Category: 2012

It only seems like Bill Ackman spends every waking moment haranguing Canadian Pacific Railway’s management. Instead, in his spare time, the activist investor has been preparing the iconic U.S. fast-food chain Burger King Corp. for a public offering, with shares set to trade in June.

At this time, we offer no comment about Mr. Ackman’s plans for CP. But a look at his Burger King presentation, coupled with the disclosure of the proposed stock offering, makes us wonder, in the words of Burger King competitor Wendy’s: Where’s the beef?

Indeed, the success of Wendy’s Co. highlights how Burger King’s return to the public markets its second IPO since 2006 – comes at a suboptimal time for the chain. Wendy’s overtook Burger King in U.S. sales in 2011 for the first time, dropping the chain to third place (the mighty McDonald’s is first).

Per Mr. Ackman’s own presentation, Burger King’s average sales per restaurant in North America sit at $1.15-million (U.S.), with Wendy’s at $1.46-million and McDonald’s at $2.43-million. Closing the sales gap with Wendy’s, Mr. Ackman says, would increase “EBITDA minus capex,” or earnings before interest, taxes, depreciation and amortization minus capital expenditures, by about $200-million, or 40 per cent of the company’s 2011 figure.

Is Burger King poised to do that? Clearly unclear. Mr. Ackman is only able to tout four consecutive months – from December through March – in which Burger King’s North American same-store sales increased. The numbers were profoundly negative for much of 2011; the company’s securities filings say it closed out 2011 with a decline of 3.4 per cent in same-store sales. (Its international locations, where growth was better, weren’t enough to make the companywide number positive for 2011.)

When a buyout firm affiliated with Mr. Ackman took Burger King private in October, 2010, it was widely assumed the tough turnaround decisions would be made out of the public’s eye. One of the presumed fixes was a significant investment in restaurant remodelling and upgrades: John Gordon, principal of California-based restaurant consultancy Pacific Management Consulting Group, wrote in a blog post on Seeking Alpha that at the time of the 2010 going-private transaction, Burger King had a capitalinvestment backlog of at least $2-billion.

Well, Mr. Ackman has a plan for that: Get the Burger King franchisees to pay for it. Various media reports have suggested the franchisees haven’t bought into the idea, and Mr. Ackman’s own numbers make clear why.

He suggests a franchisee who selects a $250,000 “low cost remodel” can achieve a 10-per-cent sales uplift and generate extra EBITDA of $28,000.

But, says Mr. Gordon, the restaurant consultant: “The problem is no one in the quick-serve restaurant space has achieved that. McDonald’s gets double-digit same-store sales bumps with a scrape and rebuild, but that is not what we’re talking [about]. Jack in the Box has done a nice job of remodelling, but reported low/minimal lifts in 2010-11, for example. The norm is single digits.”

Substitute a 5-per-cent sales lift in Mr. Ackman’s model, and the EBITDA is around $14,000 – barely more than the $12,000 in interest costs a franchisee incurs by borrowing 80 per cent of the remodelling project at 6 per cent annually (again, Mr. Ackman’s example.)

Much of the Burger King case is based on similar beef-patty-in-the-sky projections; Mr. Ackman says that while the company currently has just over 5,000 locations worldwide, it has the potential for more than 23,000, based on the U.S. rate of penetration of one restaurant for every $2-billion in gross domestic product.

The “reasonable” multiple for a newly public Burger King, Mr. Ackman believes, is 13 to 16 times EBITDA minus capex, a metric likely chosen because the company spends barely any money at all on capital expenditures. At the top end of that range, Burger King would trade above McDonald’s, which has already executed on nearly everything Mr. Ackrnan hopes Burger King can do.

At some point soon, someone may suggest to you that buying Burger King shares gets you a piece of a top -flight fast food company. That, I submit to you, would be a Whopper.

Some franchisors like their restaurants so much, they buy them back from the franchisees and convert to company owned. What’s behind the so-called de-franchising trend? Cash reserves and good unit economics.

Frisch’s Restaurants had a deal in March to sell its 28 Midwestern Golden Corral units to Aziz Hashim, the multiple-concept franchisee. But the chain’s franchisor saw the price tag and took an unusual step—Golden Corral swooped in to buy the restaurants itself.

Golden Corral was armed with a contractual option granting first right of refusal. “It just made sense for us to take this opportunity to add to our portfolio,” said Bob McDevitt, senior vice president of franchising for the 485- unit chain, based in Raleigh, North Carolina. “As we say to our franchisees, we like to eat our own cooking.”

One of the trends in franchising in recent years has been re-franchising, or the sale of company- owned units to franchisees. Numerous concepts, including Yum! Brands, Burger King, Jack in the Box and Jamba Juice, are unloading company-owned units as fast as they can. They believe they’ll do a better job if they concentrate on franchising, and franchisees typically outshine corporate when operating the restaurants.

Now a counter-trend is emerging—some call it de-franchising—in which a number of concepts seek to buy franchise units and grow company operations. Panera Bread, Buffalo Wild Wings, Ruby Tuesday, Texas Roadhouse and Chuck E. Cheese, among others, have been focusing on running more company-owned units.

For franchisees, this might actually be a good thing—a sign that the franchisor is bullish about the system and its future. While each system has different motivations, and some are “de-franchising” more than others, those chains buying franchisee-owned units are more likely to have better unit economics than are those systems selling company stores.

De-franchising can be seen as a “bull signal,” said John Gordon, a restaurant analyst with Pacific Management Consulting Group in San Diego. Refranchising, on the other hand, is more of a bear signal, an indication that the franchisor believes it would be more profitable franchising the system than running its own restaurants.

