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John A. Gordon is Principal and Founder of Pacific Management Consulting Group (, an independent restaurant analyst providing research and niche earnings analysis, management consulting and advisory expertise to those who need to know about chain... More
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  • Restaurants: Recognizable Realities In 2015

    The restaurant space slogged it out in 2014. Finally, with meaningful wisps of economic recovery seen in Q4 and more disposable income running in the system, hope of discretionary spending is seen. Several attractive IPOs, Habit (NASDAQ:HABT), and Zoe's (NYSE:ZOES) made it through the gauntlet and with more to come in 2015 (SHAK and others). On January 5, Jim Cramer of CNBC said that domestic restaurants are key to the market performance in 2015. That sets a high bar.

    Of course a reality gap exists between Wall Street wants and needs and Main Street corporate realities. The prism restaurants operate is not really seen by Mr. Market. Looking beyond the veil, restaurants are a tough business, talk to the departed CEOs of Darden (NYSE:DRI) and Bob Evan's (NASDAQ:BOBE) about that

    There are several ongoing dynamic restaurant financial realities that underpin restaurant performance. All are realities, all are opportunities. All are addressable.

    Need to manage and improve restaurant profit flow through. Also known as the PV ratio, we should not have been surprised to hear that the ten year US McDonald's (NYSE:MCD) average sales per unit (AUV) grew $770,000 but flow through grew by just $70,000, or 9%. Was it all those beverages that cannibalized food? A national survey just reported the McDonald's average consumer expenditure reported at $3.88 per person, which is shockingly low.

    It's a broader restaurant issue however: For a client, I recently examined three QSR brands (McDonald's (MCD), Burger King (NYSE:QSR), Wendy's (NASDAQ:WEN) and three casual dining brands, Denny's (NASDAQ:DENN), Bob Evans (BOBE),and Applebee' (NYSE:DIN) that grew average store sales only $46,000 and unit EBITDAR by only $500 between 2009 and 2014, about a 2% flow through rate. Shockingly low sales gains, even worse flow through.

    Both Chili's (NYSE:EAT) and Outback (NASDAQ:BLMN) added a boatload of new at or under $10 items to their menus in 2014, and Chili's added their signature fajitas to its 2 for $20 menu. This exasperates the flow through problem; let's hope additional upsell initiatives kick in to maintain the average check.

    This is the result of hyper food inflation, and some labor cost inflation and a lot of discounting. The fix? Multi dimensions required. Start by not listening to the ad agencies to take the fast, cheapo way out and simply discount; get staff to upsell.

    M&A is both a value enhancer and a destructor: Both good and bad M&A are in the background and the foreground. Bad M&A can be seen considering Darden (DRI) and Bob Evans (BOBE) this year. Good: future possible spinoff BEF foods for $400M ($413 million value estimate by Miller Tabak). Its current EBITDA baseline is only a few million dollars. Spin it and give the money to shareholders.

    Bad M&A: waiting so long to dump both Red Lobster (DRI) and Mimi's (BOBE). Interestingly, financial disclosure and visibility of both brands by their HOLDCOs was awful. Who really knew before Darden spilled the beans in 2014 that weekly customer counts were only 3000/week? That is unacceptable for investors. The fix: the sell side and shareholders should demand better disclosure. Vote with your feet.

    Restaurant IPO valuations need a reality check. First year restaurant IPO valuation ratings need an asterisk. There's nothing fundamentally wrong with Noodles (NASDAQ:NDLS) other than their unsustainable claim to get to 2000 US units. It's a nice, differentiated concept. They will grow but not at Chipotle (NYSE:CMG) rates. Potbelly (NASDAQ:PBPB), El Pollo Loco (NASDAQ:LOCO) and Papa Murphy's (NASDAQ:FRSH) may grow if they can grow profitability beyond their geographical base. The Chipotle of 2015 is not the Chipotle of 2006. It can't be: The US is proportionately more overloaded with more restaurants during the Noodles 2013 IPO than CMG's 2006 IPO.

    First year restaurant IPO price earnings (NYSE:PE) ratios and Enterprise Value to EBITDA ratios need an asterisk because they may well fall later and resume upward momentum later after the post IPO equilibrium is found and real earnings and free cash flow growth is achieved.

    Why does this matter? Growing restaurant brands that are over pressured by high valuations do stupid things. Good brands need to be given a chance to grow solidly.

    Franchise overfishing, resulting subpar restaurant cash flows in the US: earlier in 2014, when fears of US restaurant wage increases were at its peak, several industry studies noted how low restaurant franchise EBITDA flow really was: 10 to 11%. The SS&G (now BDO) restaurant data in December just backed that up. For investors, franchisors, franchisees and anyone else: 11% EBITDA on a $1 million AUV base is not high enough level to service debt, cover overhead and provide funds for maintenance and remodeling capital expenditures in the amounts needed.

    The US is overfished, with too many franchise restaurants. 1 million restaurants in the US. Until the supply issue is addressed, franchise restaurants will chase the temporary +1 or +2 same store sales customer flow that migrates from one brand to another.

