Roger Lipton | FranchiseMoneyMaker.com

FULL SERVICE CASUAL DINING – WE GO TO SCHOOL WITH GENE LEE, CEO OF DARDEN (DRI)

Posted on August 1, 2021August 2, 2021 by Franchise Strategist

Darden’s most recent reporting period was their fourth quarter, ending at the end of May. Their two largest chains are Olive Garden and Longhorn Steakhouse. Important, but less material, are Cheddar’s Scratch Kitchen, Yard House, The Capital Grille, Season’s 52, Bahama Breeze and Eddie V’s.

FULL SERVICE CASUAL DINING – WE GO TO SCHOOL WITH GENE LEE, CEO OF DARDEN (DRI)

BY Roger Lipton

Gene Lee, and his management team at Darden (DRI), provide about the most candid description of current fundamentals among the publicly held full service casual dining companies. Not only are their reported results about the best in the industry, but they describe, on their quarterly conference call, how and why. Our summary below is of “best practices”, as produced by Darden, and the outlook as presented within their conference call on June 24th.

GENE LEE’S SCRIPTED COMMENTARY

Gene Lee, CEO, commented that they have begun to see demand come back strongly. They are relying on Technomic for industry data, which quantifies the casual dining industry at $189B in 2020, down from $222B in 2019. Though the industry has shrunk by 10% in units during the pandemic, Darden believes the industry will at least regain the 2019 level, implying that AUVs could be higher than before. Not mentioned was “price”, but that would obviously contribute to higher nominal sales.

Lee considers that the Darden business model has improved over the last year. “We’ve invested in food quality and portion size….made investments in our team members to ensure our employment proposition…..and we invest in technology, particularly within our to-go capabilities, to meet our guests growing need for …the off premise experience.”

RICARDO CARDENAS’ (COO) SCRIPTED COMMENTARY

Ricardo Cardenas, President and COO, described the operational simplification effort, which has improved execution and strengthened margins. Even as dining rooms have reopened, off-premise sales have remained strong, proving to be “stickier” than expected. During Q4 off-premise was 33% of sales at Olive Garden, 16% at Cheddar’s and 19% at Longhorn. Technology within online ordering has improved to-go capacity management and curbside delivery. During the quarter 64% of Olive Garden’s to-go orders were placed online and 14% of Darden’s total sales were digital transactions. Nearly half of all guest checks were settled digitally, either online or on tabletop tablets or via mobile pay. Cardenas described the effort to recruit and retain operational talent, claiming no systemic issues. Supply chain issues have also been largely avoided.

RAJESH VENNAM’ (CFO) SCRIPTED COMMENTARY

Rajesh Vennam, CFO, described how SSS compared to pre-Covid (2019), improved from negative 4.1% in March to positive 2.4% in May and positive 2.5% in the first three weeks of June. Though to-go sales have seen a gradual decline, this has been more than offset by in-store dining. In the fourth quarter, CGS was 90bp higher (investments in food quality and pricing below inflation), labor was 190bp lower (320 bp of simplification efforts, partially offset by wage pressures). Marketing was 200 bp lower. Restaurant EBITDA margin was at a record EBITDA of 22.6%, 310bp higher than pre-Covid. CGS inflation is expected to be about 2.5% and hourly labor inflation at about 6%.

QUESTION AND ANSWER DISCUSSION

Gene Lee talked further about the “employment proposition”. The store level margin allows for adequate wages, along with promotion of a thousand team members per year into management. When questioned about store level margin expectation, CFO Vennam indicated that store level EBITDA in the short term is expected to be 200-250 bp better than in 2019, with pricing of 1-2%, lower than CPI inflation of about 3%, but full year margin (ending 5/22) has yet to play out. Commodity inflation of 2.5% for the year will be 3.5-4.0% in the first half, expected to tail off to roughly flat by Q4. Chicken and seafood are elevated, also cooking oil and packaging, a little bit in dairy.

Lee feels that the throughput improvements, including menu simplification, allow for more sales capacity from this level. Mother’s Day sales were a record and mid-week capacity is not fully utilized. Consumer behavior is not yet normalized, so the mix between dine-in and off-premise is still uncertain.

When questioned about the sales improvement “flattening” in May and June, CFO Vennam pointed out that promotional levels are not as heavy now as in ’19, obviously helping the operating margins even with sales just modestly higher. Gene Lee commented later that the current advertising is generic, removing all incentives and discounts, with record operating margins, so marketing decisions going forward will obviously be carefully considered. Later in the call, Gene Lee talked about the Fine Dining segment also improving (a little later than Olive Garden and Longhorn) from down 12 in March to down 6 in May.

COO Cardenas described how technology is reducing “friction” in the guest experience, as well as for team members, making ordering and pickup easier. To further improve the process within the restaurant, a revamp of the point of sales system is planned.

Gene Lee talked about the potential to improve direct marketing to new digital customers, especially with the newly acquired ordering preferences. Lee emphasized the effort to improve the craveability of the menu, at the same time simplifying and improving the core items.

Relative to the addition of additional brands, Lee expressed great satisfaction with the improved returns within the existing portfolio. While not ruling anything out, he seemed to feel that there is substantial opportunity to profitably invest internally.

