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Finding Restaurant Investment Ideas as Traffic Slows

Lessons from the next generation of moats in the fast-casual restaurant industry.

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The restaurant industry would appear to have challenging times ahead, with year-over-over traffic declines across much of the industry and rising labor costs on the horizon. However, we believe it would be shortsighted for investors to overlook this category, as a number of compelling concepts are redefining the way consumer discretionary companies adapt to constantly evolving consumer expectations regarding value, convenience, health, and technology.

Our analysis starts with the fast-casual restaurant category, which is not only changing consumers’ expectations regarding restaurant experiences but also influencing how the market values restaurant concepts and forcing traditional quick-service and casual-dining chains to reinvent themselves. One of the more underexplored developments in restaurants thus far in 2016 is a bifurcation within the fast-casual category, with a class of chains thriving but several other players aspiring to be the "next Chipotle" finding success more difficult (not to mention Chipotle’s (CMG) own struggles). We’ve spent 2015 and 2016 getting to know many of the up-and-coming privately held fast-casual players to gain a better understanding of what attributes restaurant concepts must have to develop an economic moat and drive traffic in today’s environment. We also spoke to a number of operators that are changing their business models to better adapt to the constantly evolving consumer environment. We then examined our restaurant coverage to see where we can locate similar traits and, more important, where the market may not be giving restaurant chains enough credit. We believe a framework for identifying the most successful limited-service restaurant chains will help investors find names best positioned to outperform industry traffic trends over the near term and identify potentially mispriced securities in the category.

Heading into the back half of 2016, we believe the key question on most restaurant investors’ minds is whether we’re entering a prolonged "restaurant recession" or even perhaps a broader slowdown in consumer spending. While the U.S. consumer faces some significant headwinds--including elevated rent and healthcare costs--we’re not ready to make the call for an extended restaurant recession, given the wide consumer price index spread between food at home (grocery store) and food away from home (restaurant), which stands at its widest point since the early 1980s, outside a brief period of industry supply/demand imbalance coming out of the Great Recession in 2009.

This spread will make it more difficult for restaurant operators to raise prices in the back half of 2016 and probably into 2017, suggesting that companies will depend more on transaction growth to drive same-store sales and margin expansion over the coming quarters, especially with expectations of minimum-wage increases across much of the country over the next two years. This will not be an easy task, especially as consumer expectations about convenience, healthy eating, food supply transparency, and mobile technology evolve. That said, we believe those players that have adapted their business models to these changing demands are best positioned to outperform industry traffic trends over the near future, and we think it would be a mistake for investors to write them off amid concerns about industry trends.

Based on our conversations with the management teams at several emergent fast-casual chains, we’ve developed a four-pillar blueprint for those chains looking to drive traffic in today’s environment:

  • Fostering a comprehensive consumer value proposition that spans more than just price, including convenience, flexibility, employee training, and restaurant design.
  • Adapting to evolving views on healthier eating by establishing authenticity to accommodate a better-educated consumer, developing a menu that is flexible enough to accommodate multiple dietary preferences, and finding ways to balance healthiness with convenience and profitability.
  • Maintaining a scalable supply chain.
  • Finding ways to connect with consumers beyond the four walls of the restaurant, such as embracing technology to foster brand loyalty, using innovative approaches to marketing, expanding delivery and catering options, and migrating brand intangible assets to new channels.

We believe this framework has a strong correlation with Morningstar’s moat methodology, and we believe the market may be underestimating the changes that several players in our restaurant coverage have made to adapt to these trends.

Meeting the Next Generation of Economic Moats
To better identify those players that are thriving in the current domestic restaurant landscape, we plotted the most recent fiscal year average unit volume of the top 50 players in the casual-dining, fast-casual, and quick-service restaurant categories, based on Nation’s Restaurant News’ Top 100 and Second 100 studies for 2016 (published in June and July, respectively). Consistent with previous NRN studies, Del Frisco’s (DFRG) and Cheesecake Factory (CAKE) were among the leaders in the casual-dining restaurant category; Shake Shack (SHAK) and Panera (PNRA) were standouts in the fast-casual category; and Chick-fil-A and In-N-Out edged out McDonald’s (MCD) in the quick-service restaurant category. Average unit volume for the top 50 casual-dining, fast-casual, and quick-service players amounted to $5.5 million, $1.6 million, and $1.1 million, respectively.

