Wally Doolin’s recent column — “Are there just too many restaurants?” — prompted me to think about how the availability of capital impacts the supply side of the supply-and-demand balance.
Before tackling that topic, two points are worth emphasizing. First, the issue of “saturation” has been debated for as long as I have been involved in the restaurant industry. In the early 1980s, many investors balked at investing in McDonald’s because there were already too many restaurants in the U.S. Other investors avoided investing in Wendy’s because they felt that the company was unable to grow from its No. 3 rank within the hamburger segment, behind McDonald’s and Burger King. Since then, McDonald’s, Burger King and Wendy’s have added thousands of restaurants in the U.S., and new hamburger chains have emerged, such as Five Guys, Smashburger, The Habit Burger Grill and many others.
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Second, the industry’s economic cyclicality is compounded by its financing cycles. For example, in the early 1980s, as the economy was recovering, there was an influx of capital raised that contributed to new unit growth. Despite the siren song of saturation, investors bought the IPOs of companies like Chili’s (now Brinker), TGI Fridays, Cracker Barrel Old Country Store, Sandwich Chef and Pizza Time Theater (the predecessor to CEC Entertainment). Capital was deployed and unit growth accelerated.
With the stock market crash in 1987, and a soft economy, unit growth slowed as returns on capital declined. Coming out of the early 1990s recession, operating results improved and capital was once again available through public offerings for companies like Outback Steakhouse, Papa John’s Pizza, Boston Chicken and The Cheesecake Factory. The same cycle was repeated in the mid-2000s, and more recently after the recession in 2008 and 2009.
The industry is currently in a period of unprecedented access to capital. From 2013 through 2015, restaurants raised an estimated $1.3 billion of public equity, not including proceeds to selling shareholders or funds raised to pay down debt related to earlier acquisitions by private-equity firms. In addition, over $1 billion of growth equity was sold privately, for a total of $2.3 billion to $2.4 billion of new equity capital raised in this cycle. If that equity is leveraged conservatively one to one, the industry would then have access to $4.5 billion to $5 billion of total capital to fund new restaurant development or build its supporting infrastructure.
In contrast, in the three years leading up to the most recent recession — 2006 through 2008 — the industry raised approximately $700 million of equity publicly, and a similar amount privately, for a total of approximately $1.4 billion of new equity to support growth. Therefore, restaurants then had access to $2.5 billion to $3 billion of capital including debt. In the last few years, the industry has had access to at least 60 percent more, and perhaps as much as double the amount of capital with which to support growth and to build new restaurants than in the earlier cycle.
Unfortunately, reliable data for the years prior to these two periods is not available. Undoubtedly, the amount of available capital was significantly less. Based on my experience, there was very limited private capital available for restaurant companies in the 1980s and early 1990s, and the average size of public offerings was substantially smaller. For example, Chili’s 1982 IPO was $15 million, while Outback’s IPO in the early 1990s was a little over $25 million. In contrast, each of the IPOs in the last few years raised more than $100 million in capital for the company, with the exception of Wingstop, $47 million, and Papa Murphy’s, $64 million.
Access to a record amount of capital is clearly fueling unit expansion. In turn, unit growth is contributing to increasing costs. Real estate that was both readily available and relatively inexpensive coming out of the recession is now becoming scarcer and more costly. Labor costs are also rising across the U.S. Labor costs are influenced by government action to raise the minimum wage, but they are also a reflection of increased demand for workers that bid up entry-level wages in many markets.
These cost pressures, combined with increased competition, are warning signs for operators and investors. Doolin had three suggestions:
1. Don’t settle for average;
2. Ask for more out of your top performers; and
3. Know how you stand in every restaurant and within every market versus the competition.
I heartily agree with his suggestions, and add one more related to cost pressures: Companies must determine a return-on-capital hurdle that each restaurant needs to meet or exceed to more than cover their cost of capital and compensate for the risk of development. They then must stay highly focused and disciplined to overcome that hurdle.
Maintaining discipline can be very difficult, given the pressure to grow as a public company, and to satisfy private investors’ ROI expectations. It is essential, though, to maintain focus and discipline, as the industry is littered with examples of companies that have failed to do so.
When evaluating whether a specific investment will meet the return expectations, projections for both the cost and operating results must be realistic. In the current environment, erring on the side of caution is prudent, especially for smaller, emerging brands, where one or two bad decisions can be devastating. Market-specific estimates need to be developed rather than relying on pro forma models.
The companies that thrive as this cycle plays out and the next one develops will be those that resist the temptation to grow at any cost, even at the price of slower growth.
This information should not be regarded as a solicitation or recommendation of any particular security or to engage in a particular trading strategy. This was prepared for informational purposes only and is not believed to be sufficient on which to base an investment decision.