GENE LEE OPENS UP A LITTLE FURTHER

When pushed about why the sales recovery within Darden is not as fast as elsewhere, Gene Lee’s response was telling. “Because we’re not participating giving away food to third-party channels…not discounting heavily….not discounting cash through selling gift cards….we put up 25% fourth quarter restaurant margins….that’s what we’re focused on. A lot has changed…..virtual brands….guys, you got to get off this……this (Darden’s portfolio of brands) is the best business in casual dining, not even by a little bit anymore…..our guests are loving the experience ….they love the changes that we made….but we’re not chasing an index and we’re not chasing where we were in the past. We love our position today.”

Lastly, when questioned about what the new normal will look like, Gene Lee summarized by saying: “I think we’ve still got another six to nine months to understand (if we don’t have any more problems with Covid) what are going to be the normal behaviors….and then you start developing your market plans and you get tactical on how to get these folks into your restaurant or use you as an off-premise occasion.”
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ABOUT THE AUTHOR:
ROGER LIPTON is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and MBA from Harvard, and working as an auditor with Price, Waterhouse, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken (as described in Chain Leader Magazine to the left) .

He also invested in gold mining stocks and studied the work of Harry Browne, the world famous author and economist, who predicted the 2000% move in the price of gold in the 1970s. In this regard, Roger has republished the world famous first book of Harry Browne, and offers it free with each subscription to this website.

In the late 1970s, Roger left Wall Street to build and operate a chain of 15 Arthur Treacher’s Fish & Chips stores in Canada. In 1980 he returned to New York, and for the next 13 years worked at Ladenburg, Thalmann & Co., Inc. where he managed the Lipton Research Division, specializing (naturally) in the restaurant industry. While at Ladenburg he sponsored an annual Restaurant Conference for investment professionals, featuring as keynote speakers friends such as Norman Brinker (the “Babe Ruth” of casual dining) , Dave Thomas (Wendy’s) , Jim Collins (Sizzler & KFC), Jim Patterson (Long John Silver’s), Allan Karp (KarpReilly) and Ted Levitt (legendary Harvard Business School marketing professor, and author). Roger formed his own firm, Lipton Financial Services, Inc. in 1993, to invest in restaurant and retail companies, as well as provide investment banking services. Within the restaurant industry he currently serves on the Board(s) of Directors of both publicly held, as well as a private equity backed casual dining chains. He also serves on the Board of a charitable foundation affiliated with Israel’s Technion Institute.

The Bottom Line: Roger Lipton is uniquely equipped as an investor, investment banker, board member and advisor, especially related to the restaurant, franchising, and retail industries. He has advised institutional investors, underwritten public offerings, counseled on merger transactions, served on Board(s) of Directors, public and private, been retained as an expert witness, conducted valuation studies and personally managed a successful investment partnership, all specializing in restaurants/retail. He has studied great success stories over the last 40 years, from McDonalds to Shake Shack. Even more important he has watched scores of companies stumble and sometimes fail. It is this insight that Roger brings to this website. His post, dated 9/30/15, called “VISIT THE GRAVEYARD…..” lists a long list (though only a sample) of companies that have come and gone over the length of Roger’s investment career. This platform is his way of maintaining a dialogue with other professionals in the field, improving his own investment results, and remaining well informed on industry issues.
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FRANCHISE YOUR RESTAURANT – CLICK HERE: http://WWW.FRANCHISEGROWTHSOLUTIONS.COM

DOORDASH – IN A HUGE STATE OF FLUX AS THE PANDEMIC WINDS DOWN

Posted on April 2, 2021April 2, 2021 by Franchise Strategist

The business model is relatively simple. Once on the DoorDash platform, the company will take orders and deliver those orders for a fee ranging from 15-30%. At the same time, DoorDash charges the customer a service fee and a delivery fee that ranges from 15-25% of the cost of the order.

DOORDASH (DASH) – IN A HUGE STATE OF FLUX AS THE PANDEMIC WINDS DOWN
By Roger Lipton with permission

DoorDash is one of the largest “local logistics platform” i.e., food delivery firm, with 450,000 merchants, over 20 million consumers, 1 million Dashers (drivers) and 1.2 billion orders completed since the founding. The company has a 50% market share in the U.S. Revenue growth over the last five quarters has averaged over 211% with Q4 2020 revenue growth coming in at 226%. However, the company has lost over $1.2B since inception and lost $312M in Q4 2020. In preview of our summary: the fact the company cannot make money in the most ideal environment for its business model in 2020 is concerning. So is the fact the company has 46 pages of risk factors listed in its 10K.

We also point out that, while we are providing some “food for thought” below, third party delivery is a complex subject and in an enormous state of flux, so we don’t expect that we can answer every potential concern within these pages. We have stated before our reservations about the enormous capitalization of DASH ($42 billion as of today) and our concern about future operating margins for all the major third party delivery companies. Our intention here is to present what we can, in the hope that our work will be useful to the restaurant companies with which we have a working relationship.

THE BUSINESS MODEL

DoorDash and the other food delivery companies such as GrubHub and Uber Eats, were primary beneficiaries of governmental policies that either closed or significantly restricted seating options for most restaurants. Adding a delivery service through DoorDash, GrubHub or Uber Eats was one of the few options available to restaurants and was therefore a requirement to stay open. Obviously when demand for your service is almost mandated by the government, you are going to grow your business tremendously.

