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How Does a Restaurant Carve Out a Moat?

R.J. Hottovy, CFA

Slides from the presentation can be downloaded here. For a For a full copy, please contact or

R. J. Hottovy: About a year ago, we noticed that the conversation we were having with a lot of the restaurant management teams we talked to, both public and private, were very similar to the conversations we had with retailers about 10 years ago or so: They're facing delivery, they have to do with mobile order and mobile payments. And the same kind of conversations that we had and frankly, there's a lot of confusion about how they go about it, do we need to have a delivery program, do we need to do these kinds of things, reminded us is a lot of what we're hearing. And since we've done a lot of work with the retailers over the past decade or so, we thought we'd try to apply some of that to the restaurant space and really develop a new playbook for you as investors, either public or private, to analyze restaurant companies within. I think this is actually probably broader than that, too. I think some of the lessons we'll talk about today can be applied elsewhere in the consumer space.

As a starting point today, I want to highlight two ideas; both have popped as of late in the third-quarter earnings, but we still think that they are valid, kind of a one- to three-year horizon idea and that's McDonald's. I think the idea here is this one is doing a lot of things right. It dovetails a lot of themes we'll talk about throughout the day in terms of technology and adding convenience and adding the utmost flexibility for consumers, because that's what they're looking for, like McDonald's. On top of that, there is pretty healthy capital allocation plan, almost a 3% yield right now. You effectively get paid away. I think they're going to have a big 2019 if you experience to the future initiatives that they have, the kiosk ordering, I think that's going to benefit traffic midway through the next year.

And then even over a longer term horizon, I know they had a big quarter last week, but Starbucks still is a name that's pretty interesting to us. I think that they still have some issues to work out in the U.S., but things that can be solved, I think there is a tremendous China opportunity, and they will be one of the more interesting CPG players in the coffee space as well.

I am going to divide the presentation into two parts. The first is we're going to do 10 predictions for the restaurant industry over the next, let's call it, two to three years; and in the second part, I'll transition into some of the questions you should be asking management teams and the restaurant industry and some of the key metrics that help you evaluate whether or not they're adapting to what is a quickly evolving consumer environment.

The first prediction for the restaurant industry, and I don't know if anybody sat in on the General Mills presentation this morning, but this kind of dovetails with it. So far if you look back the last two years in the grocery industry, the big news was Amazon-Whole Foods, yet we really haven't seen much of an impact from that integration at this point. However, I think we're starting to see just the early signs that grocery stores are getting more worried about that potential impact. I think with Amazon bringing their Prime membership in the real world, I think that was kind of the key lever here that now, we might start to see some real impact from Amazon Whole Foods.

We need to keep prices low. And this is a chart that shows food away from home CPI and food at home CPI. Right now, restaurants have been running about the 2%, 3% inflation range, the blue bar on the top. Then, if you look at food at home, which is a grocery store inflation, that got pretty artificially well in 2017, but in a sense rallied back, but we see that little tail at the end here, it's starting to widen out again.

I think, if you look in the back half of the year, you're going to see a lot of grocery store chains keep their prices low to keep the traffic they may have as a way to combat Amazon-Whole Foods. The first set of that, that's going to put a lot of pressure on restaurant chains, which are already suffering from tough traffic. They're not going to have much pricing opportunity. They're going to have to keep their prices low. I think even though we saw a pretty good third quarter at most of the restaurant chains, I think you're going to see a lot of pressure in terms of pricing and that's going to keep comps in that 1 to 2 range for most chains, even some with negative numbers on that.

Because of that pricing pressure, I think what we're looking over the next five years is actually contraction in a number of restaurant units that are out there. And, in fact, we are projecting a low-single-digit decline in a number of units. We still have the fast-casual category growing about 6.4% over the next five years, but that's down from about 10% from the five years prior to that. And then, if you look at the traditional fast food and casual dining space, we have those declining. I think it's been very difficult for those small chains, particularly the ones between 0 and 10, that has spread themselves too thin. Maybe if you're in one market and got scale there, you'll be fine. But if you really spread yourself too thin, it's going to be--I think it'll be very difficult couple of years, particularly because competition of the grocery store channel and online grocery is not going away.