    Franchisors need to take responsibility for their brand's future evolution. That they don't fully can be seen in the minimum wage debate. Franchisors, notably McDonald's, Burger King/Tim Horton's (QSR) and Wendy's (WEN) indicated that it was their franchisees that set the wages. While technically true, it is the franchisor that is the steward of the brand. If the wage goes to $20/hour, it is the responsibility of the franchisor brand to regenerate a store level model that works.

    A place to start is to rightsize store physical plants smaller to get the CAPEX lower and to find ways to thin the system of weaker operators who want or need to exit. Closely associated with this is issue poor franchisor earnings disclosure: Sell side analysts covering Dine Equity (DIN) have given up asking for meaningful information about the 100% franchised brands, and we noted one intrepid sell side analyst who was a journalist could not pry the Burger King (QSR) international new Russia and China sales levels, a pillar of their stated growth strategy and a metric that should be disclosed.

    Restaurant free cash flow matters. For a client recently, I composed a 45 year snapshot of how sales components and building size has changed over the years. Guess what: while customer traffic (transactions) has declined, the building size has not.

    The perception gap between the signal of the profit/loss statement and the other costs, and outlays that determines free cash flow is a material problem for an industry so CAPEX heavy. This same concern applies to the "asset light" franchisors, whose franchisees are the investors and have to make a return to be viable. This is not so complicated; performance appraisal systems at any level could be rejiggered to include CAPEX. You manage what you measure.

    Jan 05 11:21 PM | Link | Comment!
  • Is Noodles The Next Chipotle?

    In one of the best IPO results of the year, the first restaurant IPO of the year, Noodles (NASDAQ:NDLS) raised almost $100M and stock price more than doubled from its initial pricing at $18 to close at $36.75 on its first day. The Noodles CEO, Kevin Reddy, came from Chipotle (NYSE:CMG), at an earlier stop in life.

    Is Noodles today's Chipotle? Chipotle IPO'd in June 2006. They are both fast casual concepts, Colorado based, both early movers. And there are many fundamentals comparisons. See the table below, prepared from both the Noodles and the Chipotle SEC S-1s, for their last full fiscal year before IPO, which shows the key fundamentals drivers:

    Fundamentals ParameterChipotle, FY 2005Noodles, FY 2012
    IPO TimingJune 2006June 2013
    Enterprise Revenue$627,695,000$300,410,000
    Average Annual Sales/Unit$1,440,000$1,178,000
    Restaurant Level Margin18.2%20.3%
    Enterprise EBITDA % (book)9.4%9.2%
    Net Income $$30,240,000$5,200,000
    Number of Units481327
    Same Store Sales+10.2%+5.2%
    % Company owned100%84%
    Lead UnderwritersMorgan Stanley, CowenMorgan Stanley, Cowen
    SponsorMcDonald's (NYSE:MCD)Catterton, Argentia/Canadian Pension

    Store economics look similar? Yes, in some ways:

    · Fast casual operators, new buildings, new food types and popularized styles.

    · Average Annual Restaurant Sales in the $1.2M to $1.4M range.

    · Solid restaurant margins-Noodles now actually exceeded that of Chipotle in 2005 by 210 bpts.

    · Totally or primarily company operated model.

    Noodles' success demonstrates there is investor demand for new restaurant offerings and validates fast casual investor demand. I understand NDLS was twenty times oversubscribed. Catterton, Morgan Stanley and Cowen did a nice job.

    The issue to keep in mind is the United States consumer space is not the same as it was in 2006. Recession, fundamental changes in population, income, eating and dining preferences, commercial real estate site characteristics, and more US restaurants in operation each year make for a more difficult 2013 and out conditions.

    Noodles must deliver good quality, service, cleanliness and price/value, in a differentiated fashion, with good corporate stewardship and continue to build connections with guests, employees, investors and other stakeholders via it's culture.

    Mathematically, as it expands, it has to think a lot about occupancy costs. NDLS occupancy costs are now 9.9%. Chipotle's was 7.6% in 2005. Site supply is tight. Many legacy brands, the real first movers, like McDonald's (MCD) and Dunkin Brands (NASDAQ:DNKN) got the early best US sites. Restaurants economics was built on 6-8% rent, but some restaurant operations are facing 15-20% rent for some sites. Too much push for too fast expansion will test the rent leverage especially for a $1.2 million sales concept.

    The imputed IPO valuation from the NDLS IPO is already $800M, or an EV/EBITDA multiple of 26.6X. That's rich. But it's just the first day. I hope the pressure cooker investment world will take a break and give them a chance to grow smartly.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jul 01 11:11 AM | Link | Comment!
  • 2013 Restaurant Themes: Comps Cliff Coming

    The restaurant space will be interesting in 2013. Sales issues, cost issues, expansion issues, franchisee issues. There are still too many restaurants in the US and x-US markets sales increases have slowed. The two industry leaders, McDonald's (NYSE:MCD) and Darden (NYSE:DRI), are both somewhat in the penalty box and under pressure. Here are our thoughts on 2013 issues and opportunities.