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While DoorDash holds a 50% market share nationally, the company’s dominance is not universal across the country. In many of the major markets the company’s market share is less than 40%, which means that competition remains fierce, and this should keep margins under pressure in the long-term and advertising costs and competition for drivers increases. The lack of customer loyalty, as illustrated by the large overlap of usage of other deliver platforms, is also a long-term problem.

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THE REVENUE BASE

DoorDash makes money by charging both the restaurant and the customer. While the company does not report its actual fee structure, the practical result is that DoorDash is charging the merchant an average of about 18% of the cost of the order, though that fee is apparently negotiable from 15-30% of the cost of the order. In addition to charging the merchant, DoorDash also charges the customer fees ranging from 12-18% of the order. The average order size is approximately $37 and only 20% of orders are for more than $50. It remains unknown to what extent this is a long term sustainable model, when the profit margin of the restaurant is materially compromised and the customer ends up paying 40% or more above dining within the restaurant or picking up the food themselves. It is also not yet clear to what extent delivery cannibalizes dine-in or pick up sales.

It is important to note that cities are passing “Temporary” Price Control Regulations in response to high delivery fees.In response to companies such as DoorDash charging upwards of 30% of the cost of an order in fees. cities are starting to pass regulations to cap the fees third-party ordering services can charge restaurants. For example, in the company’s Q4 2020 investor letter, DoorDash co-founders, Tony XU and Prabir Adarkar, stated that there are now 73 jurisdictions imposing temporary price controls, which is more than double the 32 jurisdictions in the third quarter. Generally speaking, these price controls cap the amount of delivery fees charged the merchant to 15%. The controls have predictably negatively impacted DoorDash’s profitability.

The company disclosed that the net impact of price controls in Q4 2020 was $36M or 44bps of profitability. The company expects the impact of price controls to almost double in Q1 2021. In the meantime, DoorDash is trying other measures to manage these caps. The company is charging an additional $1 to $2 fee in at least 11 municipalities that have caps in place. In Denver and Chicago, DoorDash began charging customers a $2 “Denver fee” and $1.50 “Chicago fee” per order. While these price controls are said to be temporary, that remains to be seen.

THE ECONOMICS FOR RESTAURANTS, CONSUMERS, & DRIVERS (“DASHERS”)

The Restaurants

The pre-tax profit margin of a restaurant generally ranges from 5-10% of revenue at the corporate level. If a restaurant is having to pay DoorDash 15-30% of an order, and DoorDash does a material portion of the sales, the company’s profit margins can easily drop by a couple of hundred basis points. If deliveries become 30-50% of total revenue the company could turn unprofitable. While some of the deliveries may currently be incremental business, and a year ago publicly held companies were accepting that premise, we haven’t heard anyone making that claim recently. While we have no doubt that delivery sales in aggregate will be higher going forward, it is questionable whether the current growth is sustainable because of the high cost to both consumers and restaurants.

In addition, by utilizing drivers from third parties, the restaurant loses the direct relationship with the customer and there is no incentive for the driver to enhance the customer experience with any particular restaurant. This lack of control and incentive could negatively impact the customer’s relationship with the restaurant. Drivers for pizza chains like Domino’s and Papa Johns are more incentivized to enhance the customer experience because they can move up the ladder at these firms and many have eventually become franchisees. There is no upward mobility for drivers at DoorDash.

Every major restaurant chain has its own app that it uses to take orders and communicate with its customers. More importantly, when a customer uses the restaurant’s app, they gain valuable information, such as order size, composition and frequency, that the company can use to improve customer relationships. They can also offer loyalty rewards and other customer-centric offers, such as sales on specific food items.

On the latest Brinker International earnings call, CEO Wyman Roberts said that DoorDash only offers high level information about orders for their Just Wings virtual brand offered on DoorDash. Because they do not share individual customer data, it complicates their marketing and data collection efforts. In the long run, we think most major brands will try to increase customer usage on their proprietary apps and reduce reliance on third-party delivery services for customer acquisition.

As more people go back to work, we believe the necessity of paying huge markups for food delivery will diminish and DoorDash will lose a big tailwind. We also believe that companies like Brinker or Darden that already have large To-Go offerings will try to replace delivery with more To-Go orders. It is a win-win for the company and customers. Customers pay significantly less, even including drive time to pick up their food and the company saves the fee they pay DoorDash. The restaurant leverages their existing infrastructure and gains more valuable data on their customer that can be used to increase sales and profitability. It can also improve kitchen efficiency.

The Consumers

To recover some of the fees, many restaurants are increasing the menu prices for items ordered for delivery. Researchers in Minneapolis recently conducted a case study of delivery platforms to compare pricing and consumer fees.

There are several takeaways from this case study.

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Since restaurants appear to be marking up the menu price to recoup most of the DoorDash fee, the customer is paying 40-60% more than they would by eating in the restaurant and this is before the tip. It is therefore clear that DoorDash is the largest beneficiary, in this simplistic example, without considering the customer acquisition cost or the sustainability of the model in terms of satisfying the drivers and food consumers.

The Restaurant Business editorial staff did a test ordering chicken sandwiches from various fast-food concepts. It reported that some editors paid $15 or more for a single sandwich to be delivered. As one editor stated,
“My cost to have Chick-fil-A delivered to my home was roughly the same cost as I paid to east out at a local Mexican restaurant.”