In the fast-casual category, we use the $1.6 million average unit volume for the top 50 players as the threshold for a successful restaurant fast-casual concept. We then use several restaurant trade publications, including Nation’s Restaurant News, Technomic, and, to screen for chains with more than 10 units that have reached this average unit volume threshold in a relatively short time, which we’ve defined as 15 years for the purposes of this exercise. Not surprisingly, some of the most hyped players in the fast-casual space fall squarely in this range.

Among the fast-casual standouts were Shake Shack, Mendocino Farms, Sweetgreen, and Blaze, though other names also caught our eyes, including Freshii, Tender Greens, Verts Mediterranean Grill, and Honeygrow. To better understand what makes these emergent players stand out from the rest of the restaurant industry, we reached out directly to their management teams. We also connected with a few players just outside our emerging fast-casual player zone that are in a period of transition--including Protein Bar--to better understand the tactics they are using to push themselves closer to this range and avoid some of the missteps that struggling fast-casual chains are facing.

Sweetgreen Epitome of What Consumers Seek in Modern Fast Casual
In our review of today’s most successful fast-casual restaurant chains, Sweetgreen perhaps best exemplified the full list of attributes of the next generation of moatworthy companies that we’ve identified. The chain was founded in 2007 with the idea of bringing a scalable farm-to-table concept to the masses. Since then, the chain has grown to 55 locations.

In our conversations with investors, Sweetgreen is probably brought up most often as the measuring stick for restaurants attempting to capitalize on consumers’ increasingly healthy eating habits, given its success driving traffic and unit expansion while maintaining its emphasis on local and organic ingredients, combined with flexible, customizable menu offerings, However, we’ve already seen a number of upstart chains across all restaurant tiers focusing on healthier or better-for-you fare that have started to exit the market. Offering healthy food isn’t enough for today’s consumers, and successful restaurant concepts across all categories need to offer much more to drive traffic.

We spoke with Sweetgreen COO Karen Kelley about the other attributes that have made the chain successful, and we believe her answers provide a blueprint for what modern restaurant companies should aspire to be. First, the Sweetgreen experience is convenient. Customers are greeted by easy-to-navigate menu boards, rapid order turnaround, and clearly designated pickup areas for in-restaurant and mobile orders. In addition to the company being one of the more efficient operators in the fast-casual category, we found the Sweetgreen locations we visited to have an aesthetically pleasing restaurant design, such as reclaimed wood finishes and soft lighting, as well as several references to its local supplier partners (lending additional credibility to the chain’s authenticity).

Several executives we interviewed noted the difficulty in serving healthy food that has the taste to appeal to a mass audience. When we asked Kelley how Sweetgreen has overcome this obstacle, she pointed out Sweetgreen’s emphasis on cooking every order from scratch, its use of fresh produce through daily produce deliveries and local sourcing, and its implementation of an intriguing seasonal menu rotation that changes five times a year to better capitalize on produce trends in each of the company’s different markets. We believe this is an effective way to efficiently infuse menu innovation while still allowing consumers to get better accustomed with the core menu and ordering process.

Of course, this approach to menu composition wouldn’t be possible without a well-thought-out supply chain. Sweetgreen obtains as much as 70% of its ingredients at peak season from local partners (according to a 2016 interview with Kelley in QSR Magazine). While the idea of locally sourced supply chains has raised some investors’ concerns following Chipotle’s food safety issues over the past year, we believe Sweetgreen’s ties with local farmers across each market it expands to and standardized quality assurance position it as one of the leaders in developing a scalable yet locally sourced supply chain. We believe Chipotle’s woes were in part due to becoming overly dependent on a handful of key suppliers that were unable to keep up with the chain’s explosive unit growth, forcing the company to procure from sources lacking stringent quality-assurance standards. However, after our conversations with Kelley, we believe Sweetgreen has positioned itself as a partner for its local food sources--often tailoring local menus based on certain crop availability--and will avoid the same struggles that other fast-casual chains have experienced as they move from a single market to a national footprint.

Sweetgreen is also one of the leaders in the restaurant space when it comes to mobile engagement and connecting with consumers outside its restaurants. Altogether, we believe Sweetgreen has developed a meaningful brand intangible asset in just a short time.