    Comps Cliff Coming: In looking at 2013, its likely restaurants will get off to a bad start. In Q4 and Q1 2013, the restaurant space will fall off a cliff of sorts: the comps generated last winter. Driven then both by warmer weather, price increases, a bit lower sales of discounted items and the peak of the 2010-2011 restaurant recovery, the January-March 2012 number will be hard to beat.

    The following chains will likely have the hardest sales comp comparisons in Q1. Every single chain had lower comps most recently reported than the Q1 peak:

    Company/symbolFY 2012, Latest Trend2012 Q1 Jan-March Comp
    McDonalds (MCD), worldwide+2.4% (November)+7.3%
    Starbucks (NASDAQ:SBUX), US+7.0% (9/2012)+9.0%
    YUM, China company units-6.0% (1/7/13 )+14.0%
    Jack in Box, JACK, system+3.1% (9/2012)+5.6%
    Chipotle, CMG+4.8% (9/2012)+12.7%
    Texas Roadhouse, TXRH+3.6% (9/2012)+5.8%
    Bloomin Brands, BLMN+3.6% (9/2012)+5.3%
    Buffalo Wild Wings, BWLD (system)+6.0% (9/2012)+9.1%
    Panera, PNRA (system)+5.8% (9/2012)+7.7%

    More sales news. In the QSR space generally, traffic now is very marginally positive and average check app. 2-3% favorable, but in the overall casual dining space, traffic is negative and totally offsets about a 2.5% check increase. There were a few standouts, however: TXRH, PNRA, SBUX, and AFCE.

    One question is why was investor disclose so poor at YUM? The China same store sales trend is so stunningly negative-large sequential decreases from +19% in FY-11 to -6% just noted this week for Q4 2012, perhaps the largest decline anywhere over such a short time.

    Extreme discounting is the newest news but is really old news. The current price spectrum of restaurant TV ads runs from $.99 grillers at Taco bell to $11.99 30 piece shrimp at Red Lobster. Doesn't portend well for average check. The comps cliff has affected marketing strategies everywhere.

    Earnings standouts: Texas Roadhouse (NASDAQ:TXRH), Panera (NASDAQ:PNRA), Starbucks (SBUX) and Popeye's (AFCE) were Q3 (and Q2) positive standouts: positive sales and traffic, sales beat and earnings beat $.01 or more over estimate. Does prior performance guarantee future results?

    Dividends as the goal: Dividends will be important in a low growth, low return world. The US restaurant market is way overdeveloped and worldwide development takes time and proper store level economics.

    We'll be glad to see companies like DNKN (1.80% yield), BKW (.90% yield), and BLMN (0%) finally work their way out of private equity positions so that more substantial dividends can be paid.

    THI, another pure play 100% "capital light" franchisor, is also low at 1.70%. That there are two coffee sector players in this group is interesting. Lower coffee commodity costs advantage will accrue to the franchisees not the corporate entities.

    IPOs and M&A Pending: we still wonder when Noodles will be ready for their IPO. Fast casual is "hot". Another fast casual brand, Pei Wei could be a candidate once its lower newer unit open sales problem is fixed.

    It was clear from the 2012 SBUX and DRI transactions that the path to a rich valuation is to develop a unique but mainstream product that well-heeled restaurant majors can buy for entry at rich multiples.

    There will continued private equity churn, they always have fresh powder to deploy. The wave of 2006-2008 PE acquisitions will soon come due to sell.

    Turnarounds to watch: Interesting that the two worldwide restaurant leaders, MCD and DRI are both challenged. No surprise that MCD went into a new news decline as it changed CEOs in 2012. When will it change?

    It will be fascinating to watch Darden (DRI) work out of its current tight cash position caused by lagging big brands and resulting profit shortfall, big remodeling CAPEX requirements and now debt service for its 2012 acquisitions. Of necessity, they will look for another acquisition in 2014, once its free cash flow position improves.

    We wonder if BKW has the worldwide AUV sales base potential except Latin America for franchisees to expand profitably.

    Restaurants must more creatively test revenue and expense solutions: Restaurants can offset negative cost pressure and difficult comps pressure by looking at revenue increases beyond price increases and cost reductions beyond food portion cuts and labor hour savings.

    Unique store level pricing tiers and dual wage tiers to offset Obamacare are but two examples. The industry needs to test aggressively new ideas. I've published more details on my website,

    Defrancising v. Refranchising divergence will continue. Those who can operate restaurants well will continue to do so, those who can't, refranchise. Panera (PNRA), Texas Roadhouse (TXRH) and Qdoba (NASDAQ:JACK) are building new units /converting franchisees to company operation.

    Franchisors still need to improve investor reporting and franchisee disclosure if they hope the franchising "capital light" business model will be sustained. How can DineEquity (NYSE:DIN), now 100% franchised, be properly analyzed if there is no franchisee profitability reporting?

    Reasons for optimism: always. Commodity costs thus far are coming in at the light end of what was feared some months earlier. Some companies have finally fixed their marketing focus, example Sonic (NASDAQ:SONC). The revenue and cost challenges so often noted can be offset. And finally, this is a very adaptive industry. It just needs to get more creative.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jan 09 1:57 PM | Link | 1 Comment
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