (NYSE:WEN) is still testing sub-DMA and store pricing tiers and we hope they continue and set the example for more industry innovation in this area.
Mass television campaigns can be much more carefully conceptualized. This is where the rub really comes. Conventional marketing theory holds that price specific advertising works better than "culinary" or other message focused advertising. Example; see Darden's recent Q4 2012 earnings explanations of the Olive Garden sales softness.
Do restaurants advertise price so much because of the media mix? We bet that the vast body of 15 second TV spots that are aired can only work with price point appeals. And research has shown 15 second spots aren't half the cost nor have the effect of 30-second spots. Has there been a holistic cost/benefit analysis done between media mix cost and media driven price and mix at the restaurant level? Is some more optimal 15 second or the 30 second spot mix more effective?
And what about using $1/$2/$5/etc. off marketing features? Our experience is that those are highly regarded by the public. That way no specific price baseline must be noted.
What is done with mass television campaigns and massive concept repositioning has to be tested. Just must. There is much less time, money and customers for massive redos. Ask Ron Johnson and J.C. Penny (NYSE:JCP) about the cost of customer confusion in the wake of their massive repositioning (and the negative 20% same store sales resulting), that we understand was not pre-tested.
Suggestive selling at the store level always needs a lot of work. While few of us really likes to sell, renewed emphasis to not downsell once the customer is in the store ("oh … would you like the coupon offer?" or ban the comment "is that all" have to be helpful). There can be at least one universal trade-up question that even a shy person could ask over the drive thru.
This problem is the greatest in the QSR and fast casual subsegments but not zero among casual dining operators.
Get the remodel funding in place. Some franchisee centric chains, which haven't remodeled because of sub-par unit economics, will be under severe strain. Now is the time now to strengthen system fundamentals and get franchisee financial assistance support processes in place. Papa John's (NASDAQ:PZZA) gets it, and has done so, but Domino's (NYSE:DPZ) hasn't broken that code yet.
Finally, there are other cost savings possible. My favorite is utility costs, particularly that of electricity (air conditioning) and water. Have you ever been in a restaurant where it was freezing cold after dark, or on a chilly day? There is a reason, and it has to do with a single roof top unit and a single sensory control box that can't be right for either a hot kitchen or a chilly dining room.
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. I have no business relationship with any company whose stock is mentioned in this article.