The “Dashers” – a few problems

Similar to Uber and Lyft, the DoorDash business model relies on independent contractors utilizing their own vehicles to provide the service to customers. According to the 10K, there were 1 million Dashers (drivers) and their total earnings were $2B. Though Doordash says on their website that a Dasher can make between $15-$25 an hour, dividing $2B by 1M drivers amounts to $2,000 per year, $167/month, or $40/wk. Since over 90% of Dashers work less than 10 hours a week, this would amount to only about $4.00/hr. The company touts examples in California where Dashers earn $33-$36 an hour working less than 7 hours a week ($1000 a month) in various cities. We believe these figures are clearly outliers and not representative of the true earnings potential of a Dasher. Moreover, relying on a worker that only wants to work 10 hours a week for less than $167 a month does not seem to us to be a way to maintain a consistent, quality experience for the customer.

There is also a growing political pressure to increase the pay and benefits to so-called “gig workers”. A group in Washington state called Working Washington is running a “Pay Up” campaign to increase the income of these workers. The group published a study on the net income of Dashers in Washington state. We encourage subscribers to read it. The conclusion was startling, supporting our calculation above:

“On average, DoorDash pays just $1.45 per hour worked, after accounting for the expenses of mileage and the additional payroll taxes borne by independent contractors. The average job requires 6.8 miles of driving and takes 30 minutes to complete. “

As a result of negative publicity and new legislation, the company has already been forced to increase the amount it pays Dasher on a per order basis. The passage of Proposition 22 in California and the potential for other states to do enact similar legislation could cause the company to raise wages again. As discussed in the 10K, the impact of Proposition 22 on the company were as follows:

Amongst the 46 pages of risks in the 10-K are a few nuggets as they relate to these costs.

Several other states where we operate may be considering adopting legislation similar to Proposition 22, which we would expect to increase our costs related to Dashers in such jurisdictions. This could result in lower order volumes if we charge higher fees and commissions and could also adversely impact our results of operations.
Several jurisdictions where we operate may be considering adopting legislation that would pair worker flexibility and independence with new protections and benefits. To the extent these are adopted, we would expect the costs related to Dashers in such jurisdictions to increase and we could experience lower order volumes if we charge higher fees and commissions.
The necessity for DoorDash to improve the economic proposition for their Dashers will most likely reduce DoorDash operating margins because the merchants and consumers are already more than adequately burdened.

NOW – THE RUBBER MEETS THE ROAD – AND OUR CONCLUSION

Before presenting our conclusion, the following post by an industry insider on an investment website supports our concerns.:

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As the pandemic winds down, it should be no surprise that recent guidance shows sharp deceleration in revenue growth for 2021.In the Q4 2020 earnings release and shareholder letter, the company issued guidance for 2021. While the company guided for 187% growth in revenue in Q1, revenue growth for all of 2021 is only expected to be 28%. This is a significant deceleration from the 200%+ growth in 2020. Wall Street is expecting revenue growth in 2022 to slow ever further to 26%. In addition, because of the increasing costs and limits on fee and commissions discussed above, the company guided adjusted EBTIDA to $0-$200M, considerably below the $250M Wall Street was expecting going into 2021. Underlying the slower growth, we think it likely that as more people go back to work, we believe the necessity of paying huge markups for food delivery will diminish. We also believe that companies like Brinker or Darden that already have large To-Go offerings will try to replace delivery with more To-Go orders. It would be a win-win for the company and customers, as customers pay less, even including drive time to pick up their food and the merchant saves the DoorDash fee. The restaurant also gains the valuable customer data that can be used to increase sales and profitability.

We believe the DoorDash business model is far from sustainable in its present form. It is especially concerning that DASH has reported nothing but red ink in an environment so enormously supportive of third party delivery agents. Though the stock is 50% off its highs, we do not think the Enterprise Value, still over $40 billion, is justifiable. The EV multiple is over 10x 2021 projected sales and an indeterminate multiple of the ridiculously large guided range of Adjusted EBITDA from zero to $200M. We are not long or short the stock, just saying 😊

About Roger Lipton
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Roger is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and MBA from Harvard, and working as an auditor with Price, Waterhouse, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken (as described in Chain Leader Magazine to the left) .

THE RESTAURANT INDUSTRY AT THE PANDEMIC’S ONE YEAR ANNIVERSARY – WHAT NOW?

Posted on March 9, 2021March 9, 2021 by Franchise Strategist

We thought that the last twelve months of performance for individual restaurant stocks might give us a hint as to where to focus going forward. Since some of the obviously large stock gains have taken place among those with the heaviest short position, we have focused on the “short interest ratio”, the number of shares sold short divided by the average daily trading volume.

THE RESTAURANT INDUSTRY AT THE PANDEMIC’S ONE YEAR ANNIVERSARY – WHAT NOW?

By Roger Lipton with permission

The last twelve months have been unprecedented, not only from a business/health standpoint, but from a fiscal/monetary standpoint. There has been more governmental stimulus as well as monetary accommodation than ever before, which has floated all kinds of boats. The Dow Industrial Average hit an all time high just this morning, and, though the NASDAQ index has retreated the last month or so, stocks from Apple to Tesla to Gamestop have written a new book in terms of valuation.

