DC Advisory
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From a macro standpoint: Somebody should inform our political leaders that one does not get out of a hole by continuing to dig. Donald Trump’s campaign routine ignores the fact that the US cumulative debt went from $19.6T to 27.7T under his watch (with $4.2T in his last year, ending in September, 2020 inflated by Covid). In fairness, the debt was only going up an average of about $1T annually prior to Covid. President Biden brags how he has produced the largest annual deficit reduction (from $3.1T in ’20 to $1.4T in ‘22) in US history, only increasing the debt by $1.9T fiscal ’21, versus Trump’s Covid-driven $4.2T in ’20. (By the way, the debt usually goes up by more than the latest deficit, mostly because of additional “off-budget” borrowing  from the Social Security trust fund. Currently, though, the debt is now escalating at close to a $2T annual pace. The federal budget deficit, amounting to $240B in May, was up a cool 263% from $66B in ‘22, having increased to a cumulative $1.16 trillion for the first eight months (through May) of the fiscal year ending 9/30/23, up 191% from $426 billion a year earlier.  (The June deficit was just announced at $230B, up from $89B, so has matched the ’22 full year in nine months of ’23). The Treasury has attributed the increased deficit primarily to rising interest costs, rising rates of Medicare and Medicaid, and “federal depositor insurance costs related to the failure of a small number of regional banks”. This is important to us because currently more normalized interest rates will drive annual interest expense to a trillion dollars within 3-4 years, inhibiting the government from directing their entrenched deficit spending toward more productive pursuits. This is why stagflation becomes our best hope, as the Federal Reserve returns to accommodation of a stagnating economy.

A stabilizing stock market, as investors look across the tight money “valley”, has allowed  a couple of new issues, CAVA Group (CAVA) and Gen Restaurants (GENK), to come public successfully, and others (Panera and/or Fogo de Chao’) will likely attempt to get through the IPO window. Both CAVA and GENK have a long runway for growth, but the valuations seem to ignore some obvious potential pitfalls while assuming consistent success. Each will be growing organically faster than ever before. GENK is opening 8-9 units annually vs. 3-4 previously, and CAVA will be developing new sites rather than productively converting Zoe’s locations. G&A (including pre-opening expense) will appropriately run higher than will be desirable in the long run. We will be doing more work relative to GENK but have yet to be convinced how mainstream, and sustainable, Korean BBQ will become. On the subject of G&A support for an aggressive expansion program, Kura Sushi (KRUS), also with attractive unit level economics, focused on reducing  the obviously high G&A at about 15% of revenues, is now selling for about 70x trailing twelve month Adjusted EBITDA. Summarizing our view at these prices of CAVA, GENK, and KRUS – the legendary country singer, George Strait, sang it best: “now I’ve found a game I cannot play, this is where the cowboy rides away”.

“Refranchising” is a popular strategic approach for companies with a large number of company operated locations. Private equity investors are attracted to the asset light direction, getting out from under capital needs and always present margin risk within a less than robust economy. Why bother with operations, if you are only making 8-10% EBITDA or less at the store level, when you can almost match that in royalties and fees, and also free up capital. In recent years we watched as Buffalo Wild Wings, Jack in the Box, Red Robin and others have pursued this route to varying degrees. Not adequately considered, perhaps, is the fact that store level economics have to be adjusted by royalties and other service fees which will be expenses that the company was not incurring but have to be absorbed before the franchisee can generate a return on capital. This is why the franchising company often gets next to nothing for the store, perhaps some future payout in the form of debt, which is the “sale price” as far as Wall Street is concerned. Right now Noodles (NDLS) and Potbelly (PBPB), both with a predominance of company operated locations, are trying to accelerate their franchising activity. This exercise often involves using a handful of company operated locations to provide a franchisee a foothold in a particular market. Noodles has done this in California and Potbelly in Manhattan. It helps a lot that both Noodles and Potbelly have made some serious strides in terms of improving Average Unit Volumes and store level economics. Realistically, though, the mid-teens for store level EBITDA at company locations is not yet compelling. Starting at 15% EBITDA at the company run location,  after a royalty of 5% (more or less), a couple of percent of required local advertising or contribution to a national fund, a point for “other fees” (some of which used to be gratis, but not lately), and at least a couple of points of local G&A, there is not much left. Keep in mind, also, that a 2-4% Depreciation capex “reserve” cannot be ignored. A company operated location really requires something like 20% store level EBITDA margin, or higher, before franchisees will beat a path to your door. Just sayin’.

Roger Lipton