Category: 2013

Lunchtime at the flagship In-N-Out Burger restaurant in Baldwin Park, California, is a study in efficiency. As the order line swells, smiling workers swoop in to operate empty cash registers. Another staffer cleans tables, asking customers if they’re enjoying their hamburger. Outside, a woman armed with a hand-held ordering machine speeds up the drive-through line.

Such service has helped In-N-Out create a rabid fan base — and make Lynsi Torres, the chain’s 30-year-old owner and president, one of the youngest female billionaires on Earth. New store openings often resemble product releases from Apple Inc, with customers lined up hours in advance. City officials plead with the Irvine, California-based company to open restaurants in their municipalities.

“They have done a fantastic job of building and maintaining a kind of cult following,” said Bob Goldin, executive vice president of Chicago-based food industry research firm Technomic Inc. “Someone would love to buy them.”

That someone includes billionaire investor Warren Buffett, who told a group of visiting business students in 2005 that he’d like to own the chain, according to an account of the meeting on the UCLA Anderson School of Management website.

The thrice-married Torres has watched her family expand In-N-Out from a single drive-through hamburger stand founded in 1948 in Baldwin Park by her grandparents, Harry and Esther Snyder, into a fast-food empire worth more than $1 billion, according to the Bloomberg Billionaires Index.

Biblical citations

Famous for its Double-Double cheeseburgers, fresh ingredients and discreet biblical citations on its cups and food wrappers, In-N-Out has almost 280 units in five states.

The closely held company had sales of about $625 million in 2012, after applying a five-year compound annual growth rate of 4.6 per cent to industry trade magazine Nation’s Restaurant News’s 2011 sales estimate of $596 million.

In-N-Out is valued at about $1.1 billion, according to the Bloomberg ranking, based on the average price-to-earnings, enterprise value-to-sales and enterprise value-to-earnings before interest, taxes, depreciation and amortisation multiples of five publicly traded peers: Yum! Brands Inc, Jack in the Box Inc, Wendy’s Co, Sonic Corp and McDonald’s Corp Enterprise value is defined as market capitalisation plus total debt minus cash.

One private equity executive who invests in the food and restaurant industry said the operation could be valued at more than $2 billion, based on its productivity per unit, profitability and potential for expansion. The person asked not to be identified because he is not authorised to speak about his company’s potential investments.

Plane crash

“In-N-Out Burger is a private company and this valuation of the company is nothing more than speculation based on estimates from people with no knowledge of In-N-Out’s financials, which are and always have been private,” Carl Van Fleet, the company’s vice president of planning and development, said in an emailed statement.

Torres, who has never appeared on an international wealth ranking and declined to comment for this article, came to control In-N-Out after several family deaths. When her grandfather Harry died in 1976, his second son, Rich, took over as company president and expanded the chain to 93 restaurants from 18.

Torres’s father, Harry Guy Snyder, became chief executive following Rich’s 1993 death in a plane crash at age 41. The chain expanded to 140 locations under Guy, who inherited his father’s passion for drag racing.

Ford cobra

When he died of a prescription drug overdose at age 49 in 1999, Snyder’s estate included 27 cars and other vehicles, including a 1965 Ford Cobra and a pair of 1960’s-era Dodge Dart muscle cars, according to his will.

Torres’s grandmother Esther — Harry’s widow —maintained control of the company until her death in 2006 at age 86. When she died, Torres was the sole family heir. She now controls the company through a trust that gave her half ownership when she turned 30 last year, and will give her full control when she turns 35. The company has no other owners, according to an Arizona state corporation commission filing.

Few in the restaurant industry have met or know much about the hamburger heiress.

“I have no clue about her,” said Janet Lowder, a Rancho Palos Verdes, California, restaurant consultant, who said she was one of the few people to extract the company’s internal finances from Esther Snyder in the 1980’s for industry-wide surveys. “I was even surprised there was a granddaughter.”

Limited menu

Torres has little formal management training and no college degree. The company was structured to carry on after the demise of its founders, according to a 2003 Harvard Business School case study. In-N-Out has never franchised to outside operators, the Harvard researchers said, giving up a low-cost revenue stream in exchange for maintaining quality control.

