DANNY MEYER ELIMINATES TIPPING. WELL ADVISED? BE CAREFUL OUT THERE!

The talk of the town and the country, among restaurateurs and diners alike is the no-tipping policy that Danny Meyer is about to embrace in his highly regarded full service locations. No one is more respected in the industry than Meyer, with good reason. He has built a great company within the fine dining sector, in addition to launching the hugely successful Shake Shack fast casual chain. If anyone can spearhead the no-tipping approach, it is he, but we have our doubts. In any event, the outcome will not be known for months or even years. There are three constituencies to satisfy here: the employees, the customers and the management. We list the employees first just because they are the face of the company, and continuously display the corporate culture to the dining public. If they are unhappy with the quality of the food served, the performance of the kitchen, their personal compensation and treatment by corporate management, it will be continuously communicated to the customer base.

I’ve been an analyst, investment banker, investor and adviser relating to the restaurant industry for over three decades. This is one of the more radical (call it “contemplated”) “adjustments” to the labor portion of “prime costs” ( food and labor) that I’ve seen in all that time, indeed the dining out culture that has become ingrained in our lifestyle.
It is important to understand the motivation behind Meyer’s (and some predecessors) move. As Meyer has described, the kitchen staff is paid by salary (or hourly) while the servers can make much more money including tips. The back of the house is of course critical to customer satisfaction, so it has to be discouraging and unfair to the kitchen when the servers are celebrating at the end of a great evening, having made hundreds of dollars, and the kitchen staff has made a fraction of that. It is important to understand that labor laws have for years inserted themselves into the tip allocation process, when tips are pooled; in general protecting the servers whose hourly rate is usually below the minimum wage. Tips can therefore not be allocated (more than nominally) to back of the house employees, leaving their compensation to management by way of salaries and bonuses. Assuming that front of the house tips are pooled among servers and their compensation can’t be cut materially, the change implemented by Danny Meyer’s amounts to a compensation raise for the back of the house, and an increase in overall labor costs.
Considering the second “stakeholders”, the customers: Some customers won’t mind if prices go up 20%-30%, including tips, since they were tipping at least 20% anyway, can afford it, and they really like the food and service. They are customers no matter what, which may especially apply to the restaurants managed by Meyer.  Also, some customers don’t like the burden of the tip decision, so will welcome relief from this responsibility. In our opinion, this contingency is small, however. More important is the group that normally tips at perhaps the 15%-20% range, so this price rise will be a noticeable increase in the cost of dining. While some customers will tolerate it, we believe that a material number will not. Traffic is hard to come by, for all retailers, and wise managements are exceedingly thoughtful before implementing price increases. Our conclusion here: this new policy will not increase traffic, and will likely lose at least a few customers for all but the very strongest operators.

The third contingency is corporate management. Without question, the contemplated change will simplify the labor equation; compensate the back of the house more appropriately which will reduce turnover and training, and the burden of coping with governmental oversight. Operating margins are hard to maintain and management must get an appropriate return on investment if they are to prosper. In a better economy, with stronger sales, margin pressure would not be so substantial, but these days there is only one solution to higher costs, and that is higher prices.

Our bottom line: There is no one better equipped that Danny Meyer to implement this new policy, based on his relationships with employees and customers alike. We feel, however, this policy may hurt even him, over time, in terms of customer traffic. Most other full service restaurant companies would be ill advised to follow his lead, in our opinion. The economy, and the competition, is too unforgiving to tolerate what will amount to a material rise in dining prices. If I owned shares in a publicly held full service restaurant company, which I do not, I would be highly suspect of this change that is relatively radical in a very sensitive environment. In any event, even Danny Meyer intends to phase this approach in over a year or more, so this will take a while to play out. In the meantime, we say to restaurateurs and investors alike: be careful out there!