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John Gordon - May 2022



Restaurants: The Real World So Far, May 2022

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

Pricing and Customer Considerations at the Top of the List

Pricing and Fear of consumer reactions continued to take top billing in the restaurant space. On May 11, BLS reported<1> grocery store prices rose 10.8% in April which is good news for restaurants.

Food away from home, rose 8.7% in April at full service and 7.0% at limited-service restaurants.  That is yet another month where restaurant prices have risen less and thus have gotten a break—and an opportunity to take some mind share.

CNBC on-air talent is saying no US consumer discretionary companies are signaling trouble <2>. Casual dining brands and fine dining brands have been doing well, especially The One Group (STKS), Ruth Chris (RUTH), and Bloomin Brands (BLMN). QSR US brands are doing less well.  McDonald’s (MCD) SSS was plus 3.5%, Wendy’s (WEN) plus 2.4%, and Burger King (QSR) .5% from their last earnings calls, for example.

In terms of pricing reaction spots, McDonald's noted lower-income guests are trading down in terms of PMIX; WEN noted sales softness among Households under $75K income and  Dutch (BROS) noted a wave of sales softness hit in March after gasoline prices spiked. More on BROS in a bit. But that largely has been the summation of restaurant company comments to date.

Restaurant Margins have been awful, almost everywhere. That is the effect of double food/paper and labor rate inflation.

Stacked Comps and Profit Comparables

When researching and trying to isolate a trend, I am appreciative of companies and analysts that are posting sales and company store margins (at least) to a 2019 base, a 3 “three” stacked comp. The way I see it, the company cares enough to lay it all out. This is all the more relevant in 2022 with a pre-pandemic base (2019), and generally, poor quality 2-year stacked base (2020) and the usual year over year base (2021).  Companies might pick the base that makes them look the best; I would think it odd for companies to make references to 2020 now. A reference to 2019 is useful as it shows the company SSS or profit growth over the pre Pandemic base, always constructive.

Timing is Everything: Risk of Waiting too Long on Taking Price

Dutch Brothers (BROS) the 2021 IPO star ran into some trouble as evidenced in their May earnings call. They experienced a classic “turn” in which the rate of sales growth fell off, company restaurant margins fell off due to food, paper, and labor inflation, and guidance was pulled back. <3>Predictably, the stock took a huge hit. Dairy was the big commodity mover. Forensically, BROS had last taken only 1.1% price in November 2021. The preopening expense effect of opening so many stores as they are is negative. BROS also noted that sales fell off in March coinciding with the latest band of gasoline price increases. 55% of BROS guests are under 25 years of age per their research.

The effect of the sales slowdown in March is that BROS calculates that they are not getting their normal Q1 seasonal sales pickup.   In addition, the company store's contribution margin fell to 18.3% versus 26.8% in 2021. With the sales softness, Senior Management has no plans for price increases “at this time”.

Dutch BROS is a very good brand. They can work themselves out of this situation. Still, the lesson for all might be to take small disciplined price increases where warranted and not be in a situation where big catch-up price increases later might be necessary.

Franchisor CEO getting the toughest question on earnings call recently…..

The CEO of an international QSR franchisor was stretched to respond to a question asked about franchisee profitability recently. A review of the call was telling in three ways.  Here is a lightly edited recap of the total exchange, editing out only the Brand CEO and CFO name.

Chris O’Cull:

Thanks, good morning, guys. CEO, how are U.S. franchisees reacting to the margin pressure and even rising interest rates? I’m just trying to understand how these factors might affect the willingness to open new units or even just make investments in the business.

CEO, Brand X

Yes. No, as you think about the partnership that we’ve always had with our franchise community, it’s really tight. And we’re regularly meeting with them to make the right calendar adjustments, to make sure that we’re still focused on our one more visit, one more $1 strategy. So we’ve got that good high loan calendar in place, continue to drive folks into our app, and really partner with them to drive a lot of profit enhancement actions along the way. What we need to do on price, how we continue to hold in there nicely on mix, how we trade folks up with great innovation in the rest of the daypart as well as breakfast. And then a lot of work to really take out some of the complexity in the back of the house of the restaurants, and we continue to drive op simplification to make sure that we manage the profitability story. As CFO Brand X  said earlier, we’re starting to build margin. He talked about P3, we talked about additional pricing actions in the – into Q2. And as we think about the last 2 years, we’ve had a lot of momentum in our business. We talked about record profits in 2020. We’re collecting our franchise financials right now, and I’ll let CFO Brand X talk through that.

CFO, Brand X

Yes. CEO, we have preliminary financials. We will finalize it at kind of show the full detail at Investor Day, but the headline is record profit for the U.S. franchise system in 2021. That’s positive. Leverage ratios on their balance sheet are basically unchanged. And as we look at our benchmarks, our franchises are less levered than the industry benchmarks. As a result of it, we feel comfortable that we’re really going into clearly a tougher time with very healthy balance sheet, record profits and therefore, it’s still a confidence in the growth algorithm for our brand and for our system.

CEO, Brand X

So net-net, Chris, what you’re really seeing is that we’ve had some great momentum on the unit development in Q1. We’re still comfortable with the strong pipeline that we have in place and the commitments that we have to deliver on the new restaurant openings this year that our franchisees are in a position to get to that 5% to 6% net unit growth during the course of the year. Supply chain is a little more challenged, and the team has done a great job really getting ahead of making sure we’ve got all the components to get to those openings this calendar year.

So now, three observations…

Observation One: Brand X CEO really cares about that 5 to 6 % net unit growth metric. I got the impression the franchisor would move heaven and earth to make those goals. Guidance given? Investor expectations?

Observation Two: The CEO is thinking in 2021 terms, not 2022 terms. Note the CFO is now doing the annual prior-year franchisee profit and balance sheet survey. Okay, but what about the sharp margin declines in 2022? And interest rate hikes.  They need a more current FY data sampling system.

Observation Three: Brand X is thinking about units in the pipeline, already funded with 2021 cash or loan contracts. CEO doesn’t answer Chris question which was about 2022 unit level franchisee economics which will be lower as their current call results demonstrated. <4>   Those finances will matter and affect those new units going forward.

Bottom line, running a franchised system is a lot of work.  

About the author:

John A. Gordon is a restaurant industry veteran with a background in operations, corporate staff roles (Financial Management), and via his founded management consulting firm, Pacific Management Consulting Group. He works complex analysis projects for clients such as brand organizational diagnosis, investor support, and litigation projects. He is reachable at 858 874-6626, email jgordon@pacificmanagementconsultinggroup.com.

<2>   CNBC Sara Eisen, The Recession Debate, May 16 2022, https://www.cnbc.com/video/2022/05/16/you=could=build=a=case=that=the recessions=already-started.

<3>   See Dutch BROS Investor Relations Web Page and presentations.

<4>    Brand X Earnings Call Transcript, as captured by Seeking Alpha, www.seekingalpha.com, May 2022.

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