In a 2005 article in the Harvard Business Review, Boston- based Bain & Co consultants Mark Gottfredson and Keith Aspinall attributed the company’s estimated 20 per cent profit margins at the time to the simplicity of its limited menu. Contrast that with competitors such as Oak Brook, Illinois-based McDonald’s and Miami-based Burger King Worldwide Inc, which regularly change their food offerings.

“Other chains seem to change positions as often as they change their underwear,” said Bob Sandelman, chief executive officer of San Clemente, California-based food industry researcher Sandelman & Associates.

‘Calculated growth’

Butchers carve fresh beef chuck delivered daily to the company’s distribution facility in Baldwin Park, where hamburger patties leave for restaurants on 18-wheeled refrigerated trucks outfitted with over-sized tires so the In-N-Out logo can be better seen on the highway. The company only expands as far as its trucks can travel in a day, either from the Baldwin Park complex or a newer facility in Dallas, the only two places where the company makes hamburger patties.

In-N-Out expanded to Texas in 2011, after building a warehouse and the patty facility. There are now 16 units in the state. Conrad Lyon, a Los Angeles-based senior restaurants analyst for B Riley Caris, said additional expansion will continue to be gradual.

“I would expect slow, calculated growth,” he said in a phone interview. “To outsiders the company’s growth out West likely appears sluggish. However, it was management carefully leveraging its brand, real estate and distribution. As a private company-owned system, In-N-Out has the luxury of calling the shots to replicate its success without succumbing to potentially detrimental outside influences.”

Complaints, Allegations

The company’s pace of expansion was one of the issues at stake in an exchange of lawsuits in 2006 between Torres, In-N- Out executives and Richard Boyd, the company’s former vice president of real estate and development. Boyd was one of two trustees overseeing the trust that controls the company’s stock on behalf of Torres.

Among other allegations filed in California state court in Los Angeles, Boyd claimed Torres and Mark Taylor — her brother- in-law from a half-sister — conspired to remove Esther Snyder from the company to gain control of In-N-Out. He filed a separate petition with the probate court seeking to prevent Torres from removing him as a trustee.

Torres denied the allegations in both a formal answer to Boyd’s complaint and a 2006 letter to the editor published in the Los Angeles Times, in which she said she only had “minimal involvement” in the company’s business decisions, and didn’t favour rapid expansion.

16 Bathrooms

The company in turn filed a breach of contract lawsuit against Boyd, alleging fraud and embezzlement in connection to Boyd’s relationship to one of In-N-Out’s outside construction firms. Boyd’s lawyer, Philip Heller of Fagelbaum & Heller LLP in Los Angeles, said all the litigation was dismissed following a confidential settlement. Boyd resigned from the company and the trust.

“They were all in the end amicably resolved,” Heller said.

Since then, Torres has refused most interview requests, even by author Stacy Perman, who wrote a 352-page book about In- N-Out in 2009. Torres asked to set up a meeting with the author after the book’s publication, but it never occurred, Perman wrote in an afterword to the 2010 paperback edition.

Torres popped up in real-estate blogs in September, after buying a $17.4 million, 16,600-square-foot mansion in the wealthy enclave of Bradbury, California, in the foothills of the San Gabriel Mountains. A Realtor.com listing for the house described it as having seven bedrooms, 16 bathrooms, a pool, a tennis court and other amenities.

Drag Racing

Torres is one of almost 90 hidden billionaires discovered by Bloomberg News since the debut of the Bloomberg Billionaires Index in March 2012. Among them: Dirce Camargo, the richest woman in Brazil, and Elaine Marshall, the fourth-richest woman in America.

Like Camargo and Marshall, Torres maintains a low profile. Her most visible presence has been on the drag strip. She competes in the National Hot Rod Association’s Super Gas and Top Sportsman Division 7 categories, alternating between a 1970 Plymouth Barracuda and a 1984 Chevrolet Camaro, according to NHRA results. Her third husband, Val Torres Jr., is also a race- car driver.