This is, and kind of dovetails to this next slide, which shows we actually think that restaurant industry growth is going to decline from 4% to about 3%. That's a pretty big move, too. And if you look at some of the categories within that, there is a substantial decrease in the growth rates there.

One of the interesting things to point out here is Other, which is kind of the nontraditional channel, some of the hybrid things, vending, some of the other things that are starting to develop in the restaurant space, that actually is going to accelerate and that's also going to put downward pressure on industry sales across all the categories. However, I don't think this should spook investors and restaurants. I think what you're seeing is that those chains that have made adaptations to their business model for what we're seeing in the consumer space are positioned well, they just continue to grow, but that's a small group right now. And, to be honest, the conversations I'm having in the restaurant space is, people are really still trying to figure it out, but there still is opportunity for those companies that are adapting the consumer preferences.

In terms of valuation what's been interesting, if you look back the last 10 years in the industry, there's really, it's been like almost essentially a three-act play. From 2009 and 2010 to about 2014, you saw average P/E multiples in the space go from effectively the high teens to the low 20s. A lot of that had to do with rotation out of retailers and into restaurant names that didn't have an Amazon-like disruption imminent. You saw then multiple rerate to about the low-20s.

From there, from 2014 to about beginning of 2017, you saw another rerate, where you saw the P/E multiple go to the mid 20s. And that had to do with the fact that most of these companies are selling off their company-owned locations to franchisees, then taking on additional debt and then returning the proceeds from that to shareholders in the form of dividends and buybacks. That has effectively played out now. There's not as many locations to franchisee--or to start franchisees. Most of the companies are running north of 95% in terms of the franchisee ownership. that trade has effectively parsed its way out. Now we're back down to kind of low 20s P/E multiple for the space. That's probably the right range. Most of the discounted cash flow modeling that we do suggest that's probably the right multiple we will be paying for these names. However, with what we talked about in terms of downward pressure on traffic, downward pressure on pricing, they get a better opportunity on these names going forward.

The bullet point here in terms of prediction, it's talking about Starbucks, and I think this is a great case study to kind of encapsulate what's going on with the market here. Starbucks has been--up until this past quarter and even this past quarter was mostly driven by price increases or mix shifts. Traffic there has been flat to declining over the last three or four quarters. I think it underscores one of the major changes that we're seeing across the industry. We think that their recovery is still going to be somewhat volatile. We do think it's a great long-term opportunity, but they still have some things to figure out.

I think what the main message here is that if you think about Starbucks, they've built their brand on being an experience. It was the third place away from home and the office offering those customer service, and when you introduced mobile order and pay a couple of years ago, then you're trying to serve two audiences at once. You have this convenience customer that wants a coffee very quickly in and out and we try to do both of those at the same time. Frankly, don't do it very well. The idea of convenient experience is an oxymoron. It just doesn't work that way. And I think that they are still figuring on how to adjust that and I think that can be applied to the rest of the restaurant industry, too. That was the one thing when we went out and shared our findin--our results from our P/Es with a lot of restaurant operators, that seemed to be the thing that resonated most with them is the idea that, OK, we need to focus on one thing or the other, certainly there's elements of--with an experience aspect, you can make it convenient; if you have convenience, you can make it an upscale experience. We need to really focus on one of these two aspects, one of these consumer needs states and then dictate--that should dictate your hiring practices, your technology implementation, your supply chain, a lot of the other things.

I think getting more directly at Starbucks, the way to think about it is, they've got these great locations, large experience, I think those are the kind of locations you need to start parsing out a little bit on the delivery and the mobile order side. Carve that out, maybe a small percentage square footage for that. But I think the real opportunity for them is to create smaller format express stores that really all they do is pump out throughput here and get more and more transactions through. I think that's going to be the big opportunity, and I think the management team does realize that, but it's still going to take a couple of years to play out. That's why it's more on the three- to five-year trajectory. But I think that's one of the key messages is you start to think about investments and this again would apply both, not just restaurants but also retailers, what is the need state they are serving or have they put together a game plan to satisfy that.

The next projection for the restaurant industry is that looking at next year, those companies that have invested in the technology, the appropriate technology for either convenience or an experience state, those are the ones that are going to start see improvements in the next year. I think McDonald's is the one, the key example here, too. This just kind of shows you where we've been in terms of not only comps for the space, which has been in the low-single-digit range for the last two years, but then also traffic, which has been, frankly, actually in the negative 1% to 2% range for most restaurant chains.

