McDonald’s (MCD)
https://www.liptonfinancialservices.com/2023/02/mcdonalds/
Brinker International, Inc. (EAT)
https://www.liptonfinancialservices.com/2023/02/brinker-international/
Good Times Restaurants (GTIM)
https://www.liptonfinancialservices.com/2023/02/good-times-restaurants-inc-gtim/
THE WEEK THAT WAS: ENDING 8/26 – ONE UPGRADE FROM PRIOR WEEKS’ REPORTS, ONLY BRINKER REPORTS, AND DISAPPOINTS BUT ANALYSTS MAINTAIN RATINGS
Ratings Changes:
Regarding companies previously reporting, NICK SETYAN upgrades Denny’s from Neutral to Outperform.
Regarding companies that reported this week, only Brinker. In wake of disappointing results, JEFF BERNSTEIN, CHRISTOPHER CARRIL AND NICK SETYAN stay Neutral, NICOLE REGAN and ANDREW STRELZIK remain Positive.
Conference call transcripts are below for all companies reporting in prior weeks with ratings changes (Denny’s) and all companies that reported last week (Brinker)
CONFERENCE CALL TRANSCRIPTS
Denny’s (DENN)
Brinker (EAT)
THE WEEK TO COME
No companies are scheduled to report –
THE WEEK THAT WAS, ENDING 5/6, LOT’S OF EARNINGS REPORTS, SEVERAL RATINGS CHANGES, MANY MORE DATA POINTS IN THE WEEK TO COME – links to transcripts provided
Starbucks reports, only change is David Palmer upgrading. Nobody wants to be negative. NICOLE REAGAN, JOHN GLASS, CHRIS CARRIL and JON TOWER stay neutral. LAUREN SILBERMAN, JEFFREY BERNSTEIN, DAVID PALMER and ANDREW CHARLES continue to like it.
Denny’s reports, NICK SETYAN still likes it.
Restaurant Brands reports, only change is CHRIS O’CULL downgrading to HOLD. M.Stanley analyst maintains underweight. JON TOWER is neutral, while CHRIS CARRIL AND LAUREN SILBERMAN like it here.
Yum Brands reports. No changes. LAUREN SILBERMAN is NEUTRAL while JON TOWER says BUY.
Brinker reports (and disappoints). DAVID PALMER downgrades to IN-LINE. BRIAN MULLAN, NICK SETYAN, and M.STANLEY analyst are NEUTRAL. BRIAN VACCARO and ERIC GONZALES continue to be positive.
Wingstop reports (and disappoints). M. Stanley analyst, NICK SETYAN, JON TOWER and ANDREW CHARLES all stick with it.
SHAKE SHACK reports. Everybody maintains. LAUREN SILBERMAN and BRIAN MULLEN are neutral, while PETER SALEH & NICK SETYAN like it.
PAPA JOHN’s reports. LAUREN SILBERMAN and NICK SETYAN continue to like it while BRIAN MULLAN is neutral.
THE WEEK TO COME: MORE DATA POINTS
5-09 After Market Close RCI Hospitality Holdings RICK
5-10 Before Market Open First Watch Restaurant Gr FWRG
https://viavid.webcasts.com/starthere.jsp?ei=1537799&tp_key=a214d47caa
5-11 Before Market Open Wendy’s WEN
https://event.on24.com/wcc/r/3723491/E08AEE34680249F3308CCBD4D8C0EEFE
5-11 Before Market Open Krispy Kreme DNUT
https://edge.media-server.com/mmc/p/2m66abcw
5-11 After Market Close Dutch Bros BROS
https://events.q4inc.com/attendee/370340001
5-12 Before Market Open Carrols Restaurant Group TAST
https://viavid.webcasts.com/starthere.jsp?ei=1541750&tp_key=1245ec6318
STARBUCKS REORGANIZES AS SCHULTZ RETURNS, BRINKER AND WINGSTOP DISAPPOINT THIS MORNING, THE FOLLOWING ANECDOTAL REPORT ILLUSTRATES THE CHALLENGE!
We wrote our “Hope” anecdote a couple of days ago, to be published as part of our monthly column the 5/15 issue of the Restaurant Finance Monitor. However, in the wake of (1) Howard Schultz’ temporary return to Starbucks, his decision to withdraw guidance for ’22 and invest one billion dollars “to uplift Starbucks’ employees and The Store Experience and (2) the disappointing results reported this morning at Brinker and Wingstop, the following field trip observations are worth thinking about today. There will be conference calls today at 10am for EAT and WING. From an investment standpoint, we have always valued the “transparency” of this industry.
Hope is not a strategy – “Culture”, or “hospitality quotient” as Danny Meyer has put it, seems difficult to define but is recognizable when you experience it.