Whether the mother of twins will maintain ownership in the chain after she gains full control in five years is uncertain, said John Gordon, founder of San Diego-based restaurant consultant Pacific Management Consulting Group.

“It’s an open question whether she may have different feelings later,” said Gordon. “Like most kids, or second or third generations of a very wealthy family, I don’t know that she has restaurant blood in her veins, or if she’s a trust fund baby.”

McDonald’s Corp. is adding pumpkin-spice lattes to lure the Starbucks crowd and boost traffic.

The McCafe pumpkin latte — a mix of espresso, milk and flavored syrup — will come in three sizes and be available with whole or nonfat milk, the Oak Brook, Ill.-based company said. A 16-ounce latte with whole milk has 340 calories and will cost $2.89. A regular coffee is $1. The lattes are being introduced this month and will sell through mid-November.

McDonald’s, the world’s largest restaurant chain, has been introducing pricier items such as chicken wings, McWraps and steak breakfast sandwiches to maintain profitability in the face of higher labor, occupancy and operating costs. At the same time, the company is expanding its value menu to draw bargain-seeking diners.

The operating margin at McDonald’s U.S. company-owned restaurants narrowed to 18.7 percent in the quarter ended June 30 from 19.8 percent a year earlier.

The shares rose 0.4 percent to $97.28 at the close in New York Sept. 23. McDonald’s has advanced 10 percent this year, while the Standard & Poor’s 500 Restaurants Index has gained 18 percent. Starbucks has added 41 percent.

Starbucks Corp. has sold 200 million pumpkin spice lattes in the nine years since it introduced them, said Alisa Martinez, a company spokeswoman. The drink has the same number of calories as McDonald’s offering and a 16-ounce one sells for $4.55, on average. The Seattle-based company, which has about 11,200 U.S. cafes, also sells salted-caramel mochas, hazelnut lattes and is introducing new bakery items nationwide.

McDonald’s may be able to steal some Starbucks customers because Americans are focused on finding deals now and pumpkin has become such a popular flavor during the fall season in the U.S., John Gordon, principal at San Diego-based Pacific Management Consulting Group and adviser to restaurant franchisees, said.

McDonald’s also will begin serving hot beverages in paper cups, instead of polystyrene foam containers, bowing to customers’ preference for a recyclable option, Ofelia Casillas, a spokeswoman, said. Changing all 14,100 U.S. locations to paper will be a “multi-year” process, she said.

McDonald’s has recently struggled in the United States, where it is facing a tough consumer environment. In August, sales at stores open at least 13 months rose 0.2 percent domestically, falling short of the 0.8 percent gain projected by analysts. Earnings have trailed estimates for the past two quarters.

The fast-food company’s new Dollar Menu, which it’s testing in five markets in the U.S., includes items that sell for as much as $5. McDonald’s Dollar Menu was introduced in 2002 and it rolled out the McCafe lineup of lattes, cappuccinos and mochas to the U.S. in 2009.

McDonald’s is scheduled to report third-quarter results Oct. 21.

McDonald’s Corp., already struggling to sell burgers in the U.S., now must contend with a brewing franchisee revolt.

Store operators say the company, looking to improve its bottom line, is increasingly charging them too much to operate their restaurants — including rent, remodeling and fees for training and software. The rising costs are making franchisees, who operate almost 90 percent of the chain’s more than 14,100 U.S. locations, less likely to open new restaurants and refurbish them, potentially constraining sales.

McDonald’s is “doing everything they can to shift costs to operators,” said Kathryn Slater-Carter, who in June joined other franchisees in Stockton, California, to brainstorm ways of getting the chain to lessen the cost burden. “Putting too much focus on Wall Street is not a good thing in the long run.

‘‘It is not as profitable a business as it used to be,’’ said Slater-Carter, who owns two McDonald’s stores and backs California legislation that would require good faith and fair dealing between parties in a franchise contract. It would also allow franchisees to associate freely with fellow store owners.

Asked if McDonald’s is shifting costs to franchisees, Heather Oldani, a spokeswoman, said in an e-mail: ‘‘We are continuing to work together with McDonald’s owner/operators and our supplier partners to ensure that our restaurants are providing a great experience to our customers, which involves investments in training and technology.”