I think we'll start to see a bit of improvement for those players that have invested in the technology; and by the technology I mean the ones that have set up mobile order-and-pay, but not to the point where it impedes anything else going on in the restaurant, it can be timely, it can be accurate, it can be reliable. Those companies that have done that, those that have actually put together a reasonable delivery platform and, again, we'll get into delivery more because that's a big trend going on in the industry. But the ones that have done the right approach delivery, you are going to start to see some benefits. I do think that there are opportunities for those players, who have been early technology adopters and the ones that invested in the right technology.

This is the next prediction. Delivery is not going away. No surprise there. This is an environment where Amazon has retrained consumers to respond to convenience. Right now, delivery is about 6%, or about right around 6% of total sales, about 3% of overall transactions. it's not going to go away. Over the next five years, that's effectively going to--we'll see 3 points of improvement in terms of percentage of overall sales. That gets you to about 4% of overall transactions, too. It's about 2 times the average ticket when you do delivery, because there's group orders and family orders and things like that. But delivery is not going away.  You as a restaurant chain need to have a suitable plan. And, again, not every chain is going to need to do delivery. This can also be to go orders to, and I think we're seeing them more on the casual dining side. So think about the way they weighted best structure that adhere to the needs that you're serving.

This is where our team at PitchBook was usually helpful on this report. One of the things we are seeing--and I talked about the valuations coming down in the restaurant industry over the last couple of years, again, peaking about early 2017. What we have seen in the heels of that is actually a big technology boom, and it makes sense because all these restaurants are trying to figure out the best way to adapt to all these consumer changes. basically, every function within a restaurant now has some sort of technology aspect to it from the ordering platforms, to the delivery aggregators that are out there, to staffing management, to inventory management, we're seeing a big technology boom in this space and valuations, to be honest, are a bit crazy. A lot of investment in this. Some will survive. I think there'll be a lot of shake on consolidation space, too, but I think it's going to continue over the next couple of years as restaurants are desperate to not only generate traffic but also keep costs in track.

Again, just some other examples of companies that are there. It's in the full report if you can't see the graphics here. And then kind of some other things from our PitchBook team in terms of just industry expectations. We talked about valuations coming down. I think that what we're starting to see is some opportunities open up and a lot of M&A activity. One of these exactly as I spoke to for this report told me, does it make sense for anybody to be public in this market right now, the small to medium-size midcap companies. Basically, anything under $10 billion of market cap, that's not a big franchiser.

With all these changes that need to take place, that's going to require a lot of capital, and it's not something that happens overnight. Most of the time most of these technology platforms, usually it's about a three- to four-year roll-out platform. And so company like McDonald's is probably in year two.

What happens is that that's going to require a lot of time, lot of patience and, frankly, we're not going to--a lot of people in the public market are not going to get these restaurant chains that kind of time frame to work with.  We probably are going to see some other big deals happen. I don't think I'd anchor my investment strategy around that, but we will probably see a lot of operators taking out in the space. Even since this report has been published, we saw Sonic and Bojangles taken out pretty decent multiples, too. I don't think we're done yet either. I think we're going to continue to see some M&A activity over the next couple, really into 2019. At that point, we'll see what happens, but it's going to depend on capital markets.

Now, the last projection is, we just talked about the idea of does it make sense for a lot of restaurant chains to be public. To be honest, we don't actually expect any IPOs in the space over the next two years. If you're looking at the next potential candidates, I think there's three of them: Sweetgreen, Blaze Pizza, and MOD Pizza, but honestly, the management teams, we spoke to them all, they're not ready yet and they see what's going on in the capital markets. It really has not been a great time for any of the restaurant IPO Class of 2015 and 2014. Most of those are struggling right now.

And I wouldn't expect to see any IPOs in the space over the near term, but we do expect--there's actually some of those restaurant technology firms, that's where you're probably going to see some IPOs might be a way to kind of play this whole idea of changing technologies and there might be even more opportunities this time around than what we saw at the retail space about a decade ago; some names like Toast, which is a POS system; HotSchedules, which is a labor and inventory management system; Olo, which does some of the linking between the delivery platforms and the point-of-sale system. Those are the names that are already kind of on their Series D and Series E type financings that might be the next IPO candidates in the space.