But there is a downside for franchisees. Franchisors that buy up units often get them at a low price, because they either get involved in the sale early in the process or, more likely, they have the right of first refusal to buy those restaurants. Chains that exercise that right tend to drive off potential buyers, which keeps prices low.

Right markets, right price

Two of the most successful publicly traded franchises in the country, Panera Bread and Buffalo Wild Wings, are both acquiring franchisees, albeit at a pace the chains call “opportunistic,” which means they buy franchisees that are in the right markets, at the right price.

In 2008, Panera Bread had 725 franchise units, 58 percent of its 1,252 total unit count. Today that percentage is down to 52 percent. The number of company-owned Panera Bread operations grew from 527 in 2008 to 740 last year.

“Panera continues to want to be a franchise company,” a Panera spokesman said, but will move to buy when the return is right. “Some of our franchisees are in a different place in life, whether retirement or simply stepping down. When a franchisee does want to sell, we evaluate the opportunity and will move forward on an acquisition if we believe we will earn an acceptable rate of return.”

Similarly, Buffalo Wild Wings saw its percentage of franchisee-owned units fall from 64. 6 percent in 2010 to 60.1 percent last year. On the company’s most recent quarterly conference call, CEO Sally Smith said the company is “open to acquiring attractive franchise restaurants.”

Both chains boast store-level operating profits of 20 percent or more. And that’s the point. When stores are running strong and making good cash, franchisors have a greater incentive to run their own stores. “If you’re really optimistic about your ability to create value and grow profit dollars, you’re less likely to share that,” said Sara Senatore, analyst with Bernstein Research in New York.

She cited healthy store-level profit margins at Chipotle, which does not franchise any units. “A great poster child for somebody that doesn’t want to share with anybody is Chipotle. They like their margins of 25 to 26 percent. They don’t need to franchise.”

Other chains are aggressive about buying out franchisees. Chuck E. Cheese, the Texas based pizza and games chain, is down to 36 domestic franchised units as the company looks to operate all of its units in the United States. The company is franchising in international markets, however. Like the other concepts, its restaurant margins run in excess of 20 percent, thanks to its high-margin video games business. Similarly, the steak chain Texas Roadhouse has stopped franchising and will buy up franchisees as they come for sale.

“If you have a restaurant with a couple million” in average unit volume “and get a margin exceeding 20 percent, that’s a likely candidate with de-franchising,” Gordon said.

Life cycle matters

At least part of the reason is due to life cycle. Chains on a growth trajectory feel no need to franchise because their sales are booming and their profits are strong and they have the cash to add units. As chains age, sales stumble and margins shrink, pressure mounts for them to sell off company stores and focus on franchising. Companies sacrifice the cash restaurant operations can bring in for lower overhead and capital costs. In many cases, franchisees can do a better job operating those stores.

“It’s a function of unit economics, and where they are in the growth cycle,” Senatore said. Mature companies sell a large annuity (profits from restaurants) for a smaller annuity (royalty payments from franchisees) and less risk. Thus, older chains have been more likely to re-franchise, such as Yum! Brands’ chains KFC, Pizza Hut and Taco Bell, and Miami-based Burger King, which is quickly selling company units to franchisees worldwide.

There are certain exceptions. Jamba Juice is a relatively young brand and it has been refranchising, or selling company stores to franchisees. Ruby Tuesday is an older brand with weaker economics and it has been de-franchising, or buying up franchisee-owned stores, largely because it sees itself as an operator.

There’s one company that’s actually doing both. Jack in the Box has been refranchising units in that chain for years in an effort to become 80 percent franchisee-owned. But the company has been more likely to develop units under its high-growth fast-casual brand, Qdoba, which has been moving in the opposite direction—toward more company-owned units in markets where it prefers to run company- owned stores.

Yum Brands Inc. (YUM), the parent company of KFC, Pizza Hut and Taco Bell, is selling hundreds of its U.S. restaurants to franchisees in an effort to further distance itself from the volatility of the owner-operated restaurant business.

The Louisville, Ky.-based company, which now earns the majority of its profits internationally, plans to reinvest the money from sales of its domestic restaurants in building new ones in countries such as China and India, where economic growth is stronger.

The so-called refranchising of its U.S. restaurants will help the company boost its profit margin at home. But there are risks to relinquishing corporate control of a brand’s image, and it’s tough to find restaurant operators who are willing to expand in the current economic environment.

In the U.S., Yum plans to reduce its ownership of Taco Bell restaurants to 16% from 22%, and its Pizza Hut and KFC stakes to 5% from 7% and 9%, respectively.

We tend to reduce our ownership of highly-penetrated, low-growth or lower-performing businesses, and we increase our ownership in lower-developed, higher-growth businesses, where we think we can get better returns,” Chief Financial Officer Rick Carucci said during a recent investor presentation. Yum says its returns on invested capital, reaching more than 22%, are some of the highest in the industry.

Five years ago, less than one-third of Yum’s company-owned stores were in emerging markets. Because of refranchising in developed countries, and increased equity stakes in China and elsewhere, now about 60% of company-owned stores are in emerging markets, and Yum expects that figure to reach 70% by 2014.

Refranchising is fairly common among mature restaurant chains because it insulates the parent company from the impact of external factors like unemployment and commodity costs. It also relieves them of many capital expenses associated with keeping stores’ kitchens, technology and decor updated, says John Gordon, a principal at Pacific Management Consulting Group, an advisory firm for chain restaurants.

McDonald’s Corp. (MCD), which often serves as a best-practice model for the fast-food industry, maintains about 10% ownership of its restaurants in the U.S.

“Older brands refranchise because return on invested capital becomes so important, and so mathematically, it makes sense for them to do so in mature markets and develop in places like China,” Gordon said.

With the latest refranchising, Yum says it has achieved about one percentage point of margin expansion in the U.S., most recently reporting a profit margin of 14.4%.