‘Productive’ Meetings

Lee Heriaud, who chairs the National Leadership Council, a group of franchisees that meet regularly with company executives to discuss ideas and concerns, attended the Stockton meeting and others. In an e-mailed statement provided by Oldani, he said “owner/operators’ feedback and perspectives have been shared with McDonald’s and owner/operator leadership in the spirit of open dialogue.” The meetings were “productive,” he said.

Cooperation between McDonald’s and its store owners is deteriorating, according to an April 11 letter from a franchisee to other store owners reviewed by Bloomberg News.

“Many of you have said that you don’t feel that the top management understands the economic pressures that we face,” the letter said. “The tone has become much more controlling and less inclusive.”

This isn’t the first time the world’s largest restaurant company has found itself at odds with the people who own and operate its stores. McDonald’s in the mid-90s alienated U.S. franchisees when it expanded too quickly and new stores began cannibalizing other locations, said Dick Adams, a former McDonald’s store owner and restaurant consultant in San Diego.

Slowed Expansion

Under pressure from franchisees, the company slowed the expansion. It opened 1,130 net new domestic restaurants in 1995; by 1998, it had cut that number to 92.

“There was a time at McDonald’s when the franchisee morale was extremely low and everyone was extremely upset,” Adams said. “We’re getting there again.”

Today’s tensions between Oak Brook, Illinois-based McDonald’s and store operators coincide with the company’s struggles to grow after consumer confidence fell in July after increasing for the past three months and with the unemployment rate stalled at 7.4 percent or higher. On July 22, the shares fell 2.7 percent, the most in nine months, when McDonald’s reported second-quarter profit and revenue that trailed analysts’ estimates. Chief Executive Officer Don Thompson said economic weakness would hurt results for the rest of the year.

McDonald’s fell 0.2 percent to $99.11 at 9:37 a.m. in New York. The shares increased 13 percent this year through yesterday, trailing the 20 percent gain for the Standard & Poor’s 500 Restaurants Index.

Franchisee Income

The Big Mac seller, which owns or leases most of its U.S. stores, has been generating more income from franchisees. Revenue from franchised stores, which includes rent and royalties, increased 8 percent on average during the past five years, while total revenue rose 4 percent.

Some franchisees are paying as much as 12 percent of store sales in rent, according to notes of an April 23 meeting attended by store operators. Instead, they want the company to return to a historic rate of about 8.5 percent, the document shows.

U.S. McDonald’s restaurants average about $2.5 million in annual sales, according to Chicago-based researcher Technomic Inc. That means franchisees who have recently renewed leases are paying an average of $300,000 a year, up from $212,500 at the 8.5 percent rate.

Local Markets

“Across the country, the rent owner/operators pay for their McDonald’s restaurants is determined by local market real estate costs, as well as the cost of doing business in a particular market,” Ofelia Casillas, a McDonald’s spokeswoman, said in an e-mailed statement. “The range for rent has historically varied based on these and other regular business variables.”

At the April meeting at a community center in Paramount, California, a group of franchisees spent five hours discussing ways to get the company to reduce rents and other costs. Another cadre of McDonald’s store owners met in Stockton in June to discuss similar issues. The group in Paramount suggested reducing rents, royalty rates and creating a regional real- estate team of store owners to help set lease rates.

Rent is “the firmest of fixed expenses,” said John Gordon, principal at San Diego-based Pacific Management Consulting Group and a consultant to restaurant franchisees. “You pay that before you remodel, you pay that before you take owner salary out.”

Alienating Customers

As a result, some run-down stores aren’t getting fixed up, which in turn is alienating customers, he said.

“People don’t want to be in an old space, even if they’re going through the drive-thru,” Gordon said. “You get better employees, you just get a better vibe if it’s a newer store.”

As it is, remodeling a McDonald’s store costs at least $800,000, according to Slater-Carter. That’s more than twice as much as at Burger King Worldwide Inc., which after franchisees revolted cut the expense for its remodeling program by half to about $300,000, on average. Wendy’s Co. is also paring its upgrade costs and has said it will get to $375,000 for its least-expensive model.

