Wisdom on such diverse topics as: spin-offs, merger arbitrage, post-bankruptcy equities, global macro commentary and short ideas.

Jul 15, 2010

Metrics for analyzing Restaurant Companies

One of the brightest fund managers I’ve ever met once explained to me that in value investing, it is important to pick your spots. Operate as a generalist, but try to find a few industries where you can get a really deep understanding. He told me that some industries are actually closely related if you think about it. That makes our job even easier.

Take restaurants for instance. He told me that a restaurant is really just a big box. You come in, order food, eat, and leave. From there, you can gradually build on that model to analyze similar businesses. Like a retailer. Retailers are pretty similar, you walk into a box, buy some clothes, and exit. Clothes replace food in our model. From there, you can take the idea to department stores, which are really like a huge retailers. Instead of selling one type of clothes, they are sourcing from many different manufacturers. But it is mostly the same idea. You come into the box, you make a purchase, you leave.

(I am probably not the best teacher because I’ve taught myself most of how I look at and analyze companies. As a result, I might do things a little differently than the norm. If you disagree or have a different approach with the perspective that I am outlining here, feel free to e-mail me or leave a comment. That way we can improve on this and help out other novice investors who might be interested in looking at restaurants.)

If we accept our box analogy, what are some key factors to look at when analyzing a restaurant business?

First there is the box, the actual restaurant building. Sometimes a company might own the underlying real estate that will be on the balance sheet. If the company is just leasing the location, you still own everything that is actually inside of the restaurant, that will be under property, plant, and equipment. You’re going to incur expenses to rent that location (occupancy costs) or use capital expenditures to purchase new properties and equipment. So you’ll want to look for that on the income and cash flow statement. Some of your equipment is going to degrade each year which will be recorded as depreciation and amortization. Purchasing new restaurants or reinvesting in existing locations will typically be found on the investing section of the statement of cash flows, usually recorded as capital expenditures.

The first thing I do when looking at the box is take a look at if they own the underlying real estate and when they made the purchase. The balance sheet typically employs the cost approach which means asset values are recorded using the price that was paid for them. Then, depreciation might also bring down the recorded value of a building to a level that is actually below its true worth. So you need to watch out for cases like this where the accounting may inaccurately represent the value of the company’s assets.

The individual restaurants have value as well. If you were to sell an established location to a franchisee, the company could fetch a good price because much of the uncertainty that comes from a new restaurant location is gone. So what I do is compare the mix of owned locations to franchised locations and see if there might be any value that could be unlocked by shifting to a more franchise driven model. From a cost perspective, restaurants record a cost on the income statement for “operations” costs associated with doing repairs, procuring supplies, and the utilities that need to be run for keeping the restaurant open. These would be shifted to a franchisee.

I experienced this first hand with Steak N Shake, a business I purchased at $10 a share which had about $10 of value from their real estate holdings underneath. 80% of the restaurants were company owned (McDonalds is the opposite with 80% franchised 20% company owned), which meant that management could have sold some locations off to generate cash. As the financial crisis intensified, they used this strategy to make sure they did not breach any debt covenants.

Shifting to a franchise-driven model makes sense because you end up lowering the capital intensity of the business, since you are cutting out the actual costs associated with operating a restaurant. Your efforts become focused on developing new food products, marketing, advertising, and other corporate related expenses. You end up with less expenditures which means more cash for buybacks or dividends and potential for higher returns on invested capital.

Then there is the matter of food. Food and labor are your primary expenses in a restaurant. On the balance sheet you will find inventory listed as a current asset. Food is recorded on the balance sheet as inventory, and then you might also have an accounts payable line which records how much is owed to food suppliers. On the income statement, cost of sales gives you the cost of the food and beverages sold at the restaurant.

To prepare the food at the restaurant, you need workers. You’ll see their wages recorded as labor or payroll as an expense on the income statement and accrued payroll on the liabilities section of your balance sheet. Browsing the 10-K of Red Robin Gourmet Burgers (NASDAQ:RRGB ), you’ll see that food and labor combined are 60% of restaurant revenues. So there are major costs associated with actually producing the food served in restaurants.

Some sophisticated restaurants will use derivative contracts to hedge the movements in commodity prices, but many smaller restaurants do not. For these smaller restaurants, it is entirely conceivable that on a year-to-year basis, your margins might slightly fluctuate if commodities are particularly volatile.

When I look at restaurants, the food is definitely something that I analyze qualitatively. Food is what brings people into restaurants and it is also transparent to competitors. Wendy’s (NYSE:WEN ) was the first nationwide chain to serve meal-sized salads and their major competitors (McDonalds, Jack in the Box, Burger King) all quickly followed with their own meal-sized salads. So finding a competitive advantage in food is difficult because it is bound to get copied.