“If franchisees have access to capital and are good operators, then sure, go for it,” Gordon said. ’But at the same time, you can’t just ignore the U.S.; it’s still largest economy in world.”

Yum is in the midst of attempting to turn around its U.S. business, after seeing sales at established locations slip last year. Gordon says stepping further away from the ground floor of restaurant operations can make a revamp like that all the more difficult.

“But restaurant companies divesting of their locations doesn’t mean they’re abandoning brand; it just means they don’t think they’re good operators,” says Adam Hanft, a brand strategist and CEO of Hanft Projects. “Yum has been aggressive in refranchising, so it’s clear strategically that they don’t want to operate in the U.S.”

Still, the struggling U.S. economy is limiting the number of franchise operators who have the money and desire, to expand– especially in brands that aren’t doing so hot.

Adding to the hurdles, the U.S. market is heavily saturated with fast-food competition and banks are especially tight on loans. Franchisees don’t always have the access to cash that the parent company would for fixing up older units or investing in new products and marketing, necessary to orchestrate a resurgence of a chain.

Yum remains optimistic about its recent progress in the U.S. and the potential for its brands under a more franchised model. “We realize there Is much work to be done,” said Chief Executive David Novak. “And we expect more consistent performance going forward.”

For Yum! Brands Inc. (YUM)’s Taco Bell, thinking outside the bun means going gourmet.

The chain that once used a talking chihuahua to sell chalupas is working with Miami chef Lorena Garcia to win back eaters who have become accustomed to Chipotle Mexican Grill Inc.’s (CMG) style of Mexican fare. Menu items will include Chipotle staples such as black beans, cilantro rice and corn salsa, Greg Creed, Taco Bell’s president, said last month.

Taco Bell could use a boost. The chain has shrunk by more than 1,000 stores since 2000 and has been left behind as Yum expanded its KFC and Pizza Hut chains overseas. Chipotle, in the meantime, has been a stock market star, its shares tripling since the end of 2009.

“They have a tough road ahead to really reposition themselves as a direct competitor to Chipotle or Qdoba,” Mike Brumagin, a former Yum Brands senior project manager and Taco Bell store owner, said in an interview. Taco Bell has “always been about value.”

Taco Bell scored the lowest in food quality and atmosphere among limited-service Mexican eateries, including Chipotle and Jack in the Box Inc.’s Qdoba Mexican Grill, according to a September survey from Nation’s Restaurant News and consultant WD Partners.

Slow Growth

Taco Bell is also in a market that is growing slowly. Sales at so-called limited-service restaurants increased 1.9 percent to $195 billion in 2010 and Taco Bell was behind McDonald’s Corp. (MCD), Subway, Burger King Holdings Inc. and Wendy’s Co. in market share that year, according to Technomic Inc. The Chicago- based researcher hasn’t released 2011 figures.

Almost half a century old, Taco Bell was started by Glen Bell in Downey, California. PepsiCo Inc. (PEP) bought the taco restaurant in 1978, a year after acquiring Pizza Hut. Pepsi later bought the KFC fried chicken chain and spun off all three to become Tricon Global Restaurants Inc. in 1997. In 2002, Tricon became Yum Brands (YUM), now based in Louisville, Kentucky.

During the past decade, the brand has positioned itself as an affordable option for the young guy who “loves the lower price points,” said Peter Saleh, a restaurant analyst at Telsey Advisory Group in New York. Taco Bell has touted value meals with its “Why Pay More!” slogan and recently advertised a 12- pack of crunchy tacos for $10.

‘Younger Crowd’

Last year, the chain received negative publicity when Beasley Allen, a Montgomery, Alabama-based law firm, filed a class action lawsuit claiming Taco Bell didn’t use enough real beef in its food to label it as such. Chief Executive Officer David Novak called the claim “absolutely false” and said the restaurant’s seasoned meat is 88 percent real beef. Beasley Allen dropped the suit.

For a chain that made its name peddling cheap eats in the wee hours of the morning, a higher-priced menu may not appeal to the restaurant’s primary customer. The Taco Bell frequenter is an 18- to 24-year-old, value-conscious male, says Jeff Bernstein, an analyst at Barclays Capital in New York.

“It’s definitely targeted to a younger crowd,” he said.

Former franchisee Brumagin also is skeptical and says introducing somewhat fancier, higher-priced food could go the way of a healthy menu experiment in the mid-’90s that he called an “abysmal failure.”

Taco Bell is clearly taking cues from its higher-end rival.

“Chipotle is an opportunity because what it’s done has expanded the trial and usage of Mexican food,” Creed said at the investor meeting in New York Dec. 7. “It’s got people to believe they can pay $8 for a bowl or a burrito.”

Taco Bell can make food “every bit as good as Chipotle,” he said, and instead charge less than $5.

Hot Fritos

While Chipotle’s $7 or $8 burritos include ingredients such as naturally raised pork seasoned with thyme and juniper berries, Taco Bell’s menu now features the 99-cent Beefy Crunch Burrito that’s topped with Flamin’ Hot Fritos.

Steve Ells, a classically trained chef opened the first Chipotle in 1993. Since then, the company has grown to more than 1,100 U.S. locations while the menu has stayed relatively simple and consistent. Taco Bell has about 5,600 U.S. stores. While Chipotle’s shares more than tripled from the end of 2009 through last year, Yum gained 69 percent during the same time and the Standard & Poor’s 500 Restaurants Index rose 67 percent.

Yum advanced 2 percent to a record close of $60.92 in New York today. The shares rose 20 percent in 2011.

Other fast-food chains have successfully remade themselves. Oak Brook, Illinois-based McDonald’s gradually changed into a somewhat more adult and upscale restaurant by introducing McCafe espresso drinks and splashing its stores with earth tones, said John Kokoska, a managing director at BDO Consulting Corporate Advisors LLC in Atlanta who advises restaurants.