Oldani, the McDonald’s spokeswoman, said that it costs about $600,000, on average, to remodel a McDonald’s restaurant and $1 million to build a new store.

McDonald’s recently told franchisee Slater-Carter she must pay $80 a year to switch to the company’s e-mail system and she’s now forking over an extra $10,400 per store annually for new software, Wi-Fi and employee training costs — all fees that McDonald’s has tacked on in the last five years. She won’t know until 2016, when her lease must be renewed, how much extra she may be paying in rent.

“What I see going wrong is the corporation itself is forgetting that its fiscal strength rides on the fiscal strength and the creativity of the operators, and it’s just going for such centralized control,” said Slater-Carter, whose family has owned McDonald’s franchises since 1971.

Following the biggest surge in takeovers of restaurant and coffee companies since the last recession, Krispy Kreme Doughnuts Inc. (KKD) and Jamba Inc. could be next on the menu.

Acquisitions of U.S. restaurant, tea and coffee companies from Peet’s Coffee & Tea Inc. to Teavana Holdings Inc. reached $6.1 billion last year, the highest level since 2008, according to data compiled by Bloomberg. Deals are on the rise as sales growth at coffee and snack shops are forecast to outpace fast- food chains through 2017, data from IBISWorld Inc. show. Since Joh. A. Benckiser Group announced plans Dec. 17 to buy Caribou Coffee Co., Krispy Kreme shares have climbed 21 percent to the highest in more than five years as Jamba rose 19 percent.

Krispy Kreme, which introduced a new coffee lineup in 2011, and Jamba (JMBA), the smoothie maker projected to post its first profit since 2005 this year, may be targeted for their well-known brand names and the chance to expand into grocery and mass retail stores, said B. Riley & Co. and Pacific Management Consulting Group. Even after Krispy Kreme shares climbed 43 percent in a year, the doughnut seller still trades at a lower earnings multiple than 97 percent of U.S. restaurants valued at more than $100 million, data compiled by Bloomberg show.

“They’re iconic brands and it takes forever to build that brand equity,” Conrad Lyon, an analyst at Los Angeles-based B. Riley, said in a telephone interview. “To be able to write a check and add that to your portfolio is probably pretty attractive.”

Takeover Wave

Brian Little, a spokesman for Winston-Salem, North Carolina-based Krispy Kreme, and Matt Lindberg, a spokesman for Emeryville, California-based Jamba, declined to comment on takeover speculation.

In addition to its pending $340 million purchase of Caribou, Benckiser also acquired Peet’s last year for about $1 billion. Starbucks (SBUX) Corp.’s approximately $620 million takeover of Teavana was disclosed in November and completed last week.

Those acquisitions helped push industry takeovers last year to the highest since 2008, when deals peaked at $7.5 billion before consumers curbed spending amid the longest U.S. recession since the Great Depression, data compiled by Bloomberg show.

Sales at coffee, hot-beverage and doughnut chains are outpacing fast-food revenue as on-the-go consumers shift to snacks instead of full restaurant meals, according to June and July reports from IBISWorld. Coffee and snack shop sales are forecast to increase 4 percent annually to $33.9 billion in 2017, compared with growth of 1.9 percent a year for fast-food chains, the Santa Monica, California-based researcher said.

Jamba Juice

Acquirers may be interested in a coffee or beverage chain with a brand that is “strong in the consumer mind,” Lyon at B. Riley said. The profit margin for selling beverages is higher than for food, he said.

“Two brands out there that are largely the strongest in their category are Krispy Kreme for doughnuts and Jamba for smoothies,” Lyon said.

Jamba, operator of the Jamba Juice chain, sells hummus-and- cheese wraps, flatbreads and frozen yogurt alongside its signature fruit smoothies. The juice maker, founded in 1990, also sells smoothie kits and 90-calorie energy drinks at Wal- Mart Stores Inc. and Target Corp. (TGT) locations in the U.S.

While Jamba shares rose 71 percent last year as the company announced new store openings and started selling more food, the closing price of $2.48 last week was still 80 percent below its 2006 peak. The company has a market value of $192 million.