Based upon the new $1.9 trillion Covid bill, the likelihood of a new multi-trillion dollar infrastructure bill, as well as the Federal Reserve’s ongoing willingness to buy at least $120B of Treasury securities every month, there is every indication that the above trends will continue.

From a broad brush, it is shocking to see how large the moves have been from March 8, 2020 until now. It is interesting that several of the best performing “pandemic plays”, namely Domino’s, Wingstop and Papa John’s, which made very big moves over six to nine months, have retraced and are up more modestly now (zero, 56% and 47%, espectively).

This industry, by no stretch of anybody’s imagination is generally in a place that makes these companies “worth” from 50% to 90% more today than they were before the pandemic. There is somewhat less independent competition, and some companies may have learned how to serve off-premise diners better than before, but there are also a great many uncertainties. These include (1) the cost of labor with a new mix of in-store vs. off-premise (2) commodity inflation (3) other expenses to meet health requirements (4) unpredictable consumer spending (5) still substantial competition (6) ongoing high occupancy expenses, especially for new sites. There is also, in many cases, new debt to service.

Fundamentals aside: the stocks have done the following, ranked by today’s short interest ratio.

What do we see? The average gain among the fourteen stocks with the highest short interest ratio is 90%. The bottom fourteen stocks went up by 57%. Without our focus on individual company fundamentals, readers can scan the list and conclude for themselves which stock performance is most removed from the fundamental outlook.

Where do we go from here?

Before considering the above noted $1.9 trillion Covid bill and trillions more for infrastructure, the Treasury is sitting on $1.44 trillion (to be reduced to $500B by June 30th) that was returned from the Fed last year and the Fed is currently creating $120 billion per month. This means that almost $1.5 trillion of accommodation will be provided to the economy and the markets by June 30th, before the effect of the new $1.9 trillion. This also means that equities, including restaurant stocks, may well go a lot higher in the short term. There is just too much liquidity in the capital markets.

THE BOTTOM LINE

For investors: Other things equal, we would focus on the top portion of the table above. 90% is better than 57%

For companies: In almost all cases, we would sell company stock. Pay down debt and/or build your cash balance. It may be a long time before you see these valuations again.

For management: Lighten up. You can always grant yourselves some more stock options.

Roger Lipton

Click here to visit Roger’s website: https://www.liptonfinancialservices.com/2021/03/the-restaurant-industry-at-the-pandemics-one-year-anniversary-what-now/

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About Roger Lipton
Roger is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and MBA from Harvard, and working as an auditor with Price, Waterhouse, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken (as described in Chain Leader Magazine to the left) .

INVESTING IN PUBLICLY HELD RESTAURANT COMPANIES – WHAT DID THE PANDEMIC TEACH US?

Posted on November 10, 2020December 10, 2020 by Franchise Strategist

These days, investors are more typically ETFs which have to own broad swaths of particular industries, as well as institutions that are fighting for day to day performance. The result is that all stocks within an industry have a strong tendency to move together, and it takes a long time for fundamentals to prevail.

INVESTING IN PUBLICLY HELD RESTAURANT COMPANIES – WHAT DID THE PANDEMIC TEACH US?
By Roger Lipton

The dust is beginning to settle, especially with a vaccine now in view. The stocks within the restaurant industry made a huge move on Monday, going a long way to recovering from the severe decline that started at the end of February. We are comparing prices from before the pandemic to the current prices. We published a chart on October 22nd that attempted to compare the current valuations (relative to reasonable expectations) to those before the pandemic began. That exercise revealed some interesting “inefficiencies” in terms of valuations. Shake Shack screamed “overvaluation” so we wrote first about that Company. Of course, it stands to reason that the apparently most overvalued situation would make one of the largest upward moves in today’s news about a possible vaccine. Thank goodness we are not short this volatile situation, which our experience has taught us is a nerve wracking exericise in a Federal Reserve supported easy money environment.

Before we get into a broader discussion of the last seven or eight months, there’s a lesson to be learned by a conversation we had with one of our money managing friends. Back on April 30th, he asked for our suggestion as to a “paired trade” in the restaurant industry. You know… one name that was well positioned and would outperform on the upside, paired with the short sale of a weaker company that would not do as well. The theory, which fifty years ago spawned today’s multi-trillion dollar hedge fund industry, is that equal amounts invested in well chosen offsetting positions would be market neutral yet hopefully outperform the general market over time. It stands to reason, of course, that the stock price will follow the fundamental performance over time, and the good companies will fundamentally do better than the weaker participants. Ideally the long position will go up and the short position will go down, profiting on both sides in a neutral market. That was often the case decades ago, when stock ownership was more broadly spread among individuals and institutions who were picking Individual stocks. These days, investors are more typically ETFs which have to own broad swaths of particular industries, as well as institutions that are fighting for day to day performance. The result is that all stocks within an industry have a strong tendency to move together, and it takes a long time for fundamentals to prevail. Adding to this “inefficiency” is that multi-billion dollar hedge funds maintain large short positions, managed with a hair trigger to limit losses if even short term news is announced. That’s why on a day like Monday when the general stock market makes a really big move, the stocks with the largest short positions go up the most, whether the specific fundamentals justify that price action or not. We could go on….but suffice to say that short term trading has become very difficult in recent years.