Mendocino Farms Sets Standard for Upscale Fast Casual
Mendocino Farms started as a single location in downtown Los Angeles in 2003 and has since expanded to 13 locations across the Los Angeles area. The idea behind Mendocino Farms was relatively straightforward: pulling ingredients and design elements typically found in upscale and casual-dining restaurant chains and repackaging them in an inviting fast-casual layout with accessible price points and efficient throughput tactics. This approach has been successful thus far; according to cofounder Mario Del Pero, the company’s trailing 12-month average unit volume is about $3.2 million, up from $2.6 million four years ago, putting Mendocino Farms ahead of fast-casual leaders like Panera ($2.5 million average unit volume in 2015) and among the leaders of the emerging fast-casual players.

In our view, Mendocino Farms has positioned itself as the definitive example of the upscale fast-casual concept, combining the counter ordering of a limited-service restaurant with table delivery, a full beverage offering, and the ambiance of a modern full-service chain. The company meets the criteria for what we think consumers are looking for in a fast-casual concept, including a balanced menu accommodating both healthy/better-for-you preferences and more indulgent fare, an intuitive ordering system and fast-moving lines (which we partly attribute to high employee hiring and training standards), and "urban industrial" restaurant aesthetics, which goes a long way toward explaining its already-impressive average unit volume.

Mendocino Farms now finds itself at the critical juncture of moving past its initial market (Los Angeles), which has historically been the make-or-break point for many upstart restaurant concepts. However, we believe the chain has two very important factors that give it a higher probability for success as it moves to other West Coast markets this year: an intense focus on developing a scalable supply chain and a minority investment from Whole Foods.

While we believe Mendocino Farms has the management and supply-chain relationships necessary for more rapid expansion, we like its measured approach to unit expansion. In an October 2015 interview with Nation’s Restaurant News, Del Pero said he could see Mendocino Farms as "about a 250-unit concept that could be in maybe 40 great cities, with a few special stores in each city."

Blaze Leads Fast-Casual Pizza in Redefining Consumers’ Perception of Value
Given consumers’ evolving views on value, we aren’t surprised that fast-casual pizza has been one of the fastest-growing categories in the restaurant industry. According to estimates from Technomic, the fast-casual pizza category posted 37% revenue growth during 2015, well ahead of the 11.5% growth for the broader fast-casual category and 4.4% growth for quick-service restaurants. In our view, the fast-casual pizza category offers consumers an ideal combination of convenience, customization, and pricing, each of which are consistent qualities among the most successful limited-service restaurant operators.

The fast-casual pizza restaurant space largely comprises regional players at this point, although we’ve seen the beginnings of consolidation, with a few players starting to achieve national scale. These include Blaze, Pieology, MOD Pizza, and Pie Five. Among these, we’ve been most impressed by Blaze, which has grown from two locations in 2012 to 150 units. More important, Blaze has shown few signs of overextending itself, posting category-leading average unit volume of $2.5 million and $1.5 million, respectively, for company-owned and franchise locations open for more than two years (based on the company’s most recent franchise disclosure document). This compares with $1.2 million for Pieology, $1.1 million for MOD Pizza, and $800,000 for Pie Five (based on data from Nation’s Restaurant News).

We chalk up this outperformance to a number of factors, including: efficient assembly-line preparation process that gives consumers control over orders without sacrificing service speed, owing to high-speed ovens that can prepare pizza in less than three minutes; an intriguing combination of set menu items, in addition to a custom-built option with unlimited toppings at an accessible price point ($8 per pizza); better daypart balance than many rival fast-casual chains, split roughly evenly between lunch and dinner; and a compelling assortment of beverages, desserts, and other potential add-on products. While Blaze is unlikely to evoke the same level of healthiness as some of the other chains we’ve highlighted, we believe its made-from-scratch dough and commitment to clean ingredients will help to position the chain as a fresh/better-for-you alternative for consumers.

Blaze’s management determined early on that it wanted to utilize its strong base of regional franchise partners to establish itself as a national player in a relatively short time. As such, the company sought out a national supply and distribution partner in Performance Food Group (which has access to more than 5,000 suppliers across the country) for most of its products, excluding produce. For produce, Blaze has partnered with Produce Alliance, which oversees an alliance of more than 50 independently owned specialty distributors of fresh products and offers several technological solutions to reduce the risk of potential food safety issues.

Assessing Protein Bar’s Attempt at Taking Healthy Approach to Masses
Healthier and better-for-you fare has been a key to success for many leading next-generation chains. However, providing consumers with healthier options that they are actually willing to pay up for is easier said than done when consumers’ definition of healthy tends to change on a regular basis.