Starbucks Interest

“Jamba juice could be pick-up-able,” said John Gordon, a San Diego-based principal at restaurant adviser Pacific Management Consulting, with clients including Dunkin’ Donuts franchisees. “It would be relatively cheap from a strategic acquisition standpoint. They already have a very large store presence. It’s already a brand name.”

The company could fetch about a 15 percent premium in a sale, Gordon estimated.

Jamba is projected to post a profit of $7.3 million this year following losses since 2005, analyst estimates compiled by Bloomberg show. After three consecutive years of declining sales, the company also may report revenue gains of 2 percent for 2012 and 6.3 percent this year, the estimates show.

Starbucks may seek to buy Jamba if its Evolution Fresh juice brand, purchased in 2011 for $30 million, doesn’t catch on fast enough, said Lyon. There are four Evolution Fresh shops that sell items including spiced carrot juice, mango smoothies and eggs scrambled with brown wild rice. Jamba has about 755 stores in the U.S., of which 301 are company owned, according to the company’s November earnings statement.

Breakfast Foods

“It’s maybe a great opportunity for Starbucks if they really want to get into that smoothie business and juice business more,” he said.

Zack Hutson, a spokesman for Seattle-based Starbucks, declined to comment on whether it’s interested in buying Jamba.

Krispy Kreme, founded in 1937, may lure bids from other eateries looking to boost morning food and drinks sales with its cult-like following, Lyon said.

Wendy’s Co. (WEN) may look at Krispy Kreme as a way to boost its breakfast sales, Lyon said. The Dublin, Ohio-based chain, which sells chicken biscuits and home-style potatoes at some locations, has struggled to compete with McDonald’s Corp.’s morning menu. The $1.86 billion company backed off testing breakfast in some U.S. markets last year after a disappointing financial performance.

Coffee Appeal

“Most fast-food restaurants in the burger category have a huge opportunity in the breakfast arena,” Lyon said. Krispy Kreme is a “great way to expose customers to products in the morning — and then later in the afternoon, the burgers take over.”

Bob Bertini, a spokesman for Wendy’s, said the company doesn’t comment on speculation.

Krispy Kreme, which began selling a new line of “signature” coffees in 2011, has said it plans to increase coffee to about 12 percent of sales by the end of fiscal 2015. Coffee currently accounts for about 4 percent of sales, the company said in August.

Part of the allure of purchasing coffee companies now is that coffee-bean prices have been falling, Sharon Zackfia, an analyst at William Blair & Co. in Chicago, said in a phone interview. Coffee prices dropped 37 percent in 2012, the biggest annual decrease since 2000, according to data compiled by Bloomberg.

Profit Return

Krispy Kreme returned to profit in fiscal 2011 after six straight years of losses, data compiled by Bloomberg show. Earnings for the third quarter topped analysts’ estimates, and the company said that in the fiscal year ending Jan. 31 it will earn more than previously thought. Krispy Kreme has a net cash position of $24 million, the data show.

“It’s still a very recognized brand,” Gary Bradshaw, a Dallas-based money manager at Hodges Capital Management Inc., which oversees about $800 million including Krispy Kreme shares, said in a phone interview. “The company has returned to profitability. They really cleaned up their balance sheet. It could certainly be bought.”

While the improvements sparked a 48 percent stock gain since the Nov. 19 earnings report, Krispy Kreme still trades for 5 times its trailing 12-month profit. That’s a lower price- earnings ratio than 97 percent of U.S. restaurants larger than $100 million, the data show. Only Denny’s Corp. (DENN) is cheaper at 4.5 times.

Doughnut Calories

“It’s not dirt cheap, but it’s an improving picture that we think will continue to get better,” Bradshaw said. “There’s not a lot you can do if someone comes in and offers $15 a share for the company, but we think if they continue to grow, it could be worth a lot more than that a couple of years out.”

Krispy Kreme shares rose almost 11 percent to $11.15 on Jan. 4, giving the company a market value of $727 million, after Alton Stump, an analyst at Longbow Research, initiated coverage with a buy rating and $15 stock price estimate.