Besides the overall unique recipes, food related competitive advantages tend to come from the economies of scale that the business possesses. McDonalds (NYSE:MCD ) once thought about putting shrimp in one of their salads, but they realized that ordering a sufficient quantity of shrimp would have caused a global shortage. That is buying power and it means McDonalds can achieve cost savings and advantages that give them a leg up against smaller upstarts. This is especially when you look at low margin value menu items.

We have a rough idea of the box, the food that is sold in the box, but what about the people? The customers are what drives a restaurant’s results. To monitor customer activity, there are a few useful metrics. Most restaurants will provide data on same store sales or comparable store sales which get us an idea of how sales activity has fluctuated on average. You have to compare this data on a YoY basis because seasonal effects such as winter storms or summer vacations might impact the data on a month to month basis. You also need to take into account aberrations or outlier events that may have occurred for the year.

Most restaurants will give you sales data on a monthly basis. As an investor, you really don’t want to get too bogged down by focusing on revenues. We care about the earnings and cash flows. Sometimes restaurant management teams will get too glued to revenues and expand too much, into weak markets. Ultimately, this hurts earnings.

So then why do I mention same store sales? It is a useful metric for seeing how a restaurant is doing. Typically, we are going to be looking at distressed restaurants, where sales have dipped and the company is posting a loss or barely breaking even. I use sales figures to get an idea of whether or not a turnaround is working. If management rolls out a few promotions and new menu items to entice people to return to the restaurant, I’ll see if the effects carry through into the sales figure. Ultimately it is a simple metric that can help tell us a lot about the business.

The way consumers get notified about new menu items is through advertising. You can find annual advertising expenditures in the SG&A line of the income statement. In the footnotes they will break out how much is being used for advertising within the larger SG&A figure. It is useful to monitor how this figure fluctuates, in order to see if SG&A is rising due to salaries or due to ad spending. Then, you can also track how increases in ad spending are translating to same store sales.

Distressed Restaurants

In order for us to find a restaurant that meets our value criteria, something usually has to be wrong about it. There are a few ways restaurants can run into trouble.

Most restaurants blame the economy or weather, basically factors that they claim are outside of their control for poor performance. There is some legitimacy to the economy argument. If times get hard, people are going to cut back on their spending and trade down. Trading down can mean different things to different people. For one person trading down might mean eating less at Red Robin and more frequently at McDonalds. For another, it might mean eating less at McDonalds and eating more at home.

How can a restaurant counter-act the effects of the economy? By bringing value to customers. Usually, you will see restaurants roll out new promotions that are supposed to entice you to come in. McDonalds is truly awesome at doing this. For example, they rolled out their $1 menu which features certain menu items which have thin to no margins, such as the McDouble. To help balance that out, they are also offering any all soft drinks for only $1. The idea here is that you might opt for one low margin item (McDouble) with higher margin items (soft drinks, french fries) creating a net benefit. Burger King (NYSE:BKC ) did this successfully with their $1 Buck Double paired with their ribs (>$6). Going up the chain, Red Robin is using a strategy where they are selling a bacon cheeseburger for about $7.50. The average cheeseburger on their menu is around $9.50 so it is a price reduction.

The second most common issue I’ve seen with restaurants has to do with debt. Management teams will sometimes keep their eyes so glued to their restaurant count that they become empire builders. They start building out more and more units, even though the cash flows coming in cannot support those types of expenditures. So then they take on debt. Normally, this can work but if the economy goes to negative and the company is not prepared to make the right decisions, the situation can rapidly deteriorate.

When something like that happens, you need to pay careful attention to the balance sheet and conservatively analyze the assets on there to see if they would have potential value if sold. That might allow the company to shed certain assets and amend debt covenants or reduce overall indebtedness. Whenever analyzing in a leveraged company, sit down and research the terms of the debt covenants.

C. Catastrophes

I think the classic catastrophe example in the QSR business is Jack in the Box (NASDAQ:JACK ) with the E. coli outbreak in 1993. Four children died and sales plummeted, millions had to be paid out in lawsuits, and their debt rating was cut to junk status. I keep this same example in my mind whenever I invest in a restaurant because it is still a very real risk.

So how do I handicap towards that risk? The best way is to try to do research into what sorts of cleanliness and food safety measures are employed by the company and gauge employee perception around that. You can usually find this out by talking to employees or restaurant industry experts. I’ve found that people are generally pretty willing to help.

For bigger chains, there might be more scrutiny which would lead them to enact a rigorous safety procedures that are uniform across the chain. Some chains have a truly global reach, such was Yum! or McDonald’s which diversifies away from being too tied to any one city.

If you have a chance, read the latest 10-K from Red Robin and the presentation that they have on their website. With the shareholder activists involved and the quality of their product, Red Robin might be attractive right now. I plan to have a post that goes in more detail on Friday.