As a positive example: I visited a First Watch restaurant last week for the first time, around 9:00 am on a Monday morning. As I noticed that the entrance door and adjacent window glass were sparkling clean (the first tell), a young woman with a big smile opened the door and ushered us in. We sadly didn’t see any more of her but the entire service team was equally friendly, made easy eye contact, tried to be helpful (without being intrusive), obviously happy to be there. The menu was appealing and well priced, the coffee included flavored creamers and we both enjoyed the blueberry pancakes. More important than the food, because you can get coffee and pancakes in lots of places, was the dining experience. I came back to NYC and bought the stock (FWRG, trading at about 12x trailing EBITDA).
On the other hand: That same night, we had dinner at a publicly held full-service restaurant chain. There were tables available but we waited for twelve minutes to be seated, so our assumption was that they were short of staff. We were handed menus, a bit worn, as we were seated but it was six or seven minutes before a server showed up to take our drink orders. The appetizer arrived in an acceptable amount of time but the entrees took way too long. As we waited, there seemed to be quite a few service people in the area but it felt like they were a bit confused. The activity was not frenzied but it seemed less than organized or purposeful. After waiting too long for our entrees, and finally making eye contact with our waitress, I said: “So I guess our entrees will be here soon?” Her response: “I hope so”, as she disappeared from view, is as much as we need to know. My basic reaction was one of sympathy, since this girl’s orientation had obviously been far from adequate in today’s labor environment. It must be a daunting challenge to hire, train and motivate the rapidly turning over service staff in a high volume full service restaurant. On top of that, the kitchen staff may not do their part, and the service person who just happens to be on the firing line will get discouraged pretty quickly.
If restaurant management is throwing service personnel out on the floor, to interface with customers (who are increasingly hard to come by these days), “hoping” for a good outcome, there’s some serious work to be done.
Roger Lipton
P.S. Four and one half years ago, we wrote about Starbucks as follows:
August, 2017
IT’S A ‘BUM RAP”, STARBUCKS DOES NOT SELL “$5.00 CUPS OF COFFEE”
It’s a “bum rap”. The media, and the skeptics like to point to the folly of customers paying $5.00 for a cup of coffee. However, we priced (before tax) Starbucks, Dunkin’, and Horton’s in Detroit (to avoid NYC prices) this morning. Starbucks’ 12 oz.“tall” coffee is $2.20, Dunkin Donuts 10 oz. “small” is $1.75, and Horton’s 10 oz. “small” is $1.58. Per oz., Starbucks costs $.183, Dunkin’ is $.175 and Horton’s is $.158. If you want a latte’, the gap is wider ($.312 per oz. at Starbucks, $.253 at Dunkin’, and a materially cheaper $.222 at Horton’s). A latte’ costs more at Starbucks, but Dunkin’ and Horton’s don’t even offer the Soy Latte’ that I order. I can’t vouch for the “quality” of latte’ at Dunkin’ or Horton’s. You can judge for yourself whether the service component, or the type of coffee, is worth the price premium at SBUX but, in any event, it is not a “$5.00 cup of coffee”, and Starbucks’ prices are not grossly higher than the competition.
THE STARBUCKS DIFFERENCE
In my opinion, what has distinguished Starbucks over the years has been the corporate “culture”, which they have incredibly duplicated in 27,000 stores worldwide. Their employees, selected, trained, and motivated to an unmatched degree in food service, look you in the eye, remember your name and drink if you are anything close to a regular customer, and become part of your daily social life. A couple of years ago, about the time that Chipotle ran into trouble, I asked a SBUX employee if he knew anything about Chipotle. This young man, perhaps 18 or 19 years old, told me he used to work at Chipotle, then gestured kind of frenetically with his hands saying: “at Chipotle it was all about speed. Starbucks makes me a better person”. That’s what Starbucks has been all about, creating a uniquely welcoming retail environment that produces “better persons” of their employees.
THE TIMES THEY ARE A’CHANGIN’
BARRON’S MAGAZINE this morning has a front cover entitled THE FUTURE OF COFFEE (AND RETAIL). The subtitle reads “Starbucks has succeeded where Silicon Valley hasn’t: changing the way consumers pay. The behavioral shift holds big promise for the coffee giant and its stock”.
Not exactly, in my opinion. It is not just about “the law of large numbers”, and the difficulty of satisfying investors by building on profit margins that are well above peers. The business model has changed, and the question becomes whether the new model will match the original. It’s well known that a new loyalty program bothered some customers and also that an increasing number of customers are ordering and paying online, often in advance of entering the store. In the most recent quarter, 30% of US transactions were paid using the smartphone app, up from 25% a year earlier and 20% two years ago. More important, to my view, is that 9% of US orders were ordered and paid for in advance. The company has been discussing the store level congestion for several quarters now, as mobile orders slow down service for customers going through the line. Perhaps it’s just me, but I am put off somewhat when the line at the register (where I like the human contact) is short, but I have to wait while eight or ten orders are pumped out ahead of my own.
MILLENIALS, WHO ARE THE SPENDERS, DON’T VALUE HUMAN CONTACT (AS MUCH)
It’s not so long ago that pundits dismissed the internet as a retail venue. The public was not expected to give out their credit card information, and certainly was not going to buy “touchy, feely” products like apparel or shoes through online channels. The public is not only ordering “everything” through Amazon and others, but relationships are maintained through Facebook and other social channels. As a corollary, customers are increasingly seeking “experiential” retail situations, rather than visit the malls, with their undifferentiated stores and restaurants, most often staffed with poorly trained employees.