Now, I want to shift gears and talk about just the most important questions you should be asking yourself as a restaurant investor or retail investor or the management teams that you work with or talked to in the restaurant space. And this is kind of a quick overview but we'll run through the key metrics that you should be measuring those answers with over the next couple of slides here.

As a starting point, what we looked at--and I think this is probably the right way to think about it just in terms of anchoring all your investments decisions as-- take a look at the average transaction size. That's a good starting point.  This is a chart that shows the average ticket for the--it's actually the last five years for each of the sample group of about 20 restaurant chains we looked at. What's interesting about this is it can kind of show you opportunity or you know places where pricing might be out of line, maybe a company is charging too much to try to offset some costs there, maybe they're undercharging to drive traffic. If you see kind of weird imbalances on it, that's a good starting point to really start probing management on what their long term strategies are. 

But what's more important from this, because when we now know the average transaction size we can back in a number of transactions the company has and more importantly, what we decided that the average transaction per square foot is probably your most important metric going forward that picks up on things like delivery, that picks up on things like changes to the store format, those are the kind of things to be looking at. I think that this metric and particularly growth in this metric is going to be your key metric going forward that you really have to focus on. Those companies that outperform in that generally doing something right either demand creation or adjusting to the marketplace in terms of new technologies, new formats.  We like to think that this is going to be an important metric to monitor going forward.

Now that leads us to our next question is, how do you deal with consumer fatigue? One of the things about the restaurant industry is we see a lot of short attention spans, people like new things right away. They see something on a food channel, they want to try it out in the restaurants. It can be very much a shorter attention span. We see the limited time offers. The new products that are out there changes very rapidly.

How do you deal with that? One of the ways is, now that we know how many transactions this company has, we can insert it back into a transaction acquisition costs number here.  We take the marketing--the incremental transactions divided by the marketing costs and we kind of come up with, you know who's doing it right, who's able to drive traffic organically or with minimal investment. You know one of the things we do see is, obviously, there's the up and coming brands like a Shake Shack, for example, does very little marketing and that makes sense because the word of mouth and buzz carries it. But at a certain point--and I think Chipotle is a perfect example of this--at certain point either have to, on a national level start to do advertising or you start to have, maybe had a specific food safety incident that you have to start advertising. That doesn't last forever, but this is a good benchmark to show you who's driving traffic organically here. Again, some of--I think McDonalds has been a very, They spend a ton of money, but they do drive enough transactions through it. But it's an interesting way to kind of look at the space.

The third topic I want to talk about is something that comes up a lot, and probably in your day to day conversations. I know I had a couple of conversations during the reception last night about it. But the idea of health and wellness; this is something of a buzzword across the entire consumer space right now. But what's interesting about it too is that we've had a thesis and if anybody has looked at my previous research, we've had this idea that authenticity is actually the key driver, it's not health and wellness. But we wanted to try to find some ways to do this, and we did this in two ways. The first one was a study--to be honest going into it I didn't expect to find any kind of data from it. It's one of those things that we decided to try to see what happen. What we did is we lined up all the brands in our sample group against eight different key words in Google trends and kind of did a correlation analysis here. And this is something that--there's too much spurious correlation. You know we're not going to find any key takeaways here.

What we did actually find, though, is that those brands that have the highest correlation to the word authentic were also the ones that had the highest transaction per square foot growth for last five years. That was essentially company like Wendy's, company like Dominos, Starbucks, Dunkin, or Panera, those are all very interesting to us. But we wanted to take it a little bit further, and what we decided to do on this one, the next slide here, we took a look at calories per item and if there is any correlation with transaction growth here. What we found is there actually isn't a lot of correlation. It's almost zero correlation if you look across the board.

Now, obviously, there are some other factors there. If your brand is centered on being healthy versus not market as such, there's things to keep in mind there.  That's interesting to us and that kind of proves a point that I think the idea that having authentic products – and by authentic what I mean is that it's as close to being from the source itself, less ingredients, less preservatives, less additives. The General Mills CFO discussed that this morning, too, in some of their products, cutting it out and making it more natural authentic. It's also kind of a derivative on the idea of millennials and experiences. When they travel the world and come back and a lot of times, they are going to want to recreate those experiences. Restaurants sometimes become that outlet. If you could come up with the product that re-creates a product from some part of the world that that's popular in terms of travel, we've seen a lot of success stories on that front as well.

