John Gordon - August 2023

Restaurants: Notable New News Seen Recentlyby John Gordon, Principal and Founder, Pacific Management Consulting Group The March 2020 Pandemic changed global business and society in every way imaginable. Our industry, a service industry essentially based on commercial fixed assets working with and serving guests was fundamentally affected. We are recovering but with many issues remaining. To see ahead, we have to look at current conditions but also forward-looking forecasts, history, and looking at the industry in every which way possible. I’ve noted several events and observations over the last month that are useful: Quarter 2 Earnings to date are OK, but not great. The global QSR powerhouses such as McDonald's and YUM have done well, as have the US-based company-operated concepts such as Darden and Starbucks as well as Chipotle. Sales Not So Exciting. Industry Q2 SSS slowed to 3.4%, versus 7.3% last quarter. Definitely slowing. Hat tip for numbers: Jonathan Maze, Restaurant Business Online. Based on the brands that have reported thus far, I have created the table below of “Positive Fundamentals”-not stock price, but sales, store margins, etc: Restaurant Brands w/Positive FundamentalsPositiveMostly PositiveNeutralNegativeM&AJACKBROSBLMNNDLSFRGIRBIWENLOCOSTKSFATTASTSHAKPTLOPZZACHUYTXRHCAVADINCAKEDPZSGMCDFWRGCMGDRISBUX What is happening now at the store level is that some brands can get a high enough level of SSS increase—still mainly through ticket as will be discussed below. That is enough to offset labor rate increases still underway and some elements of food commodities that might still be inflationary. We can see this in reported company store results or via our friends at Restaurant Research.  Universal comments reflected the difficulty of covering costly new construction costs, delayed opening cycles, and a range of comments about pushback on pricing from lower-income guests. Confusion on whether too high ticket is a bad thing:  Much discussion on the August 1 SBUX earnings call centered on whether the elements of the 7% SSS US gain were too unbalanced, with 6% ticket and 1% traffic. Unfortunately, among some, “ticket increase” and “price increase” mean the same thing. They are not. Given the limited devices that restaurants have to count both ticket and transactions, price increases and the number of guests covered by that ticket are variables. So too are the number of food and beverage items (called units) to each guest. So too are the changing mix of items sold. During the call, CFO Ruggeri did her best to explain to explain the increased SBUX food attachment (now 40%) and other initiatives that increased ticket. She also reminded us changes in the loyalty program resulted in changes in guest traffic recording patterns. It became an issue nevertheless, with investors arguing about it and a small stock downtick thereafter. How to quantify traffic as true as it can be There is a solution for SBUX, and most every QSR operator: provide the number of food and beverage units sold v. prior year and other benchmark periods. That becomes the de facto gold standard indicator of restaurant volume. “Subway Sale Show” Update: I say show because that is the reaction heard from M&A professionals when this issue comes up. The data room opened in February and now Reuters and Bloomberg are noting “just a couple more potential suitors” have signed NDAs to look at it with resolution by Labor Day. Hope springs eternal. The problem for Subway/DAI and the John Chidsey Administration is the deal has now been rejected by scores of investors. It may have been smarter to have withdrawn the offering earlier due to “market conditions”—higher rates—and bring it back to the market later. Two Potential Takeover battles are looming focused on two tier 2 concepts, making us wonder what is the real goal:  In late June, the Dallas-based Hoak Management Investment Fund took a $9 million investment in Noodles (NDLS) stock. While there have been no communications yet, Hoak had prior restaurant ownership experience. As we saw this quarter, Noodles had a difficult quarter on its hands. There are a lot of fundamental sales and marketing practices that need to be enhanced. Can the PE be of use? In addition, Sardar Biglari, activist and owner of Biglari Holdings, took a 9.1% stake in El Pollo Loco (LOCO) on August 1. Biglari a philosopher investor/personality, won a proxy contest at Steak N Shake in 2008 and acquired Western Sizzlin same time. He had some initial success in Steak and Shake but later ran out of steam. He acquired a men’s magazine and a healthcare operation. Biglari stalked Cracker Barrell (CBRL) via expensive and unsuccessful proxy board contests for years. His interest in LOCO is unknown at this point. In the last week, LOCO has taken steps to execute a poison pill defense against Biglari. This is smart, especially as a cost-avoidance tactic. Franchisees raise an issue about the inefficiency of the size of restaurants and amount of in-store dining:  Earlier this year, the McDonald’s National Operator’s Association reported in an FTC opinion letter that dine-in customers accounted for only currently 10% of the MCD US transactions. It contrasted that with the billions of dollars of future remodeling requirements. In the last earnings call, the MCD CEO acknowledged future units might not need such large dining rooms. This is a vital consumer, CAPEX, and debt topic. Some brands still working with 50 year old store fronts believe remodels are essential and have the sales lift numbers to back it up. Current problems are that interest rates are up 500 bpts and new store/remodel/equipment costs are up about 30% from 2019. One solution seems to be to create multiple remodel cost options (thank you, Wendys, and Jack in the Box) and focus on outside and drive-thru access features. Importance of geography in restaurant expansion: Pollo Tropical:  Also this month, we got word of the buyout of Pollo Tropical, the final restaurant of the once three-brand Carrols holding group. It was acquired by PE-backed ARB, which has other restaurant brands under its umbrella. The purchase multiple is in the 8-9X adjusted EBITDA range we believe. I wish ARB senior management, including chair Alex Macedo the best. Pollo is a higher volume, specialized Caribbean theme, QSR plus, a popular brand in Florida with attractive unit economics. It did go through a very difficult period in 2016-2020 when a prior CEO worked a massive and fast expansion into Atlanta and Dallas.  Both of those markets failed. The lesson of course is that the development of specialized cuisine brands must be worked slowly and incrementally, building off the current base. Being public with great management seems to be a great place to be to do this. About the author: John A. Gordon is a long-time restaurant industry analyst and advisor. He has experience in corporate staff roles in QSR and full-service brands and founded his consultancy, Pacific Management Consulting Group in 2003. He is a Master Analyst of Financial Forensics (MAFF)and works complex restaurant brand, organization, and financial reviews. Call him at (858)874-6626,email:  jgordon@pacificmanagementconsultinggroup.com.