Still, the iconic doughnut’s nutritional drawbacks may give a possible buyer pause, said Jason Moser, an Alexandria, Virginia-based analyst at the Motley Fool. A glazed doughnut with creme filling has 350 calories, according to the company’s website. That’s why Krispy Kreme has recently introduced oatmeal and fruit juice to its menu.

While Nick Setyan, a Los Angeles-based analyst at Wedbush Inc., says strategic buyers may be lacking for Krispy Kreme, he also said the company is a potential buyout candidate for a private-equity firm at as much as $13 a share. That would be a 17 percent premium.

“You can capture the future growth at this point,” Setyan said. “A lot of the sort of bad news is behind them now.”

Restaurant Space: 2013 Standouts to Date

A rising tide lifts all ships: Consumer discretionary stocks are doing well, leading the pack with the highest forward PEs in May, as FactSet reported last week, www.factset.com/insight

But for franchisees, the stock price is not the same as free cash flow in the pocket. At Dunkin Brands (DNKN, Dunkin Donuts) for example, the DNKN stock price has more than doubled since its 2011 IPO, but core northeastern franchisee shop level profits are up 1-3% since 2008, per management.

Same store sales: Despite some same store sales headwinds caused by the so called 2013 same store sales cliff, the theme noted http://seekingalpha.com/article/1111341-restaurant-conditions-comp-cliff-coming early this year that sales comps would be down versus mild winter weather in 2012, the industry is doing fine. There are no large publicly traded restaurant companies in real trouble, although one could argue Ruby Tuesday (RT) is, but not any of the major players from a liquidity or default basis.

The industry was at +2.5% SSS (per MillerPulse) in May, almost all driven by ticket. McDonald’s (MCD) May sales gains reported Monday were foreseen and no surprise.  Yum’s (YUM) -19% May China same store sales decline was not moderate but met the Consensus Matrix number. http://finance-yahoo.com/news/yum-says-sales-fell-2051586651.html.

In almost all cases, the two year and five year comps trends are solid; if that was the Street metric we’d all be celebrating.  See the following trend sales display from RBC’s Larry Miller’s MillerPulse Survey.

MAY 2013 RESTAURANT TWO YEAR COMPS TREND (MILLER PULSE)

Restaurant Segment	Industry	Fast Food	Fast Casual	Casual Dining	Fine Dining
2 Year Comp	+5.6%	+8.6%	+6.3%	+.9%	+10.4%

 Legend; two year comparables are the May 2013 v May 2011 comparison.

What are the Standouts:  I’ve invented a restaurant fundamentals standouts group, to note restaurant companies that have all of the following fundamentals going the right direction:

• Positive same store sales and traffic, both, with no major geographies negative.
• Meets or beats on analyst revenue consensus, beats earnings per share (EPS )by $.01 or more, with no downgrades within 90 days.
• Positive sequential momentum, early peek SSS current period, if revealed, positive.
• No gimmicks with adjusted, proforma or restated EPS values, and as validated by the operating income beat.  A publicly traded track record of one year.

Who are the Standouts: SBUX, with new product new news every quarter, the only restaurant chain growing traffic at a greater rate than average check. Also, Ruth Chris (RUTH), Texas Roadhouse (TXRH) Domino’s (DPZ) and Popeye’s (AFCE) are on the standouts list.  Both Ruth Chris and Mitchell’s in the RUTH house are moving, ahead smartly.  AFCE is building company stores, capturing  US KFC units and reflagging them, and touting itsUS stores franchisee 20% EBITDAR margins, in addition to new flavors/new product news. AFCE was the first franchisor ever to report franchisee profitability in a quarterly call that I can recall.

Implications:  My number one concern going forward is that the industry not shoot itself in the foot via over discounting. NPD noted that after a time, customers see discounted prices as the new normal. Restaurants that don’t play in the ever discounting spiral space are at an advantage.

