The entrepreneurial spirit that pervades the restaurant industry has created an often out-of-control growth culture.
Management teams feel the unrelenting need to expand their companies’ restaurant bases to create both ever-larger enterprises and career advancement opportunities for employees. That strategy is clearly critical to growing the value of an enterprise since it increases the revenue base and earnings potential.
But there can be a downside to such growth. Building more restaurants can mean compromising the profitability of the existing restaurant base if unit-level margins fall below their potential. And that can lower a company’s value in investors’ eyes.
Most entrepreneurs are compelled by instinct to open new restaurants. They may not fully realize that developing new units comes at a price: the ability to focus on current operations and optimize margins at existing restaurants.
Few companies have the financial and human capital to support both the development of new restaurants and the optimal operation of the existing restaurant base. Consequently, senior management’s time and focus is typically diverted to finding the right new locations, obtaining the capital and then managing the development of those new restaurants — all at the expense of focusing on the cash flow at existing restaurants.
Invariably, the existing restaurant base suffers from this growth focus either in lower sales or margins, or both. Since many companies do not benchmark their operations against those of competitors, they may be unaware of this consequence. They may also believe that the total value of their company has increased because the additional restaurants have led to revenue growth.
The reality could be very different when viewed through a liquidity lens. Investors typically do extensive analysis of a target company and any comparable ones, focusing on returns on capital and operating margins. Lower margins at existing restaurants reduce cash flows, dampen returns on capital and lower the multiple investors are willing to pay for the enterprise.
Narrowing the gap in profitability between comparable companies should increase the multiple and could result in a higher valuation for the company being analyzed, even without the cash flows from the new locations. This is illustrated by the following hypothetical example:
| Company A | Company B | |
|---|---|---|
| Sales | $30,000 | $30,000 |
| Cash flow margin | 10 percent | 15 percent |
| Cash flow | $3,000 | $4,500 |
| Multiple | 5.0 | 8.0 |
| Value | $15,000 | $36,000 |
If Company A were to expand by 10 percent and its new locations were to achieve the average margin, its value would still be less than half that of Company B. However, if management were to allocate the expansion resources to improving profitability at the existing restaurants — and ultimately achieve the same margins as at Company B — the value of Company A would more than double.
This hypothetical example assumes that average unit sales are the same for both companies. In reality, the growth focus could result in lower sales at existing restaurants, making the no-growth argument even stronger.
Margins tell the story
Many management teams are unaware that their restaurant margins are lower than those of comparable companies, choose to ignore the difference or believe they can grow their way to a higher valuation. Frequently, they delude themselves into thinking that they have built the organization both to manage growth and improve profitability at existing locations. However, the margins at these companies tell the real story.
I have also heard the rationale that the new locations are too good to pass up and/or that the landlord is providing most of the financing, so the new locations have very little financial risk. Then the question of why these locations are such good deals must be asked. How many other restaurants/retailers passed on them and why?
Further, landlords don’t give something for nothing. They will get their return on tenant improvements, typically in the form of higher rents. And if profitability is below potential, the risk of expansion increases, so a “can’t miss” location could become problematic.
The desire to jump on these landlord-incented locations may also be the result of a belief that what may be a great opportunity would be lost if not pursued. Management may not fully appreciate, however, that if they are able to improve profitability, their company has a greater chance of becoming a tenant of choice, opening up additional potential locations. Additional financing alternatives could also become available, simplifying future development.
Unit growth is very important to the appeal of a concept. Once that is established, however, a focus on achieving higher margins at the existing restaurant base can have a greater impact on enterprise value than building more units.
The focus on existing operations could also result in higher average unit volumes. Higher sales and margins would likely lead to greater credibility of the concept, increased location options and a higher multiple applied to earnings in a liquidity event. In short, suppressing the urge to grow could be the key to unleashing and increasing a concept’s value.
Steve Rockwell has 30 years of experience in the restaurant industry, including as a restaurant analyst, finance executive, investor and consultant. He is a partner in Results Thru Strategy, a consulting firm based in Charlotte, N.C., and can be reached at [email protected].
