(TMA International Headquarters) People have to eat. This singularly unassailable fact is the foundation of the food service industry, which has two primary segments — food at home (FAH) and food away from home (FAFH). The health of restaurant industry profits depends on the rate of consumer spending in the FAFH category and containment of the basic prime costs to produce the “food” and “service” in “food service.”
Today, as with most consumer categories, the restaurant industry is under stress. People still eat, but they spend less doing so. Restaurant sales have declined, customer traffic is stubbornly negative, and operators grapple with well above average operating cost inflation. Industry profitability is compressed and is likely to remain so into 2010.
This has created meaningful excess capacity across the industry that in some way, shape, or form must be addressed. Clearly, these operating challenges do not affect all concepts equally. However, in this environment it is unlikely that the average restaurant company is capable of engineering a significant and sustainable improvement in sales or profits (“operate out” strategy), absent a very broad consumer rebound.
As a result, the probability of a swift recovery for the industry is low. This has significant implications for owners of or lenders to (both senior and subordinated) restaurant chains. For many leveraged companies, declining cash flows and lower expectations for future earnings are not synchronized with constrained capital expenditures, tight financial covenants, and pending debt maturities. Debt levels were aggressive as a proportion of equally aggressive transaction valuations during the recent liquidity boom but may be fundamentally unsustainable considering a weaker profit picture.
This article briefly highlights the fundamental restaurant operating issues and provides a view on reasonable expectations for industry trends.
Melting Profits
The increase in the fundamental restaurant cost structure, food in particular, appears to have a degree of permanence to it, even though commodities have backed off relative to 2007 and early 2008 levels. To improve profits, operators require positive sales trends to leverage the fixed and semivariable components of their business. Until sales stabilize, let alone improve, profit improvement will be difficult to attain.
Restaurant industry profits have been impaired for the following reasons:
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Less discretionary spending, sales turn negative
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Above average operating cost inflation (food and labor)
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Operators lack pricing power to offset rising costs
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Weak sales and rising costs rapidly deleverage the profit and loss statement (P&L)
Critical profit variables are cyclical by nature, and the catalysts for systemic improvement are historically murky. Prior down cycles were characterized by weak demand or elevated costs, but not by both to the current degree. The issues that plague discretionary consumer spending appear more deeply rooted and pervasive than at any time in recent history. It is both intuitive and fact-based — absent significant improvement in the overall economy, restaurant industry profitability will remain under pressure.
Rising energy costs (oil, natural gas, diesel) are partly responsible for both weak demand and rising costs. The biggest impact is to the demand side of the equation. In recent months, more of a consumer’s paycheck went into the gas tank, leaving less for food. After-tax household income spent on energy costs is significant and especially so for mid to lower income households already on strict budgets.
On the supply side, the diversion of grain production from food to fuel added to rising production costs for operators. From the producer’s standpoint, a chicken is little more than corn with wings, and all grain and grain-fed protein costs soared. In addition to base commodity costs, fuel surcharges on cost of goods sold (COGS) deliveries are a pressing concern. The recent retreat in oil prices, if sustainable, is clearly positive for industry fundamentals, though not sufficient to singularly change industry fortune.
The industry is experiencing prime cost pressure unlike any other cycle in modern history. A sampling of restaurant chain margins from 2006 through the second quarter of 2008 suggests a food cost increase of approximately 150 to 200 basis points (bp) as a percentage of sales. COG inflation in 2009 is likely to be around 5 percent. For the average chain with a 30 percent food cost, 5 percent inflation equates to 150 bp of margin erosion, prior to mitigation efforts, such as pricing, menu mix, portion control, and quality.
Over the past decade, at a minimum, confidence in the reliability of growth, spending, and profitability of the FAFH segment was supported by several dogmatic facts. Among them:
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Dual income households avoid ingredient-based meal options
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Fast feeders replaced brown paper bags for lunch
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Grocery does not provide affordable, convenient meal options
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Consumers can’t or are too busy to cook
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Price increases offset cost inflation without eroding traffic
Today these fundamental “truths” are being questioned and with good reason. The growth rate of dual-income households has declined. Fast feeders are a pocket of relative strength due to trade-down, but demand is weakening recently. Grocers have significantly upgraded their meal options and the trade-out to grocery is now meaningful.
