February Chain Restaurant Fundamentals

February 4th, 2011

In January and early February, we had a lot of restaurant earnings and investor conference news, from YUM (NYSE:YUM), Darden (NYSE:DRI) Wendy’s Arby’s Group (NYSE:WEN), Brinker (NYSE:EAT) and McDonald’s (NYSE:MCD).

And we’ll count SBUX too, even thought they are hoping to transition to a CPG company. As always, we look for interesting notes and common denominators.

Retail activity surprise: the January 2011 traditional retailer same store sales monthly values were shockingly favorable, reported at plus 4.9% by the top 30 retailers tracked by RetailSails. As we know, with life threatening US weather throughout December and January, sales should have been softer. This backs up some aspects of the optimism of the National Restaurant Association’s 2011 forecast, but we don’t see their forecasted logic that “quick serve sales gains will outpace full-service.”

Earnings Hit/Miss: MCD was at consensus, DRI, EAT, SBUX, YUM above, and WEN likely below. Every CFO likely has several million dollars of flexibility and buybacks in their back pocket, and as a result, we are really most impressed by earnings blow-outs (plus $.10 or more). No one hit that.

Likewise, no one reported same store sales pops, our definition of a same store sales trend movement of 1000 basis points or more from trend. Of the group, we note that SBUX reported a very healthy plus 7 with 5 coming from traffic, which is healthy.

It was interesting to see the MCD European shortfall in comps (-.5%) and YUM’s (YRI--International, non China) softer performance (the full year was zero SSS, Japan, Canada and Australia all negative in Q4).

Restaurants in market share battle: the fairly consistently cited long term EPS growth goals (10 to 15%) all seem to signal the necessity of weaker operators dropping out, more cost containment (DRI had extremely focus here), and more stores.

But: Long-term Earnings Assumptions Problems: We see a disconnect between the logic indicating chain restaurants will get market share from independents and new store growth, versus the fact that restaurant counts really haven’t declined. Coming out of the worst economic down period since the 1930s, and with very tight to no credit available, surprisingly only 1% of independent restaurants closed last year (and chains unit counts were flat). That doesn’t work down the over expanded restaurant supply at all.

In addition, as the population ages, dining out propensity generally falls. Despite putting on a great analytical display as they always do, we saw this disconnect most evident at the Darden (DRI) Investor event.

While they downplayed the need for it, we also feel DRI must find an appropriately priced acquisition that meets their national platform standards and the 15% growth. BJ’s Restaurants (BJRI) or California Pizza Kitchen (CPKI) could be it. BJRI is still in nosebleed territory PE wise (57.1 X), but a CPKI acquisition seems to be better timed.

Commodity and Pricing Potential questions properly got a lot of attention on the earnings calls. Every single major food item commodity cash price was above year ago (some well above), except 12 ct chicken broilers on February 2, for example.

Brinker has stepped up its franchisee reporting but otherwise in this entire group there was little discussion of franchisee conditions. There must be more proactive metric to discuss other than unit closings and royalty write-offs.

Older brands being shopped: Wendy’s/ Arby’s Group will become just Wendy’s, putting Arby’s on the street. YUM is doing the same with Long John Silver’s and A&W. A&W was one of the oldest food franchisors, dating back to 1921 in Lodi California. It has a significant cluster of units in Indonesia.

Arby’s/ LJS/A&W M&A Valuation: Our rough parent franchisor level EBITDA base, multiples and possible selling price guess for these concepts are:

Arby’s: $75M EBITDA times 5 to 7 equals $450M potential price
Long John Silver: $28M EBITDA times 5 to 7 equals $168M potential price
A&W: $6.5M EBITDA times 5 to 7 equals $39.5M potential price

Keep in mind that while Arby’s has about 1000 company units, Arby’s, Long John Silver’s and A&W have around 4000 franchisee units in total that are really the ongoing core value of the brand.

This signals the death of the multi branded QSR concept thrust: the late 1990s and early 2000s idea of multi restaurant concepts under one roof has died out, with even Dunkin Brands not working new growth (it will support existing franchisee concept commitment growth). But interestingly, Darden is studying/researching exactly a combined Olive Garden and Red Lobster format. They are doing elaborate research.

Ever complicated YUM: YUM is a worldwide company with such an international focus that it is hard to explain. YUM has proven the company operated model can work, and US brands can have life cycle extension internationally. Think about its twice than US level AUV levels, much higher restaurant margins and less than 3 year cash paybacks in China. However, the risk of deempahsis and maintenance of the US brands remains a risk. YUM US same store sales for the year were only plus 1 (plus 5 in Q4). YUM didn’t talk its Q4 Pizza Hut or KFC US same store sales numbers but noted Q4 US Taco Bell was plus 4, and Pizza Hut was plus 8 for the year.

The expected 15% China wage growth note was striking because it is precisely there that YUM has a big cost advantage versus US labor cost metrics.