For this reason, we’ve been intrigued by the evolution of Protein Bar. Specializing in products that are high in protein and fiber but low in saturated fat and refined sugar, the Protein Bar menu offers a variety of burritos, bowls, salads, and soups as well as a wider beverage platform than most fast-casual concepts, including protein drinks and cold-pressed juices. After its start in Chicago in 2009, the chain now has 18 units.

Despite its early growth, Protein Bar is still adapting to changes in consumer expectations and attempting to enhance its overall consumer value proposition. In June, Protein Bar opened a secondary concept, Thrive360 Eatery, which attempts to make Protein Bar’s "healthy food" mantra accessible to a more mainstream audience through a wider assortment of proteins and grain-based products. While the development of a secondary concept is unusual this early in a company’s lifecycle, we believe it underscores how significantly consumers’ views on healthy eating have changed in recent years.

We believe the new concept has several qualities we’ve seen in among other successful fast-casual chains, incorporating an emphasis on healthy eating and one of the more developed beverage menus in the fast-casual category. We also identified a number of intriguing design elements at Thrive360, including a river-flow walkway guiding consumers through the ordering and pickup process, a menu balancing premade suggestions with a lineup offering customized plate options through a wider assortment of proteins and sides, and a reconfigured seating area with dedicated space for takeout orders. Nevertheless, we believe there are still steps that could improve the overall consumer value proposition, including a more accessible entry price point and a more simplified menu structure that will allow for faster speed of service.

Despite opportunities for in-restaurant operational improvements, we believe Protein Bar has been one of the more effective players in the fast-casual space in finding ways to connect with its consumers outside of the four walls of its restaurants. The company has a content-sharing relationship with health consultant Aligned Modern Health, whose nutrition experts are regularly featured on the company’s different social media outlets, providing Protein Bar with a level of credibility that many fast-casual chains emphasizing healthy menus can’t match.

Starbucks and Panera Are the Best Ideas in Our Restaurant Coverage
In our coverage, we believe  Starbucks (SBUX) and  Panera Bread (PNRA) have best adapted to consumers’ changing expectations about convenience, healthy eating, supply-chain transparency, and mobile technologies. We’ve assigned both companies an economic moat--a wide moat rating for Starbucks and a narrow moat rating for Panera--based largely on the strength of their brand intangible assets, but like many of the emergent players in the fast-casual space, these are also the companies that have enjoyed the most success connecting with consumers outside the four walls of their restaurants through enhanced loyalty programs, growing consumer packaged goods businesses, and new channels of distribution, such as delivery. While we acknowledge the potential risks with these names in the case of a more meaningful slowdown in consumer spending, we believe current market prices don’t give the firms enough credit for their compelling longer-term cash flow generation opportunities.

We believe Starbucks is just starting to scratch the surface of its longer-term opportunities for channel development, brand diversification, and geographic expansion, and we remain intrigued about the potential mobile, digital, and loyalty program synergies among its different businesses. The company continues to deliver solid global comparable sales growth, driven by beverage innovations and a revamped food platform, expanded peak-hour capacity, and My Starbucks Rewards usage. At a time when most restaurant and retailers are struggling to stimulate same-store sales growth, Starbucks’ gains are impressive and underpin the global strength of its brand. Profitability remains strong, and while easing coffee costs have played a role, much of the margin gains can be chalked up to a highly leverageable business model. We see a number of positive catalysts, including strong returns from international restaurant openings, increased emerging-market consumer packaged goods distribution, and greater consumer awareness of Starbucks’ nascent brands, each of which should better insulate the company if we see continued moderation in consumer restaurant spending trends in the United States.

We view Panera as one of the best-positioned players to weather a potentially more challenging consumer spending environment. First, we still believe that recent market share gains more than justify the level of "Panera 2.0" technology/operating and delivery capacity investments. With these initiatives shifting to franchises in the next few years, it should drive system comparable sales higher (and narrow the gap between franchise and company-owned locations) with reduced company expenses/capital investment, setting the stage for medium-term margin improvement and potentially an increase in capital returned to shareholders. Second, we share management’s views about Panera customers being more affluent and engaged across multiple dayparts/channels, offering some insulation from cyclical pressures. Lastly, Panera’s efforts to develop a more convenient restaurant experience, accommodate consumer preferences for better-for-you products, and connect with consumers outside its restaurants (catering/delivery/Panera at Home consumer packaged goods) have had a palatable benefit on its brand positioning.

R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.