KFC Focus

Such an undertaking hasn’t been a priority at Yum, which has been more focused on expanding its KFC and Pizza Hut chains in China.

Since 2005, when Yum began reporting its China division separately, it has more than tripled revenue there while increasing store count more than 80 percent to about 4,200, topping McDonald’s 1,300 locations in the nation.

“Investors are in the stock as a play on China,” Jack Russo, an analyst at Edward Jones & Co. in St. Louis, said in an interview. Instead of a place for a quick, cheap meal, Yum restaurants in China are considered a nicer place for a family to go out for dinner, he said.

Taco Bell, meanwhile, hasn’t expanded much overseas. Yum has said it plans to sell hundreds of its U.S. stores to franchise owners. While the chain has stores in 21 countries, the U.S. accounts for 96 percent of its locations.

“It’s the tale of two cities,” John Gordon, principal at Pacific Management Consulting Group, a restaurant adviser in San Diego, said in an interview. Yum has “lost the capability to be able to run and work U.S. stores.”

Strategy Details

In the coming months Taco Bell will “be announcing further details” about the menu and strategy, Rob Poetsch, a Taco Bell spokesman, said in an interview.

Taco Bell in 2010 generated about $400 million in operating profit, about 60 percent of the company’s U.S. total and 23 percent of its global earnings by that measure.

Yum has sought to sell franchises back to U.S. store owners, in part to minimize its risk from rising raw-ingredient prices, Gordon said. In the quarter ended Sept. 3, U.S. restaurant margin narrowed to 12.1 percent from 14.4 percent last year, Yum said in a filing.

Turning around a fast-food chain with fancy new menu items can be pricey, especially for franchised store owners, said Kokoska, the BDO consultant.

“It might mean kitchen equipment where the franchisee has to cough up the cash,” he said. “It isn’t just a matter of buying better ingredients.”

Bob Watson has his eyes on New Jersey.

And why not? Watson, the chief executive officer of 5 & Diner, a restaurant company, sees the Garden State as ground zero for diners, and diners are what his company is all about.

“I know you’re crowded there,” Watson said. “You go to Red Bank, you can hit a diner in 10 miles in any direction. … But the fact of the matter is, we think our diners are a little bit different in that we think they’re kind of cool.”

So different that Watson hopes to open up 30 franchised diners, which in the 5 & Diner model are vintage 1950s retro, over the next five years around New Jersey, in areas such as Toms River, Freehold, Edison and Somerville. The family restaurants don’t serve alcohol.

He’s looking for franchisee candidates and locations in New Jersey, a state that many chain restaurants have shied away from over the years.

Sure, you know there’s a Ruby Tuesday’s, Five Guys or Subway nearby. But as a percentage of its overall restaurant base everything from delis and pizza joints to casual and fine dining, New Jersey has among the lowest concentrations of chain restaurants in the United States.

Of the state’s 20,339 restaurants, only 4,932, or 24.49 percent, are chains, restaurant companies with 10 or more locations, according to CHD Expert, a food service consulting firm based in Chicago. As a percentage, that’s fourth lowest in the U.S. Washington, D.C., is third, New York is second and Vermont is the lowest.

It’s different from other parts of the country where chain restaurants followed the construction of the interstate highway system and expanded from the 1950s through the 1970s, said John A. Gordon, principal and founder of Pacific Management Consulting Group in San Diego.

For one thing, New Jersey has a strong base of independent restaurants, including diners and those preparing Italian and ethnic food, Gordon said.

“We all know to get really good Italian food, that’s where you’ve got to go, really truthfully,” Gordon said.

As land became available for restaurants, local entrepreneurs picked up prime spots and developed a brand and loyalty, Gordon said. Chains such as McDonald’s grew. Casual dining restaurants such as Applebee’s followed, but they didn’t come in as many numbers as they did in other parts of the country, he said.

Costs are a major factor behind that, experts said. Rents and the price tag to build out a restaurant – filling it with a kitchen, tables, chairs and decorations – to get it ready to open are high, said Chuck Lanyard, president of the Goldstein Group, a commercial real estate brokerage in Paramus.

The cost of a liquor license, a scarce commodity in many towns because they are issued based on the size of the local population, can cost $250,000 to $1 million.

“When you take all those expenses in, people are less likely to look to open up in Jersey if they can look to open up in other areas where it’s less expensive,” Lanyard said.

The high costs are an added pressure to stay in business.

Franchisees have to pay a portion of its sales to a chain restaurant’s franchisor, said Stacy Gilbert, a partner at Citrin Cooperman in Springfield.

“You really have to have enough margin in the company to be able to do this and yet still walk away with a profit for yourself,” Gilbert said. “You can basically be running your business at a loss and still have to pay royalties.”

It leaves companies to wait for the right location to open.

“In New Jersey, there is just a lot of red tape when it comes to developing and getting stores open,” said Jack Koumbis, chairman of the New Jersey Restaurant Association. “The cost of it is almost prohibitive.”

For example, an Applebee’s may cost $2 million to $2.5 million to build, said Koumbis, chef and proprietor at The Assembly Steakhouse in Englewood Cliffs.

“If they are not doing $2 (million) to $3 million in that location a year, it doesn’t make any sense for them to do.”

It’s expensive to run or open a chain restaurant even without the expense of a liquor license.

The Five Guys chain first came to Parsippany in 2007, and it recently relocated from its storefront in the Pathmark Shopping Center in Lake Hiawatha to nearby Route 46 in Arlington Plaza. The restaurant is owned by Genco Development, a partnership of five local guys with exclusive franchise rights to Morris, Passaic and Sussex counties.