We believe Wendy’s has a wonderful QSR Burger platform to build upon as it gets breakfast in place. It has the second highest AUV ($1.4M) of the national burger operators. We believe breakfast is critical to building daytime/lunch/dinner synergies.

Our opinion is that the fixes at Chili’s and Red Lobster will take substantial time to work.

Casual dining Happy Hour emphasisis epidemic and growing and will truly be an interesting academic topic to plot out customer perception/sales/traffic/margin trends.

MCD Free Cash Flow Metric: there were some notes (and even a CNBC debate) that MCD free cash flow was failing. That was of course due to the new unit construction and remodels thrust, especially in 2010 and 2011 (with more coming up). While we really like free cash flow as a metric, that number will be clumpy and should be examined on a compound average growth rate basis.

John Gordon

John A. Gordon is Principal and founder of Pacific Management Consulting Group, which provides chain restaurant sales, profitability, earnings and economics research and special analytical projects to those in, or who need to know about the restaurant sector. Among others, we support franchisees and those supporting franchisees.

Gordon has a long background in chain restaurant operations and financial management roles, such as cost analyst, financial analyst, manager of planning and analysis and CFO, and has been consulting since 2000.

He is passionate in providing independent, creative, detailed and useful perspective, with no conflicts of interest. Email him or call (619) 379-5561.

Comments

February 4, 2011 - 22:02pm

Metrics

John writes:

"Brinker has stepped up its franchisee reporting but otherwise in this entire group there was little discussion of franchisee conditions. There must be more proactive metric to discuss other than unit closings and royalty write-offs."

As usual, John writes a comprehensive, if terse, analysis. I wonder what other metrics he has in mind, and what the franchisee associations could do to faciliate Brinker's reporting of these metrics?

February 6, 2011 - 23:40pm

Franchisee Financial Reporting Standardization Suggestions

Thanks for the comment, Michael.

Its amazing to see how little some restaurant franchisors have in terms of real time franchisee operations data. Truly. Many struggle with coming up with sales, product mix and financial data. And sales shouldn't be a problem since that is the foundation base of the royalty payments, a large portion of the franchisor's cash flow.

For publicly traded companies, this lack of disclosure is particulary problemsome for investors (and franchisees) in those franchisors who are 80%, 90% or even 100% franchised.

But it can be done: McDonald's has quoted average franchisee cash flow per store before, and in its January 2011 Investor Day, Wendy's went so far as to state total franchisee cash on hand. So it is possible, it can be done.

To keep it simple as possible, we recommend that franchisors report just two metrics: weekly AUV and store EBITDAR dollars per store, updated and stated annually..

Metric One: Franchisee average weekly annual unit volume (AUV) on a net (not gross) sales basis. The best practice is to state it on a comparable (same stores) basis, some 12 months open, some 18 months open. Just define it and state it and be consistent year to year. Stating on a weekly average basis removes the problem of comparing 52 to 53 week years.

Metric Two: Store level EBITDAR dollars: The profitability metric is complicated: profit before or after rent, before or after franchisee overhead, before or after debt service (P&I), etc., are always variables. We'd suggest that it be reported and standardized on an EBITDAR basis, that is, display average annual store level profit before interest, taxes, depreciation amortization and rent. Franchisee overhead (e.g., salaries and other forms of owners return) should be excluded so its on a store level basis.

EBITDA is now a very common metric, every bank in the country sees it or will want to see it.

And for the invariable question about Item 19 and the FDD, the above two major data elements can be displayed, by quartile (top 20%, and so forth), for the last full annual FDD reporting cycle.

This isn't perfect but would go a long way to standarding meaningful disclosure.

Franchisee Associations could play a role in insuring this happens. Since these numbers are so critical to the ongoing success of any business, franchisors could empower the associations to participate in the follow-up or data collections role. Nothing here can't be tracked via EXCEL. And kept confidential. The personal business net return that many owners are hesitant to reveal isn't , just the store level data. Associations can also play a big role in collecting product mix (menu mix) information, which is also problematic for some franchisors to collect. Even if based on a confidential units cross partial units sample, it would be an improvement over nothing. And its exactly that kind of data that is actionable and meaningful for the associations to work with.

Don Sniegowski

February 7, 2011 - 13:39pm

Yum Loses Flavor Even in China

Insightful analysis. Good stuff!

Here's an article by Alyce Lomax in Motley Fool last week recapping the major issues facing Yum. She does touch on something John Gordon has said in his article; namely, Yum! Brands is losing its flavor not just in the United States but also in China.

Yum! Brands has also been busy defending its reputation against a lawsuit that questions the quality -- heck the very existence -- of Taco Bell products' ground beef... An unappetizing PR debacle, rising costs for Chinese labor, and spiking commodity prices (including in China, where the company said it has already raised some menu prices) all converge to make Yum! Brands look a little less appetizing at the moment.