The popularity of the Food Channel and related offerings suggest that consumers have a newly discovered or rediscovered interest in cooking that is not just from necessity. Increasing menu prices no longer protect store-level profit from rising operating costs. On the contrary, increasing menu price today typically results in further declines in traffic.
Menu pricing strategies (i.e., discounts) and modifications to basic menu architecture are timeworn tactics used by all operators. While constant menu innovation helps to “create news at the local level,” menu-based “silver bullets” are few and far between. Menu manipulation is something of a zero-sum game. More frequently, menu innovation and marketing support consist of discounting as a traffic driver. There is a significant rise in “value messaging,” which often is little more than selling more for less. When direct competitors adopt more-for-less strategies, they often realize simply less.
The most important leading indicator for industry health is consumer confidence. Broad industry sales trends are directly linked to the direction of consumer confidence. From a low in early 2003 until mid 2007, more confident consumers spent more on FAFH. There were many reasons to feel flush. Rising home values and easy refinance strategies put more dollars in wallets.
However, confidence peaked in the summer of 2007, rapidly reversed course, and quickly plummeted to levels not seen in more than 20 years. Industry sales trends that weakened earlier in 2007 accelerated downward, taking profits with them. Improved consumer confidence is a prerequisite for improvement in restaurant spending.
Value Preservation
Declining profits and lack of credit have direct implications for restaurant valuations. The multiyear flurry of merger and acquisition (M&A) activity portrayed “comparable transaction” valuations well above historical averages. The mathematics supporting valuations are riddled with exceptions and circumstance, but a general frame of reference may be helpful.
From 2005 to today the average chain restaurant transaction valuation was approximately 8.5 times earnings before interest, taxes, depreciation, and amortization (EBITDA) (enterprise value/EBITDA). An historical perspective from about 1995 to today suggests transaction valuations of about seven times the same metric. Furthermore, for the same historical period, slower growth chain transactions were just under six times the same metric.
However, it is important to remember that these valuations are skewed by many factors: growth prospects, business model (franchisor, franchisee, pure operating company), and availability of financing among them. So, as acquisitions and leveraged buyouts within the sector proliferated and multiples expanded, leverage — and particularly senior leverage —increased substantially.
The market view suggests that valuations are currently at the low end of (or below) the historical range. Many public restaurant chains trade at multiples below certain private market transactions of the last couple years, which has negative implications for capital providers to the industry.
Given current consumer confidence, industry distress, and few viable “operate out” strategies, chains must focus on an “operate through” strategy. This means positioning leveraged companies to maximize cash flows and operating flexibility vis-à-vis their capital structure (amendments, exchange offers, reorganizations, etc.). In pursuing this flexibility, a complicating characteristic for many restaurant chains is a multitiered debt structure, typical during the liquidity boom, resulting in discrete collateral pools associated with disparate pieces of debt.
In addition to the traditional tranches of senior and subordinated debt, restaurants often have various operating lease agreements (including unitary leases, which cover multiple locations under a single contract), as well as specialized equipment financings covering key pieces of value-added equipment. For leveraged companies brushing against or tripping financial covenants or debt maturities, a practical and realistic assessment of viable strategic options is crucial to maximizing opportunities and preserving value.
Recipes for Success
What are reasonable forward expectations for the restaurant industry? Despite best-effort operating strategies, without help from the economy the industry will continue to struggle with slack demand, a stubborn cost structure, below-trend-line profitability, high leverage, and excess capacity. Without a rebound in consumer confidence, sales trends are unlikely to improve in a meaningful way.
However, during every historical cycle, good or bad, some chain and independent restaurants outperform their peer group and the industry at large. In this cycle there will be more casualties (liquidations) than usual. But there also will be chains that have or obtain the financial flexibility, staying power, and concept strength to operate through.
The food service industry is so large and so necessary that eventually it corrects, stabilizes, recovers, and moves on. After all, people have to eat.