The move has given the crew a larger exhibition kitchen. Customers can place their order and walk down the line to watch it being assembled, or grab a table and enjoy unlimited free peanuts while they wait for their number to be called.

“Same Five Guys, new vibe,” says Brian McHugh, director of operations for Genco.

Part of the success of the company is the franchises are community-oriented, McHugh said. So when they made the move, “We wanted to make sure the move worked for our team,” he said. “Liliana Luna is one of our original crew members, and we found out that now it’s a little farther for her to walk to work.”

Chip Ohisson, Genco managing partner, added: “So we bought her a bike. She’s one of our key employees and we take care of our crew.”

Since the first location, Genco has opened franchises in Denville and Madison, and on March 28, they opened Five Guys’ 997th location at 246 Route 10 West in East Hanover, near Marshall’s and Dick’s Sporting Goods.

Restaurants Earning Fundamentals, Q2 2012:  Outstanding OPTEMPO

In watching the Q2 2012 restaurant space earnings, six brands interested us by exhibiting what we define as outstanding operating tempo (OPTEMPO). Not only significant EPS beats of $.02 or more (meets or a penny over doesn’t excite us much), but also positive traffic and positive early peek Q3 trends—that early Q3 trend prerelease info that some companies give. This quarter’s entire group has performed well recently.

• Brinker (EAT)
• Texas Roadhouse (TXRH)
• Ruth Chris (RUTH)
• Popeye’s (AFCE)
• Panera (PNRA)
• Papa John’s (PZZA)

Common Denominators: Two casual dining operators, one fine dine operator, one bakery/café, one QSR pizza, one Chicken QSR operator. Two of the six are steak centric (RUTH, TXRH), with one other making inroads into higher steak menu mix (EAT).  No big restaurant conglomerates (ala’ DRI) involved, but of the two with two brands under the HOLDCO, one brand greatly predominates over the other (EAT: Chill’s v. Maggiano’s) and RUTH (Ruth Chris v. Mitchell’s).

• Steak centric: we noted in 2011 that steak centric operators did well, no doubt by the improving travel/expense account traffic. RUTH’s peer, DelFrisco (DFRG) via its first call since IPO noted +SSS of 5.1% and traffic of +2.2% at the flagship Double Eagle units.
• Positive traffic and early peek looks: All had positive traffic—RUTH greatest at +3.9%; AFCE and PZZA don’t reveal traffic/check but one can so deduce it was positive).
• All had consensus earnings move up $.02 or more over the last 90 days—PNRA highest at +$.11, PZZA +$.09, EAT +$.07. Three of the six had 5 analysts or less providing estimates, with PNRA, TXRH and EAT well in double digit analyst coverage territory.
• None of these chains had eyeball high debt. Interestingly, none of the chains was actively refranchising, all were growing company units, with even franchisee heavy AFCE planning a significant slug of new company units.

Four of the six chains (RUTH, AFCE, PNRA, PZZA) had positive free cash flow increases from quarter to quarter. EAT and TXRH free cash flow was off from prior year but EAT is doing heavy duty remodels (and is still a huge cash generator) and TXRH is building new units.

Price/earnings ratios: only RUTH cheap but…

John A. Gordon

September, 2012

Restaurant Margins:  Rising Food Commodity Costs are Workable

Looking into 2013, there is no doubt that rising food commodity costs will have an effect on restaurants. The effect of the US drought, global economic, currency, weather and supply/demand conditions will have negative margin effects. All of the proteins will be difficult, especially beef and chicken. Coffee and vegetable oil are among the few food groups lower.

The cost effect will be felt in 2013, and beyond.  This comes on top of an up/down/up cycle from 2007. Depending on concept, restaurant cost of goods sold is typically 30-40% of revenue, the largest expense. Restaurants might cover moderate levels of food inflation, but if labor or other operating costs rise, and if revenues fall and produce deleverage of fixed costs, a real problem exists.

We think the ‘low hanging fruit’, the easier to implement, plate centered cost savings actions have already been taken.  Many restaurants have already reacted, in the recessionary 2008-2009 period by trimming portions and prices and by featuring lower cost per pound items and “small plates” in their menu and promotional mix. CKE Restaurants, for example, rolled out turkey burgers, and pork, lobster, chicken and other items have been periodically featured elsewhere. PF Chang’s implemented expansive happy hour food and alcohol offerings.

Many restaurants have already attacked staffing costs mercilessly, such as Darden, which eliminated bussers nationwide, expanded tip credit and is recertifying servers in massive workforce reorganization. Sonic (SONC) expanded the tip credit, lowered wages for some and rolled out car hops on roller skates to enhance service (and tips).

What to do? The show must go on of course.  Other than price increases, which always has to be considered in relation to competitors and customers, more work on menu mix and the rest of the P&L has to be considered. Here are some ideas from our travel and research.

More work towards developing store, zone, and regional pricing tiers needed: most US restaurant chains grew out of a 1960s/1970 culture of mass conformity. It is what the newly traveling public demanded in reaction to inconsistent restaurants in the 1940s-1960s.  The US today is has a far more diverse population, competition, operating cost and real estate characteristics.  Pricing really need not be the same everywhere in every location, either in a DMA or in a region. Ask ABC stores, the famous convenience retailer in Hawaii how they invented store level pricing. Does a Subway customer expect exactly the same price to the penny for a sub everywhere in a DMA?

Restaurant management systems and today’s analytics really are sophisticated enough to handle tiers of pricing. For example, one of Burger King’s (BKW) international high volume markets do not use the same lowball price tactics and is not the worse for wear.

Wendy’s (WEN) is still testing sub-DMA and store pricing tiers and we hope they continue and set the example for more industry innovation in this area.