As an illustration: relative to the request for a couple of paired trades back in April, after we suggested that this approach has become pretty difficult, we provided a couple of apparently compelling suggestions. We paired the highly respected Darden (DRI) on the long side with the enormously challenged Dave & Buster’s (PLAY) as a compensating short. Surely DRI would outperform PLAY, especially with the predictable health concerns of the public, even after the worst of the pandemic. The chart below shows in retrospect that by 4/30 PLAY, which had declined by 68% between 2/14 and 4/30, was already “oversold”. The profit in Darden (62%) from 4/30 to 11/9 (today) was almost exactly equal to the loss (60%) on the PLAY short. So that trade hasn’t worked yet. It is worth noting that PLAY would have worked well from 2/14 (before the pandemic) to 11/9 (45% profit), against a 2% loss in DRI, but it was already too late by 4/30.

The second presumably intelligent paired trade I suggested on 4/30 was to go long Starbucks (SBUX) along with a short sale of Shake Shack (SHAK). Who could argue with a worldwide brand selling an addictive product (with major growth ahead in China), offset by the short sale of a ridiculously valued hamburger chain whose business model couldn’t be designed more poorly to cope with a pandemic. SHAK had no drive-thrus, high rents, resort locations, city locations inhibited, etc.etc. You can foresee the result. Between 4/30 and 11/9, an investor would have made 26% on his long SBUX position, and lost 51% on the SHAK short. Even from pre-pandemic 2/14 until 11/9, right through the pandemic, SBUX gained 9%, but the SHAK short lost 14%. Every time we write about SHAK, we emphasize our respect for their management, but they are not magicians, and the store level culture cannot force customers to come to the mall or bring NYC stores back to the $7M level of a few years ago.

So…be careful “trading” out there.

On a broader level, we tabulated, as shown below, the price changes among the “darlings” of the institutional investing set, the asset light, free cash flow pursuing pure franchising companies. Without the operating “risk” of running restaurants, they can leverage up their balance sheets to 5-6x trailing EBITDA in a historically low interest rate environment, often with the intent of declaring special dividends to shareholders.

The chart below shows that the ten fairly pure franchising restaurant companies declined by a relatively modest 12% from 2/14 to 4/30. The average was helped quite a bit by Domino’s, Papa John’s and Wingstop which had the twin benefit of delivery and pure franchising. Even eliminating those three names, the seven remaining companies were down 24%, a lot less than the 37% decline shown by the company operated restaurant chains shown below. The franchising companies rebounded 23% between 4/30 and 11/9, more than recouping the worst of the pandemic, and showing a 6% gain through the cycle.

The chains that are primarily operating company stores, with all the operating challenges, have fared worse, also shown below. The stocks were down as a group by 37% by 4/30, recovered 48% by 11/9 and were down 8% through the cycle.

CONCLUSION:

Avoid “paired trades” on a short term basis. It’s just too tough.

For longer term investing, we too, in this environment would favor the pure franchisors, in general, even at their high multiples of earnings and cash flow, and historically high debt/EBITDA levels. We don’t see anything on the economic horizon that will reduce the availability of low interest rate financing. The operating challenges for those companies with company stores are not going away. It’s of course true that franchisors cannot prosper unless their franchisees are doing well, and franchisors will likely have to do more than in the past to support their franchisees but they can borrow at low rates and could even pass through part of that low cost capital to their franchisees.

About Roger Lipton:
Roger is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and MBA from Harvard, and working as an auditor with Price, Waterhouse, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken (as described in Chain Leader Magazine to the left) .

The Franchisor/Franchisee Economic Relationship – It’s A New World!!

Posted on June 1, 2020June 5, 2020 by Franchise Strategist

Photo by Lukas from Pexels
This specific suggestion will not be adopted by existing large chains, because it would be such an obvious reduction of the current royalty stream. However, well established franchisors could, and should, absorb more of the additional systemwide needs…

THE FRANCHISOR/FRANCHISEE ECONOMIC RELATIONSHIP – IT’S A NEW WORLD !!

By Roger Lipton

Almost everybody has noticed that there is an increasing strain between franchisees and their franchisors. It is no accident that new franchisee associations are being formed and existing organizations are getting more militant. There are many intangible reasons, as too many franchisors do not treat their “z’s” as partners. We have written many times that the “asset light”, “free cash flow” model is not reflecting the necessary investments in the system to keep franchisees as profitable as possible. Many franchisees are especially bothered by the fact that their franchisors are spending hundreds of millions, sometimes billions, of dollars buying back stock and making acquisitions, while leaving the franchised operators without the necessary new product development, technology upgrades, marketing initiatives, etc.etc.
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Franchise your company, expand your brand, collect your royalties!

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With all of that in mind, the bottom line is the bottom line. Too many franchisees are suffering financially, under more pressure than ever. The typical franchise royalty is 5%, give or take a point, plus 2%, as an advertising contribution. There are often additional charges, not all that material in and of themselves, but adding to an already large burden. Let’s say the franchisee is fortunate enough to be making 17-18% store level EBITDA (and Depreciation is not free cash in the long run). Rebating 7 points out of 17 or 18 points starts to feel like a pretty big load, and there is still local G&A to be carried. Even if store level EBITDA, before royalties, is in the low twenties, 7 points gets to be a bother. Additionally: many franchisees, Dunkin’ Donuts and Burger King and Jack in the Box are just a few examples of mature systems where decent money is still being made at the store level because the store leases were signed ten or fifteen years ago, so occupancy expenses are lower than today’s economics would allow. That’s, of course, why so few new units are being built by many mature franchised systems, especially in the USA. Today’s economics do not allow it.