Although I pour over the trades daily, I see little in writing from analysts about franchisees. That's why John's insights at the macro and micro level (franchise owner-operators) are greatly appreciated. It's rare.

Granville_Bean

February 4, 2011 - 21:47pm

Good stuff if...

Good stuff if this really was an industry forum. But few of these brands mean much to the typical 1st time Hurt Zees who are the most frequent post sources on BMM. If you feel you were swindled by your Zor and are about to lose your home (and your savings and 401k are already gone) then some big corporation's EBITDA trends and overseas sales growth are not going to interest you much when you are woking double shifts to save on near-minimum wage labor .

February 7, 2011 - 14:58pm

Weekly reported AUV and EBITDA a must

Having each store report a standardized EBITDA / EBITDAR and weekly net average unit volume is an excellent idea if the chain and the stores want an edge in getting money from banks to grow restaurants. Jagsd01is right. This is a brave new world we are in -- one where credit is hard to come by and now such information is required.

How would those franchisee associations that were spoken about get around the problem of revealing their store financials to their fellow peers in their association?

February 7, 2011 - 14:58pm

Weekly reported AUV and EBITDA a must

How would those franchisee associations that were spoken about get around the problem of revealing their store financials to their fellow peers in their association?

February 8, 2011 - 14:00pm

Confidentiality of P/L

Ian McBean writes:

"How would those franchisee associations that were spoken about get around the problem of revealing their store financials to their fellow peers in their association?"

Excellent question. Franchisees are in competition with each other and certainly are not going to simply trust the members of the franchisee association with their profit/loss statements.

However, before a technical solution to the privacy issue is offered, it would be important for everyone involved to understand the basic strategic structure of confidential information. The difficult is that confidential information is valuable only when it is shared, but if it is shared with the wrong person/group, then you will lose your share of the increased value.

There are a number of little strategic exercises that a group can train on to understand this point in more detail - more practical detail. (I can guarantee you that 90% of those involved in IP litigation should try to understand this strategic point because they keep wasting their money asking the courts solve this problem for them.)

Ultimately, a franchisee association is going to have to enter into a contract with the franchisor to provide some santized version of the database, ensure that access to the db is a secure as possible, and plan for the eventual failure of that security.

Again, this is another product of coordinated action that the franchisee association can engage in which provides value to the franchisor and increases the franchisee's collective bargaining power.

February 8, 2011 - 23:40pm

Internalizing for better performance

John: “Its amazing to see how little some restaurant franchisors have in terms of real time franchisee operations data. Truly. Many struggle with coming up with sales, product mix and financial data.”

That is truly franchising from the dark ages and I’d suggest franchisors that don’t have the information to fine tune the business for franchisees and the franchisor are a poor if not dangerous investment. Fine tune franchisees’ business bottom line and you get franchisees prepared to reinvest in any number of ways.

Ian: "How would those franchisee associations that were spoken about get around the problem of revealing their store financials to their fellow peers in their association?"

I’d ask people to consider how accurate benchmark percentages fit as opposed to actuals. In my experience any seriously hot discussion or sharing of information on any element of performance comes from P&L comparisons. But to preserve confidentiality they do not need to be actual $s.

Aside:- While 'net' as a benchmark comes from the composition of typically many category benchmarks I’ll use 'net' as an example; if I ask a franchisee achieving a 10% net to calculate what a 14% network average [benchmark] does to his business the result is onehot discussion on how to get to the benchmark. If I ask a room full of franchisees to work off the network’s high mark of 17% everyone is keenly interested. The effect should be that all performance increases.

Michael: “Franchisees are in competition with each other and certainly are not going to simply trust the members of the franchisee association with their profit/loss statements.”

To my way of thinking the concept of franchisees being in competition with other franchisees from the same brand should only exist where encroachment stacks markets. When franchisees grow the value of individual businesses they grow the brand value that pulls even higher resale values. There for there is big profit in franchisee collaboration. What happened to value-added franchising where one of the benefits was to utilize the experiences of others?

Guest: "There for there is big profit in franchisee collaboration."

That applies to conflict resolution.

February 9, 2011 - 11:28am

Benefits of Interdependence

Guest writes:

"There for there is big profit in franchisee collaboration. What happened to value-added franchising where one of the benefits was to utilize the experiences of others?"

Yes, this is correct. I was simply making the observation that franchisees are also in coopetition with each other, whether or not encroachment makes it apparent or not. Yes, and franchisees should understand the value of interdependent action and co-optetition.

Don Sniegowski

February 7, 2011 - 15:30pm

Restaurant chains compare-o-matic

I found a neat interactive chart by Kapitall comparing both franchised and corporate chains. Although MCD, WEN and YUM that are mentioned in John's article aren't in this comparison, other major chains in the industry are, e.g. AFCE, SONIC, BJ's Restaurants, PF Chang, Brinker and other of the largest restaurant chains.

Hit play.

Now hover over the purple buttons for more info on each brand. Click on the buttons. See? Interactive.