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John Gordon - July 2022



RESTAURANTS: IT’S ALWAYS COMPLICATED!

by John A. Gordon, Principal and Founder, Pacific Management Consulting Group

WHAT'S IN A NUMBER OR A CALENDAR VIEW?

Plenty. We restaurant types live and die by numbers all the time.

For example, in the restaurant M&A business, the calendar and numbers matter a lot in plotting the attractiveness of a transaction. In 2020-2021, QSR brands in particular were coming off of an early 2020 sales recovery, run-up of average ticket per transaction, closed dining rooms, higher drive through, and higher digital (think: higher average ticket as a result). Food and labor inflation had not yet hit.

Contrast to now, where restaurant level margins (of both QSR and sit-down restaurants) continue to be hit by rising food, paper, and labor rates. Restaurant operators everywhere are griping about margins 400-500 bpts lower than last year. Since the current year EBITDA base (adjusted or not) is now down, operators are finding their businesses are worth less, using the traditional earnings multiples and the current year EBITDA dollar base. That has caused selling to freeze up. Some small acquisitions have been noted. IPOs and the really big acquisitions are affected by interest rate declines, fear of a recession, prior deals, and intraday stock volatility.

What to do? I strongly recommend in your presentations you focus on multi-years (to not get caught in a downturn year) and also move away from EBITDA! EBITDA even as adjusted is awful, move it to free cash flow, which is a far more meaningful economic measure. Otherwise, wait, do due diligence, and strengthen your business.

MORE ABOUT REPORTED PRODUCT MIX TRENDS

One thing that is happening in the QSR space is that there is a reversion of product mix as we have gotten further away from the Pandemic. Recall then that digital traffic rose, dining rooms were closed, people ordered en masse for several days and average baskets—number of food items per transaction—grew. That is now slightly reverting to normal as we heard from Starbucks (SBUX), Chipotle (CMG), and McDonald’s (MCD)<1> just this week. So is this bad or good for us?

I recall being asked this question by investors during the Pandemic who were coming at from the context that eventually consumers can’t afford those big baskets of purchases forever. I told them then, and now, that I didn’t think affordability was the issue as the purchase was being spread out over a mass of people.

I believe this is mostly bad for us but we should be able to tolerate the normal mix moves guests make. Anytime we get our revenue more efficiently we like it but that is the joy of serving guests. They do what they do.

FOOD COMMODITIES ARE TRENDING DOWN BUT….

Looking for what we have all been waiting for, and yes, many world commodities have begun to shift downward. My friends at Restaurant Research recently published a chart in their weekly newsletter that showed downward producer price index costs noted for most of the vital food commodities, along with fuel oil and gasoline. That is great news!

However, it is going to take some considerable time for the shifts at the top of the supply chain to make their way through to the restaurant FOB back door pricing. One issue is that all the other costs in the supply chain have to be applied….manufacturing, driver wages, storage, transportation, markup, etc. And then the most important…all of the older, more costly inventory has to be used before the full effects of the less costly new inventory are used.

For restaurant chains who “contract out and lock in a price” this can be problematic when raw material costs finally fall. Restaurants need the assured product at a good cost. Experienced supply chain professionals know when there is a hint the cost begins to weaken, they will ease off on the contract amounts. But it is a dual-edged sword as you can see. Expect food commodity costs restaurant backdoor to fall later. McDonald’s is still talking about continued cost inflation for example, but later easing in the US.    Restaurant analysts often ask the question “ are you contracted out” but in reality, the proper question is, “are you contracted out for the proper amount of inventory on contract and where do you think the cost market is headed”?

RESTAURANT HOCKEY STICK UNIT DEVELOPMENT MENTALITY

I saw that family office Nierenberg Investment Management Company has taken a 10% ownership stake in Potbelly (PBPB) the 450-unit sandwich chain.  Potbelly has had difficult times and several CEOs and at least one activist battle that I can recall in the past. Current management is better but unfortunately mentioned the “hockey stick” development goal, e,g, we can be at 2000 franchisee units in 10 years. That is very difficult. The number of franchisees is down to about 46 system-wide and store-level margins are sub-par. That is where management must devote its priority.

IMO, it is just so critical for “activists” like Nierenberg to understand how the restaurant business really works before another inevitable cycle of management change is forced.  New franchisees want strong concepts before they join, with store-level margins 18% plus with royalty embedded.

About the author: John A. Gordon is a long-time restaurant industry veteran, with 45 plus years of experience in operations, restaurant corporate staff roles (FP&A), and management consulting. He is an IU graduate and a Master Analyst of Financial Forensics. His founded management consultancy, Pacific Management Consulting Group has been working on complex operations, financial analysis, and organizational assessment engagements since 2003. Contact: 619 379 5561, jgordon@pacificmanagementconsultinggroup.com.

<1>   SBUX Quarter One Earnings Call, Chipotle and McDonalds Earnings Call on July 26 2022.

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