When Ray Kroc started franchising McDonald’s restaurants over 60 years ago, the royalty was 1.9%. By the 1960s, franchisors had started charging 2-3%, by the 1970s 3-4%, by the eighties 4-5%, and 5% seems to be the standard today, plus advertising and other fees.

Read the entire article click here https://www.liptonfinancialservices.com/2019/03/the-franchisor-franchisee-economic-relationship-this-is-not-your-fathers-world/

Restaurant Industry In Turmoil, But There Is A Way Out!

Posted on May 4, 2020June 3, 2020 by Franchise Strategist

Photo by Benjamin Davies on Unsplash

RESTAURANT INDUSTRY IN TURMOIL, BUT THERE IS A WAY OUT!
By Roger Lipton

The world, as we have known it, is seriously changed for the foreseeable future. Restaurant and retailers will have to cope with lots of new requirements that deal with social distancing and testing.

PAYROLL PROTECTION?? NOT QUITE!

One of the current priorities is to access the Payroll Protection Program. Unintended consequences are already coming into focus. Restaurant operators realize that business will be slow after opening, which is still weeks or months away. If they spend 75% of the money, mostly for payroll and rent, in the next eight weeks to qualify for loan forgiveness, they will not have the resources to carry the predictable losses when they first reopen, and those losses will likely last for months at least. They have the option of holding the money, which will then remain a loan rather than a “grant. However, while the two year term, at only 1%, seems cheap enough, there is no way that cash flow will be sufficient to pay back the loan that quickly.

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Some operators will therefore let their ex-employees remain on unemployment insurance for the time being, use the government capital to cushion losses after reopening, and deal with the ramifications two years from now. Other operators, will take the money, never reopen, and walk away. There are no personal guarantees, after all.

At the least, therefore, the program must be changed to allow for a sufficient payback period to recoup losses. We suggest this will happen, because the problem, and the fix, is so obvious. There are, predictably, other unintended consequences of this huge program that was implemented with such a rush, but we will leave that for another day.

RENT – THE BIGGEST FIXED COST

We are all reading about various companies, small and large, holding back rent. It’s understandable under the circumstances, and landlords realize that their world has changed as well. At the end of the day, we believe that percentage rents will be the new normal. The lessors have no real option. Yesterday’s rent structure is gone, and their alternative in almost all cases is to have empty space for perhaps years.

OFF-PREMISE CONSUMPTION BECOMES CRITICAL

Even after vaccines and treatments are in place, it is going to be quite a while before consumers are comfortable in close contact with strangers. We can be assured that dine in traffic will be at a lower level than previously. It therefore becomes critical for restaurant operators to do everything possible to build their off premise activities. Drive-thru locations, where applicable, can help a lot, but delivery (with or without third parties), catering, curbside pickup, packaged products to go are all brand building alternatives that can help to carry the physical overhead.

OVER-STORED NO MORE

Stated most concisely: there will be more closures than we have seen in at least fifty years (from today’s huge base). Far fewer chains will be expanding. Survivors will have less competition.

LABOR COST PRESSURE WILL ABATE

When the stores open, there will be less upward wage pressure than we have seen in the last few years and that we were anticipating would continue.

The cost structure will be more variable than ever before. It will take a while for negotiations to take place but rent will be based on a percentage of sales. Cost of Sales is variable and Labor is largely variable. Other Operating Costs at the store level (waste removal, bank fees, insurance, property taxes, etc.) can be negotiated lower. (It happens that I am affiliated with a Company that can help in this regard, with no up front cost.) Corporate Overhead can be scaled for the new world we are all living within.

In short, most operators, with a great deal of effort, should be able to generate enough sales, on premise and off, to satisfy their landlords, who will have become their partners, dependent on sales. Store level expenses will be largely variable, including rent, and there should be less upward pressure on the fixed costs at store level. Store level cash flow may not approach previous levels but should be adequate to support, if not enrich, a reasonable level of corporate overhead. Regional operators will have an advantage, with their proximity to the store level and their ability to respond quickly and efficiently to changing circumstances. National operators should decentralize to whatever extent possible for the same reasons. Dedicated corporate management should be able, in most cases, especially if not burdened by excessive debt, to lead their companies to survive, and even prosper over the long term.
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About Roger Lipton
Roger is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and MBA from Harvard, and working as an auditor with Price, Waterhouse, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken.

A Roger Lipton Update – Chicken Salad Chix

Posted on March 10, 2019January 16, 2020 by Franchise Strategist

A Roger Lipton Update – Roger is an investment professional with decades of experience specializing in chain restaurants and retailers, as well as macro-economic monetary developments. He turns his background, as restaurant operator and board member of growing brands, into strategic counsel for operators and perspective for investors.

By Roger Lipton -with Permission
An archive of his past articles can be found at RogerLipton.com.

Chicken Salad Chick, based in Auburn, Alabama, was formed in 2008, by Stacy Brown. Stacy was a stay-at-home mom and self-proclaimed connoisseur of chicken salad who began the business by selling chicken salad made from her home kitchen. She was eventually shuttered by the local health department for selling food from an un-approved facility. She then joined her future husband, Kevin, who left a career in software sales, to help build the foundation for multiple corporate locations and future franchise growth.