Mass television campaigns can be much more carefully conceptualized. This is where the rub really comes. Conventional marketing theory holds that price specific advertising works better than “culinary” or other message focused advertising. Example; see Darden’s recent Q4 2012 earnings explanations of the Olive Garden sales softness.

Do restaurants advertise price so much because of the media mix? We bet that the vast body of 15 second TV spots that are aired can only work with price point appeals. And research has shown 15 second spots aren’t half the cost nor have the effect of 30 second spots. Has there been a holistic cost/benefit analysis done between media mix cost and media driven price and mix at the restaurant level? Is some more optimal 15 second or the 30 second spot mix more effective?

And what about $1/$2/$5/etc. off marketing features? That way no specific price baseline must be noted.

What is done with mass television campaigns and repositioning has to be tested. Just must. There is much less time, money and customers for massive redos. Ask Ron Johnson and JC Penney’s (JCP) about the cost of customer confusion in the wake of their massive repositioning (and the negative 20% same store sales resulting), that we understand was not pre-tested.

Suggestive selling at the store level always needs a lot of work.  While few of us really likes to sell, renewed emphasis to not downsell once the customer is in the store (“oh…would you like the coupon offer?” or ban the comment “is that all” have to be helpful. There can be at least one universal tradeup question that even a shy person could ask over the drive thru.

This problem is the greatest in the QSR and fast casual subsegments but not zero among casual dining operators.

Get the remodel funding in place. Some franchisee centric chains which haven’t remodeled because of sub-par unit economics will be under severe strain. Now is the time now to strengthen system fundamentals and get franchisee financial assistance support processes in place.  Papa John’s (PZZA) gets it, and has done so, but Domino’s (DPZ) hasn’t broken that code yet.

Finally, there are other cost savings possible. My favorite is utility costs, particularly that of electricity (air conditioning) and water. Have you ever been in a restaurant where it was freezing cold after dark, or on a chilly day? There is a reason.

John A. Gordon

September, 2012

Why CKE postponed its IPO

Analysts, industry experts weigh in on what caused the Carl’s Jr. and Hardee’s parent to postpone its initial public offering

August 10, 2012 | By Lisa Jennings

Concerns on Wall Street over restaurant industry health, recently fueled by a sales miss from McDonald’s, may be to blame for CKE Restaurants’ decision to postpone its initial public offering, according to various sources.

The planned IPO that was set to begin trading on Friday was called off late Thursday “due to market conditions,” CKE said.

The Carpinteria, Calif.-based company operates or franchises 3,263 restaurants under the Carl’s Jr. and Hardee’s brand names. The company had hoped to raise more than $200 million with an offering of 13.3 million shares of common stock priced between $14 and $16 per share.

A report on Thursday by the International Franchising Review, an online publication of Thomson Reuters Capital Markets Publishing, said CKE owner Apollo Management turned down an offer presented by the underwriting banks because it was too low.

According to the report, which did not name sources, the offer by joint underwriters Morgan Stanley, Citigroup and Goldman Sachs was believed to be $10 per share. Earlier, the banks had communicated investor interest in the $10 to $11 range.

Two days before CKE’s IPO was scheduled, Outback Steakhouse parent Bloomin’ Brands Inc. went to market with stock priced at $11 — well below the previous target of $13 to $15 per share. The size of the offering was also reduced to 16 million from the 21 million initially stated, and, though the stock price climbed through the week, some saw the situation as an indicator that investor interest in the restaurant space was cooling.

“For it to be priced below [the target range] and for it to be undersubscribed, that tells you a lot about that market,” said Conrad Lyon, securities analyst with B. Riley & Co. in Los Angeles. “The appetite probably just wasn’t there.”

Observers disagree, however, about the “market conditions” that might be scaring investors off.

On the same day as Bloomin’ Brands’ IPO, McDonald’s reported that its global same-store sales in July were not positive for the first time in years. The quick-service leader reported that same-store sales fell 0.1 percent among U.S. locations, 0.6 percent in Europe and 1.5 percent in Asia Pacific, Middle East and Africa.

Analysts blamed weakness in the global economy but also stiffer competition from competitors like Wendy’s, Burger King and Taco Bell, all of which have shown improving results.

Concerns about beef prices next year may also have been a factor in the postponement of CKE, according to International Franchising Review.

In earnings reports in recent weeks, several public companies said ground beef prices were expected to be favorable for the rest of this year as cattle are sent to slaughter because they are becoming too expensive to feed with the drought in the Midwest putting increasing pressure on corn prices. The long-term result, however, will be even higher beef prices next year, as it takes time to rebuild herd counts.

Others said investors may simply have had enough of restaurant IPOs after a busy year so far. “The client base only has so many bullets to shoot at restaurant investments, and those bullets have been fired already,” said Lyon.

CKE’s planned IPO would have been the fifth this year, following those from Bloomin’ Brands, Chuy’s Holdings Inc., Del Frisco’s Restaurant Group and Ignite Restaurant Group.

Dunkin’ Brands Group Inc. also on Friday announced a secondary offering of 21.7 million shares by stockholders. Last year, Dunkin netted about $423 million with an IPO, selling 22.25 million shares for $19 per share, which was higher than the range initially set at $16 to $18 per share.

John Gordon, principal of Pacific Management Consulting Group, said CKE’s large debt load may also have scared off potential investors. CKE was acquired in 2010 by Apollo Management in a $700 million deal. The company was planning to use income from the IPO in part to reduce net debt of $654 million to a projected $590 million.

Since going private, Carl’s Jr. and Hardee’s have not been able to show strong signs of turnaround, as competitors Wendy’s, Burger King and Taco Bell have shown. CKE’s blended same-store sales rose 2.6 percent in the first quarter, which was “okay, nothing exciting,” Gordon said.

