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FOLLOW THE MONEY by ROGER LIPTON 7-15-22 – a monthly column in the Restaurant Franchise Monitor

The Party Has Ended and the Hangover is in Process. You don’t need us to tell you that the stock market over the last six months has been the worst in the last fifty years and the bond market worse than any in over one hundred years. It could have something to do with the fact that the US Federal Reserve, joined by other central banks have presided over the largest experiment in financial history. This publication has discussed many times the historically very high valuation of restaurant chains. In this column we’ve additionally discussed bubble like symptoms such as companies selling at 50-75 times sales, trillions of dollars reflected by 20,000 different cryptocurrencies and hundreds of billions of dollars in the form of SPACs that could purchase a trillion dollars of companies “to be determined”…The Federal Reserve is kidding themselves (and lots of investors), as they project the possibility of a “soft landing” for an economy that is already in “stagflation” and about to get worse under the increasing burden of higher interest rates. While the Fed is claiming that the economy is strong enough to tolerate higher rates and Quantitative Tightening (QT) (discussed below), Q1’22 GDP was negative and, as this column foresaw in May, the latest projections for Q2 are now negative. Moreover, while the demand destruction from slightly higher rates, and the easing of supply channel distortions will likely allow inflation to come down by two or three points, we are a long way from the level of short-term interest rates which must be above the rate of inflation to encourage savings and reduce inflation to the supposedly tolerable level of about 2%. Recall that back in ’18, when the Fed balance sheet was only $4.2 trillion, they reduced it all the way to $3.7 trillion before the stock market crashed 20%, the politicians screamed “do something” and they backed off. We predict that, within just a couple of months, the Fed will once again (especially with mid-term elections pending) find an excuse to back off from forcing rates higher, even though inflation is far from tamed. In a similar vein, we don’t expect the Fed to materially reduce their $9 trillion balance sheet, backing off just as in early 2019, from the QT that the already slowing economy can once again not tolerate. The good news is that when our Fed telegraphs its new accommodative posture, the stock and bond markets could, just as during the stagflation of the1970s, rally substantially from the currently depressed level, even if only a “dead cat bounce”.

Regarding the Restaurant Industry: The negatives are now more than apparent, even to casual observers. Traffic was terrible for the two years of the Covid, now finally running ahead of 2019 at some chains. Similarly, efficient staffing was almost impossible for two years, and is still in a state of flux as customers tentatively return with sales stabilizing between dine-in and off-premise. At some junctures within the two-year Covid time-

frame, it was a challenge to merely get the restaurant opened, let alone operate efficiently. The other major expense line, Cost of Goods, has also taken its toll on margins as higher protein prices were amplified by supply channel inefficiencies.  Restaurant operators have therefore been penalized by the triple negative of challenged Traffic while Labor and CGS have simultaneously been climbing sharply. The normal remedy of higher menu prices has been difficult to impose on the dining public in the midst of an unprecedented health crisis. TODAY, however, management of publicly held chains has learned a great deal about managing the current situation as well as planning future growth. From an investment standpoint, stock valuations correlate strongly with the “2nd derivative”, which is the “change in the rate of change”. For example, if traffic has been down 5%, and it is still down, but by only 2%, that is a big positive. Similarly, if crew wages have been inflating at 10%, it is encouraging to hear about (only) a 5% expectation. Management cannot control commodity prices but have learned how to adjust the labor content to respond to the mix of business. We do not suggest that traffic will suddenly accelerate, or wages and commodity prices will come down, but there is a good chance that the worst of the “rate of change” is behind us. With that possibility in mind:

Valuations of Restaurant Equities are Historically Low – We cannot know where stock prices will bottom. We can say, however, that valuations are currently closer to historical lows than highs. With the exception of a couple of “best of breed” operators like Darden, TX Roadhouse and McDonald’s, as well as the pizza and chicken franchisors that benefited from the Covid (DPZ, WING, PZZA) restaurant stocks are down generally from 25-50% from their twelve-month highs. Acknowledging that each of the following companies has its unique set of opportunity and challenge, a group of mid to large cap, financially stable, generally well-run companies (BLMN, CHUY, EAT, CAKE, CBRL, PLAY, and BJRI) @6/11/22 sell for an average of under 6x trailing twelve-month EBITDA. A group of franchisors (RUTH, DIN, JACK and DENN) sell for an average of 10x trailing twelve-month EBITDA. More venturesome investors can look at smaller capitalization and/or troubled chains within a group (RRGB, BBQ, GTIM, NDLS, ARKR, STKS, FRGI and BDL) which sell for an average just over 5x trailing twelve-month EBITDA, a couple of them materially lower than that. Dining away from home and consuming food prepared outside the home will remain embedded features of today’s consumer behavior. Well run restaurant companies will once again prove to be relatively recession resistant, and the current prices of many of the above referenced companies should prove to be opportunistic over the long term.

Roger Lipton