In terms of equity ownership, in early 2015, Eagle Merchant Partners (“EMP”), an Atlanta, GA based private equity firm, purchased the majority ownership of the company. Kevin Brown, tragically, succumbed to colon cancer in 2015 at the age of 40. Before his death however, Kevin was instrumental in negotiation of the PE transaction, and he also helped establish the Chicken Salad Chick Foundation, which raises funds for cancer research and feeding the hungry.

In conjunction with that transaction, Russ Umphenour and Scott Deviney become chairman and President/CEO, respectively. Both are highly respected industry veterans. Mr. Umphenour was the CEO of Focus Brands (parent of Moe’s, Auntie Anne’s Pretzels, and others), and before that ran RTM Restaurant Group, the Arby’s franchisee that he founded.

Mr. Deviney was CEO of SDZ (a multi-unit Wendy’s franchisee) and SVP with SunTrust Bank, specializing in the restaurant industry. Over the last several years, the management team has obviously been broadened further to support the ongoing rapid growth. Stacy Brown, the cultural creator of Chicken Salad Chick remains a prominent spokesperson and brand voice, as well as a shareholder.

Originally a drive-thru and takeout only operation, the menu was expanded and sit-down facilities were added as additional stores opened. With franchise operations beginning in 2012, 29 units were open by the end of 2014, with contracts for an additional 114 locations.

The comfortable family oriented decor is combined with a creative and modestly priced menu, featuring over a dozen varieties of made from scratch chicken salad plus pimento cheese and egg salad, as well as fresh sides, salads, soups and sandwiches.

The primary meal special called The Chick includes a scoop of sandwich of chicken salad with a choice of a fresh side, salad, soup or another scoop of chicken salad, egg salad or pimento cheese. All meals are accompanied by a pickle spear, wheat crackers, a selection of breads for sandwiches and a small cookie. The menu also offers chicken salad BLT and turkey club sandwiches, though over 85% of sales come from chicken salad, which is also sold in large and small grab’n go containers called Quick Chick. Upwards of 70 percent of guests are women and the chain prides itself on being “chick friendly.”

Chicken Salad Chick ended calendar 2018 with 104 locations operating—74 franchised and 30 company operated. There were 21 franchised locations and five company stores opened in 2018. When EMP purchased the business in May 201, there were 32 stores in the system, so growth has been dramatic over the last four years.

The 104 locations are now located within twelve states—ALA, GA, FLA, NC, SC, TN, MS, LA, TX, KY, AK, OK. It is expected that 45 locations will have opened in 2019, 13 of them being company operated. It has so far not been necessary to advertise for franchisees, as the curb appeal of the physical unit combined with the menu and employee culture, as well as attractive unit level economics have generated more than adequate franchise interest.

According to the most recen Franchise Disclosure Document: The stores are about 2750 square feet in size, generally located in strip malls, costing an average of about $450,000 in total to establish, including up front franchise fees.

Much of the franchise appeal is the operational simplicity, which in turn generates attractive unit level economics. The equipment package is basic, with a steamer to cook the chicken (everything is prepared daily in the restaurant), food processors, refrigerated sandwich tables, a walk-in cooler, reach-in freezer, water filtration system, toaster and Quick Chick refrigerated case.

The absence of fryers (which must be vented) reduces construction costs, creates site flexibility as well as relative desirability as a tenant. The entire package of furniture and fixtures cost around $120,000. The up front franchise fee is $50,000 per unit, the ongoing royalty is 5% of sales with an additional national advertising contribution of 1.5%.

Last twelve months’ AUV was $1.2M in 2018, growing by about 9% in 2016, 13% in 2017 and 11.2% in 2018. Same store sales were up 15% in 2016, 8% in 2017 and 4% in 2018. Traffic has also been up consistently, most recently up 2.9% in 2018. The sales improvement is especially impressive within a restaurant industry that has been challenged in this regard.

Cost of Goods Sold has averaged about 30.5% with fully loaded labor at roughly 25.0%. Stores are open from 10am to 6-8pm (depending on the market) and closed on Sundays, taking a page out of Chick fil-A’s playbook, and allowing operating management to “have a day for family life.”

It is noteworthy that only about 45% of sales are dine-in, the balance being takeout (25%) and catering. Dine-in and takeout sales combine to provide a ticket average of $14.82. Also important: Drive through locations generate 27% more sales than without. 31% of the current system has drive through windows, and 40% of the planned locations will have them.

While the company makes no unit level profitability claims, our analysis indicates that franchises are likely earning at least 15% EBITDA (after royalties) at the store level. With sales now running at about $1.2M per unit, that would generate a “cash on cash” return of $180,000, or 40% on the $450,000 investment including franchisee fee, among the best returns in the franchised food industry. We emphasize: this is our analysis, not their claim.

Chicken Salad Chick continues its smart and rapid growth with no obvious impediments. While still relatively small, with only 104 units system-wide, franchisees are “voting with their pocketbooks,” and opening stores at a rapid rate. The concept seems “defensible” in terms of product line differentiation, combined with an employee “culture” reflecting the “chick” founder, but an operational simplicity that allows for fairly rapid growth. We look forward to following this company’s future development.