CKE has a growth story to tell, Gordon noted, with plans to grow overseas and into the as-yet underpenetrated Northeast. However, those factors were not enough to overcome the changing outlook for restaurant stocks, which looks very different today than it did in May, when CKE first announced its IPO plans.

“There’s no doubt things are looking worse now than they were in the spring,” he said.

However, he added, investor outlooks are cyclical. “Investor sentiments tend to bounce back and forth between quick service and casual dining,” said Gordon. “And when the economy softens, investors start favoring QSR again.”

The question remains when, if at all, the IPO may still happen, if market conditions improve. Company officials said they could not comment on potential timing.

The planned IPO was based on first-quarter numbers, and the company will likely have to re-file based on second-quarter results, which won’t be released until mid to late September.

Contact Lisa Jennings at lisa.jennings@penton.com.
Follow her on Twitter: @livetodineout

Chuy’s IPO leads way for new restaurants on Wall Street

July 24, 2012 | By Ron Ruggless

Chuy’s Holdings Inc., the casual-dining Mexican restaurant operator, debuted on the public market Tuesday, bucking a down market to close up 15.9 percent.

The 36-unit Austin, Texas-based company offered 5.8 million shares at $13 each, the top end of its forecasted price offering between $11 and $13 per share. The stock closed Tuesday at $15.06, boding well for upcoming restaurant public stock offerings, including Southlake, Texas-based Del Frisco’s Restaurant Group, which is scheduled to debut on the market Friday.

In comparison to Chuy’s first-day spike Tuesday, the Dow fell 0.8 percent and Nasdaq fell 0.9 percent. Wall Street darlings like Chipotle and McDonald’s were also hit hard by investors as the companies reported depressed sales and earnings news.

Proceeds from Chuy’s offering will be used to pay down debt and add new restaurants, Steve Hislop, chief executive of Chuy’s, said in an interview with Nation’s Restaurant News after the chain debuted on the Nasdaq market.

Restaurants take to Wall Street

With Wall Street headed into the doldrums of August, John A. Gordon, principal of Pacific Management Consulting Group, said companies wanting to go public try to squeeze in public offerings “before the usual summer Street slowdown.”

Gordon cited Bain Capital, in the news now as presumptive GOP presidential candidate Mitt Romney’s former company, as doing its IPOs in late July. “The real market slowdown now couldn’t be anticipated 120 days ago,” Gordon said in an email, “so it’s all about the vacation break.”

Market-wide, five IPOs went up last week and eight are scheduled this week, including two restaurant companies — Chuy’s Holdings and Del Frisco’s Restaurant Group.

Del Frisco’s, which operates the Double Eagle Steak House brand as well as the Sullivan’s Steakhouse and the newer Del Frisco’s Grille, said it plans to sell 7 million shares at between $14 and $16 per share. Del Frisco’s plans to offer 4.3 million shares and parent company LSF5 Wagon Holdings LLC, which is owned by Lone Star Funds, will offer 2.7 million shares.

The company, which tried to go public in 2007 but withdrew its application in December 2008, again filed for an IPO of up to $100 million in January this year.

Other public offerings in the wings are those from Outback Steakhouse parent OSI Restaurants of Tampa, Fla., which said in April that it will change its name to Bloomin’ Brands and seek a $345 million IPO. Cheddar’s Casual Café of Irving, Texas, which used a provision under the Jumpstart Our Business Startups Act to file confidentially for its IPO in May, is also on the blocks. Dallas-based Dave & Buster’s Entertainment Inc. filed for an IPO in 2011, but it has yet to come to market.

CKE Inc., which operates the Carl’s Jr. and Hardee’s burger chains, had filed for an initial public offering of up to $100 million in May and on Monday said it now expects to raise as much as $230 million. CKE was taken private by Apollo Management in a $700 million deal in 2010.

Shares in Ignite Restaurant Group of Houston, which owns the 127-unit Joe’s Crab Shack and the 16-unit Brick House Tavern + Tap, went public in a $83.8 million offering in May. The company’s stock lost more than 20 percent of its value last week when the company announced it would have to restate financial statements for 2009 to 2011, and the first quarter of 2012, because of accounting issues with fixed assets and depreciation expenses.

Chuy’s future as a public company

The casual-dining chain most recently opened a unit in Gainesville, Fla., and is looking to back fill markets in Texas and Oklahoma, as well to colonize new ones such as Atlanta, Birmingham, Ala., and Louisville, Ky.

Hislop said the company, founded in Austin in 1982, expects future units to follow the non-cookie-cutter approach. “We’re going to follow our motto of ‘If you’ve seen one Chuy’s, you’ve seen one Chuy’s,’” Hislop said.

Current units range from 7,000 to 12,000 square feet, and Hilsop said the lower end is likely to be the target for future development.

The chain’s menu of burritos, enchiladas and fajitas produces a per person check average of $12.99, Hislop said, “which makes us very affordable.” The concept’s emphasis on rock ‘n’ roll music and in-store Elvis altars also positions Chuy’s differently than many Tex-Mex operations, Hislop said.

Analysts link 2Q Chipotle sales slowdown to Taco Bell success

July 23, 2012 | By Lisa Jennings

A slowing of sales at Chipotle Mexican Grill in the second quarter sparked debate among Wall Street analysts and observers that Taco Bell’s new Doritos Locos Tacos may be to blame.

Taco Bell introduced the new taco line, which feature shells made with nacho cheese-flavored Doritos, in March, and the product has been hailed as one of the company’s most successful. Last week, parent company Yum! Brands Inc. attributed a 13-percent increase in Taco Bell’s same-store sales during its second quarter to the launch of Doritos Locos Tacos.

Meanwhile, Chipotle last week reported a less-than-expected same-store sales increase of 8 percent during its second quarter — a slip after seven consecutive quarters of double-digit same-store sales.