Restaurant marketing tends to be copy cat in nature, and like a battleship, takes forever to turn. Darden (DRI) has reset to the $12.99 television price point, doing Red Lobster and Olive Garden $3/$4 off coupons too. US Pizza Hut (YUM) is doing $5.55 anniversary pizza price (one large) undercutting even Domino’s (DPZ) and weaker QSR players are at or under the “my $.99” at Wendy’s (WEN). We wonder what customers must think of the long term pounding on price.  NPD https://npd.com/wps/portal/npd/us/news/press-releases/deals-are-no-longer-driving-restaurant-traffic  presented five year data that shows that restaurant deal sales mix is flat and declining, as follows. This means more discounting is chasing even fewer deal consumers.

RESTAURANT SALES MIX CHANGES ON DEAL TRANSACTIONS (NPD)

Year:	YE 2008	YE 2009	YE 2010	YE 2011	YE 2012
Sales Mix Change,Y/Y	+5.0%	+3%	0	0	-3%

Legend: Deal Mix” restaurant meals sold at discount, change v. prior year

Limitations of EBITDA as a Meaningful Financial Metric

In the restaurant finance world, the big number is the EBITDA—EBBADABADOO as some call it. EBITDA is earnings before interest, taxes, depreciation and amortization, and is really a sub-total to the income statement. It is earnings without any charges for cost of funds, taxes or capital spending.

EBITDA’s use began popularized as a credit metric, used in the 1980s M&A and credit analysis world—to test for adequacy of debt coverage. EBITDA is often the common denominator to track and report company buyout values:  the acquisition enterprise value to EBITDA ratio is a very commonly reported metric. So much so that that’s where the focus goes. And its use as a simple business valuation tool: the company is worth some multiple of EBITDA; the higher the multiple, the higher the price, and vice versa.

In the franchising space, where franchisors might report a simple EBITDA payback for an investment, or report EBITDA value in their franchise disclosure document item 19 section. The special problem there is this EBITDA is stated in terms of the restaurant level profit only—before overhead. Really, the problem is this: EBITDA doesn’t show the whole picture. It is a sub-total. It doesn’t show full costing.

EBITDA alone as the metric misses at least eight costs and expenses, that are vital to know, calculate and consider in operating and valuing the business as a cash and value producer.  Using a business segment such as a store, restaurant or hotel as an example, here are the eight required reductions to EBITDA that must be subtracted, listed in order of magnitude of the cash outlay, to really get to operating economic profit.

1. Interest expense:  the cost of the debt must be calculated. Interest is amount borrowed times the interest rate times the number of years. One can have rising EBITDA but still go broke.
2. Principal repayment:  the business cash flow itself should contribute to the ability to pay back the principal debt. That often is in a 5 or 7 year maturity note and is another very large cost that must be considered.
3. Future year’s major renovation/remodeling: once the storefront is built, it has to be renewed and refreshed in a regular cycle, often every 5-10 years, via capital expenditures (CAPEX). That often is 10-30% of the total initial investment, or more, over time.
4. Taxes, both state and federal. Financial analysis often is done on a pre-tax basis as there are so many complicating factors. But the reality is the marginal tax rate is about 40%.
5. New technology and business mandates: aside from the existing storefront that must be maintained, new technology, and new business innovation CAPEX must be funded to remain competitive. Example: new POS systems for restaurants, new technology for hotels.
6. 1. Overhead: if the EBITDA value is stated in terms of a business sub-component, like a store, or restaurant or hotel, some level of overhead contribution must be covered by the EBITDA actually generated. Generally, there are no cash registers in the back office, and it is a cost center.
   2. Maintenance CAPEX: for customer facing businesses (retailers, restaurants, hotels, especially) some renovation of the customer and storefronts must occur every year and does not appear in the EBITDA calculations.  New carpets, broken windows, you get the idea. In the restaurant space, a good number might be 2% of sales.
   3. And finally, new expansion must be covered by the EBITDA generation, to some level. New store development is often a requirement in franchise agreements, and new market development necessary. While new funds can be borrowed or inserted, the existing business must generate some new money for the expansion.     

   You might say…these other costs and expenses are common sense, they should show up in the detailed cash flow models that should be constructed. Or they can be pro-rata allocated. But how times does this really happen? The EBITDA metric becomes like the book title….or the bumper sticker that gets placed on the car. You really do have to read further or look under the hood. And the saying is true…whatever you think you see in EBITDA…you need more.