We'll wrap through the next couple of topics here, the questions, fairly quickly. But one of the other things too, we talked about technology and the importance of this too--mobile order ahead. This is something we hear, you probably have all done it in the last couple of weeks. It's becoming kind of the way to interact with restaurant companies. The companies that are ahead of the schedule on this one, so Starbucks, Dunkin, I put KFC China because they're actually way ahead of the U.S. in terms of mobile order adoption there. When your restaurants are rolling out mobile order platforms, you should effectively see about 1 percentage point each quarter in terms of the percentage of overall transactions. That's when you know you're starting to really kind of resonate. You've got a technology platform that works that's seamless for consumers to work with.

And then one of the key topics that we've talked about in our previous research is the ability to connect with consumers outside the four walls of the restaurant. Some of that's new products, some of its advertising. You really have to find a way to get people coming back. This is no switching costs environment. It's very tough. Consumers can pick whatever restaurant they want. So you have to find way to build stickiness into it. And so this is where technology and kind of mobile platforms give companies an advantage.

One of the things we like to look at too here is a loyalty program. You probably are members of it. You know Starbucks right now has about 14 million members in the U.S. You've got Panera, it's upward of 20 million to 25 million members at this point. What's interesting about it too, this can create some real stickiness and create--I wouldn't call it a moat source here, but it does create some advantages in the company here too. Those companies that can drive 2 times of traffic out of the loyalty programs, and we show that Panera is actually doing about 4 times. They have a transaction for their loyalty program member. You know that shows you you've got some real stickiness with your brand there. It can be another supportive to a brand intangible asset.

Delivery. We talked about this and this to be honest is one the most controversial parts of the restaurant industry today. Most restaurants sees an opportunity to expand, enter new category or enter new avenues of growth. But at the same time, there is risk inherent with it that restaurant item leaves the restaurant. You never know how it's going to end up when you get to the consumers home. And again it's the brand that suffers not the delivery company to that end. But I do think the most chains have to have at least some exposure to delivery. I think what we're seeing is most of the large QSR players partner with one of the large delivery aggregators; so McDonald's and Uber Eats, you've got Yum! Brands and Grubhub. You're finding that they find one partner to kind of learn the game. I would not be surprised to see those companies over time build that in house because economics work better when you do have your own delivery comp services. You don't have to pay that commission.

Obviously, the pizza companies right now, way ahead of the QSR firms, which are generally in the 2% to 3% of sales in terms of delivery, and about 1% to 2% of the overall transactions. Pizza guys have been here for a while and show that it can work and having your own internal fleet of delivery drivers does make sense. This is the fast-casual guys here, too, about the same as where we're at the QSR. I think over time we're going to see this again over the next three to four years, sort of five years or really effectively double for most of these companies. So you have to have a game plan in place. And some of the things we talked about in terms of the technology, making sure you got the right ordering system in place, it's got to be seamless, it's very important. The best strategy does make sense to go through deliver aggregator or do we have enough scale and route density to do something on our own. Those are the considerations that you should be asking restaurant management teams at this point.

One of the other key topics in the space and probably, if I had to rank the number-one pressures for restaurant companies today, I think the number-one thing is actually labor. That's without a doubt the thing that came up most and you see the push to $15 an hour minimum wage coming up over the next five to 10 years.  Who can generate the most sales per labor hour? Can you creatively find a way to cut back on labor or change the format of your restaurant to cut down on that? This shows labor or sales per labor hour for every category in the restaurant industry. 

Generally the average is about $40 in terms of sales per labor hour. if you're not above that, you have to find ways to do that. So this is what we're seeing why companies like McDonald's are moving to more automated and technology-focused approaches because you can cut back a bit on labor there. Every management team says, oh, yeah we're going to reallocate labor to something else, we're not cutting back on hours. But the reality is that they're moving to less employees, less labor hours to generate higher sales per labor hour.  This is another key metric to look at from across a different categories.