Though Chipotle’s results overall were enviable, including a 61-percent increase in profit and a 21-percent gain in revenue, the chain’s typically high-sailing stock price took a plunge, losing nearly a quarter of its value on Friday.

In a call with analysts last week, Chipotle blamed the sluggish economy and difficult two-year comparisons. In reports, however, Wall Street analysts pointed to a possible correlation between Taco Bell’s same-store sales rise and Chipotle’s relative fall.

“We believe Taco Bell’s resurgence — at four times the number of units and three times the amount of system U.S. sales — may have had some impact on Chipotle,” wrote John Ivankoe of J.P. Morgan, who attributed Taco Bell’s lift to the “decidedly un-Chipotle-like” Doritos Locos Tacos.

Ivankoe warned that Taco Bell’s new Cantina Bell menu, which launched July 5, at the beginning of Chipotle’s third quarter, was a more “direct competitive move.”

The Cantina Bell menu was designed by celebrity chef Lorena Garcia and includes a line of bowl or burrito options with new ingredients for Taco Bell that evoke the style of Chipotle — though they are more similar to what might be found on the menu at other fast-casual competitors, such as Baja Fresh Mexican Grill or Qdoba Mexican Grill.

Taco Bell’s’ Cantina Bell offerings, however, are positioned at under $5 — a premium offering for the quick-service Taco Bell, but a value position compared with Chipotle and others.

Mark Kalinowski of Janney Capital Markets noted, “There is not a ton of overlap between Chipotle’s customer base and Taco Bell’s customer base.”

Still, he also warned of the Cantina Bell threat, citing “industry sources” who said the new menu is “off to a great start in terms of sales.” He quoted one Taco Bell franchisee who credited the Cantina Bell menu for double-digit same-store sales increases since the launch, which has been heavily promoted.

“While we do not expect the vast majority of this business to come at Chipotle’s expense,” Kalinowski wrote, “it is possible that it might take a bit of business from Chipotle at the margins. And, given the high valuation multiples Chipotle receives, we want to be mindful of this risk to Chipotle’s sales trends, particularly in regards to the third quarter.”

John Gordon, principal of San Diego-based Pacific Management Consulting Group, however, does not believe that Chipotle fans suddenly jumped ship for a taco shell made of Doritos.

You just don’t change people’s thought patterns and preferences that quickly,” he said. “You’re looking at different customers. Chipotle customers are younger, and Taco Bell draws from a totally different demographic.”

Taco Bell’s impressive jump in same-store sales was likely in part because the chain had been lacking in “new menu news” for some time.

Just as Burger King saw same-store sales rise significantly after announcing its menu revamp earlier this year, it should be no surprise that Taco Bell would see an “outside bump,” he said.

David Tarantino of Baird Equity Research warned that Chipotle’s disappointing same-store-sales trends should not necessarily be seen as an indicator, saying his firm’s surveys of fast-casual chains do not suggest a broad-based pullback on consumer spending.

Tarantino said the slowdown was likely company-based, possibly because of the tougher multi-year comparisons, as well as extreme heat conditions that might suppress the appetite for burritos and aggressive promotions by other quick-service competitors, though he did not specify Taco Bell.

Though growth might be slower in the third quarter, Tarantino and others encouraged investors to take advantage of Chipotle’s lower stock price as an opportunity to get in on what will likely be long-term earnings growth.

“We still consider Chipotle’s top-line growth prospects among the best in the industry,” wrote Stephen Anderson, senior analyst for Miller Tabak + Co. LLC.

Read more: http://nrn.com/article/analysts-link-2q-chipotle-sales-slowdown-taco-bell-success?page=0,1#ixzz22cKXLRQw

Yum’s new menu items spur optimism

A look at how recent menu rollouts from KFC, Taco Bell and Pizza Hut could affect Yum’s performance

July 12, 2012 | By Mark Brandau

While the economies of its international growth markets, especially China, may be slowing down, Yum! Brands Inc. is going to market in the United States with new-product news that may bolster the domestic portions of its earnings, which the company will report next Wednesday.

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During the past several weeks, the company’s three brands — KFC, Taco Bell and Pizza Hut — have each rolled out new products that star in comprehensive marketing campaigns. The wave of menu innovation comes at a time when economists fear international markets, which generate 65 percent of Yum’s operating profit, could falter from recently reliable and robust growth.

China, Yum’s key market, could be a particular concern. An Associated Press story reported Thursday that the country’s economy might only grow an expected 7.3 percent. While it would be an enviable figure for the United States economy, a growth rate below 8 percent would mark one of the lowest quarterly expansions in several years and signal weakening demand and consumer confidence.

Austerity measures, a possible banking crisis and depressed consumer confidence also could hamper Yum’s outlook in its Yum Restaurants International division.

If Yum were to look to the United States to make up some of the sales slack, recent performance and new products could be reason for optimism. After same-store sales for its domestic system fell 1 percent for fiscal 2011, they rebounded with a 5-percent increase in the first quarter of 2012.

John Gordon, principal of San Diego-based Pacific Management Consulting Group, an analysis and advisory firm focused on restaurant chains, said Yum should be able to win back sales and trial with its new offerings, provided the company makes up for lost time in the United States and stays aggressive in its advertising.

“I don’t understand why their new-product development has been so slow in the United States,” he noted. “This business is fundamentally driven by new-product news. … I’m impressed they have this new news rolling ahead, but they’ve got to sustain that and have to support it with good media. You need to bang on that drum for at least a year to get people’s involvement with the products up.”

Take a look at some the most recent menu rollouts from KFC, Taco Bell and Pizza Hut, as well as analysis of how the offerings could affect Yum’s performance.

Read more: http://nrn.com/article/yums-new-menu-items-spur-optimism#ixzz22RcPm568