And then I want to wrap up with a couple of more practical things in terms of restaurant operations. Market expansion is a big topic for this one, and really the only way to survive in this industry is to build scale like most industries. These are kind of some benchmarks that show where you should be at as both from average, unit volume and margin numbers as your business expands. If your company is not doing these kind of numbers then you have to start asking is this a right approach, should we be expanding or do we need to refine our actual platform. Restaurant margins, which are effectually gross margins, you know if you're starting out, should be in the low-double-digits. You know if you're a national company, something in the 20% range is good.

Operating margins, this is a low margin business to begin with, with all the things we talked about, with labor and then we'll talk about rent in a minute here. You know operating and labor costs are, you know just the input cost goes with it. It's pretty low margin business. But these are kind of the benchmarks that you should be looking at in terms of where that company is on the scale. Most of the companies we cover are going to be at the national level, so that's kind of a general benchmarks we use or maybe in that multi-market stage. But some of--if you're looking at kind of the upstart--you know up and coming chance, those are kind of numbers that maybe one or two markets that you should be looking at.

I apologize for the size of this, but this is a buildout cost per restaurant here. You know kind of numbers that should be--you should be using there. We're seeing a lot of creativity in the space. You know there's some--and we talk about technology in the ways restaurant operators have been able to use technology to drive down costs. We'll also see some innovation on the restaurant formats. Restaurant chain is finding ways to drive down that buildout cost. You know some of these things, you know the cubby format where you go in and it's got--you've already placed some mobile order, they have a kiosk, then your food is ready in a couple more minutes. You can cut your labor in half by doing that, you can cut out your buildout cost by quite a bit by doing that as well. these are some benchmarks in terms of buildout cost and how to compare a restaurant concept to other players in space.

And then rent, behind labor, rent I would say is the other pressure we're saying. Especially, we talked about unit growth for last five years, that was a big time for growth in the restaurant industry in terms of number of units. But what we're seeing is that the five year escalators on a lot of lease terms are coming up right now, so we're going to see rent costs continue to go up. This is just some general benchmarks in terms of rent per square foot. If you're looking as a percentage of sales, I think 8% to 10% anything below that--typically right around 8% of sales is probably the right number for a restaurant concept. You know anything way above that, they are probably paying too much. If they're paying way below that too, that's also cautionary because maybe they are not on the right location to really drive traffic.

And this is the last question I think you should be asking a restaurant concept is whether or not it supply chain is really scaled the way it should be. These are just some benchmarks in terms of supply chain headcount, number of distribution centers, the number of products they have. This is important because for those who follow the Chipotle story closely, this is effectually that company outgrew its supply chain. You had a situation where they had to outsource a lot of their supplies to smaller independent contractors and you lose control of your supply chain and you might get some bad produce or bad protein that goes through that. So this is the kind of numbers that you should be looking at in terms of, what the supply chain should look like for a small, medium and large size chain.

This is just a quick summary, the benchmarks for across all the topics we talked about. It's in the report if you want to look at in closer detail. I just want to wrap up with we covered a lot of topics, lot of points here. Is there a way to wrap this all up into quick, easy to digest data points. I think there is really two here. One is restaurant level profits per square foot, so effectually gross margin per square foot. What are the companies that are doing exceptionally well here, which are the ones that are not. I think this is an interesting benchmark to look at and you see some real success stories stand out here, company like Dominos or Shake Shack, Taco Bell. I think those are the companies that have done probably the best (shop) the last five years, you know probably put Starbucks in there as well. But this could be an opportunity to kind of show which companies are maybe adapting to consumer expectations better than the markets giving credit for.

Then one of the other metrics we came up with in this piece to kind of evaluate what the market is saying about this company versus maybe what they're really doing, is take a look at EV/EBITDA divided by expected transactions per square foot growth over the next one to five years. We're looking at a one year basis here because maybe the market is underestimating the impact of the company's ability to generate transaction growth. This is where my--the picks that we provided earlier, McDonalds and Starbucks--and again we ran this before third-quarter earnings, but this is the number that you can kind of show. Maybe the market, in terms of EV/EBITDA valuation is not giving them the full credit for the transaction growth that these companies might have. Another creative way to look at it, especially when transaction growth is going to be the really key metric to look at in the restaurant space.