WHAT’S IT ALL MEAN TO EMPLOYEES, AND CUSTOMERS?
Relative to Starbucks, their leadership with mobile order and pay, increasingly in advance of the store visit, may well be appropriate and necessary, but the business model has changed. It’s become a production challenge, not a relationship driven enterprise. The employed “people person” who was the star of the previous model, is not going to be as easily satisfied, because most of the employees, for most of their time, are busy pumping out product. It’s going to be harder to find someone as described above who says that Starbucks “is making me a better person”. From the customer side, there are 27,000 stores already existing that are already tightly configured and can’t be reconfigured too much to handle a lot more production. From a customer standpoint, some, like myself (perhaps in the minority these days), who value the human contact, may decide that the local independent shop, or even the home or office kitchen, can provide an adequate cup of coffee at a competitive price without the “tumult”.
CONCLUSION
I remember when Howard Schultz said that food will never be a material part of Starbucks’ sales. Today, it represents 30% of revenues. Schultz originally envisioned his coffee shops as a “third place”, to hang out other than home or office. That’s a little hard today, in a small busy shop, but we can call this an “unintended consequence” of building one of the still growing premier worldwide brands. Comps and traffic have slowed in recent years, due to the “law of large numbers”, the natural limitations of small stores that were not originally built to handle today’s volumes, and the evolving environment that every successful retailer must adjust to. Starbucks is one of the most successful retailers ever created, and we don’t doubt that they will continue to succeed in a major way. We caution however, that the rate of progress demonstrated in the past, already slowing, will be increasingly difficult to replicate. The business model has evolved. Starbucks was a retail “disrupter” but their previous approach may not be quite as successful. Accordingly, valuation parameters that have applied to SBUX equity in the past may not apply in the future. The stock chart that has languished over the last couple of years may well be reflecting the most likely future business model; still good, just not quite as great.
UPDATED CORPORATE DESCRIPTIONS: CARROL’S, FLANIGAN’S, BRINKER, FIESTA RESTAURANT GROUP, PORTILLO’S, EL POLLO LOCO – recent conference call transcripts
CARROL’S (TAST)
https://www.liptonfinancialservices.com/2022/01/carrols-restaurant-group-tast/
FLANIGAN’S (BDL)
https://www.liptonfinancialservices.com/2022/01/flanigans-enterprises-bdl-in-process/
BRINKER (EAT)
https://www.liptonfinancialservices.com/2021/11/brinker-international/
FIESTA RESTAURANT GROUP (FRGI)
https://www.liptonfinancialservices.com/2022/01/fiesta-restaurant-group/
PORTILLO’S (PTLO)
https://www.liptonfinancialservices.com/2022/01/portillos-ptlo-in-process/
EL POLLO LOCO (LOCO)
FIVE UPDATED WRITEUPS, – KURA SUSHI (KRUS), ROCKY MOUNTAIN CHOCOLATE FACTORY (RMCF), McDONALD’S (MCD), STARBUCKS (SBUX) AND BRINKER ((EAT)
The links below take you to the updated corporate descriptions, which includes a link to the transcript of the most recent conference call.
Kura Sushi (KURA)
https://www.liptonfinancialservices.com/2021/11/kura-sushi-krus-write-up/
Rocky Mountain Chocolate Factory (RMCF)
https://www.liptonfinancialservices.com/2021/11/rocky-mountain-chocolate-rmcf-in-process/
McDonald’s (MCD)
https://www.liptonfinancialservices.com/2021/11/mcdonalds/
Starbucks (SBUX)
https://www.liptonfinancialservices.com/2021/11/starbucks-updated-write-up/
Brinker (EAT)
https://www.liptonfinancialservices.com/2021/11/brinker-international/
UPDATED CORPORATE DESCRIPTIONS – SHORTLY WILL INCLUDE VIRTUALLY EVERY PUBLICLY HELD RESTAURANT COMPANY – to be updated each quarter
The summaries we show, while not complete in detail and involve a number of approximations, provide a good starting point for our own investment banking activities and will hopefully do the same for our readers.
https://www.liptonfinancialservices.com/2021/11/bbq-holdings-bbq-in-process/
https://www.liptonfinancialservices.com/2021/11/bjs-restaurants-2/
https://www.liptonfinancialservices.com/2021/11/bloomin-brands-updated-write-up/
https://www.liptonfinancialservices.com/2021/11/brinker-international/
https://www.liptonfinancialservices.com/2021/11/cracker-barrell-cbrl-write-up/
https://www.liptonfinancialservices.com/2021/11/darden-restaurants/
BRINKER, INTERNATIONAL, INC. – UPDATED WRITEUP – HERE COME THE WINGS!
As of December 23, 2020 Brinker owned, operated and franchised a total of 1,655 restaurants, of which 1601 were Chili’s and 54 were Maggiano’s Little Italy. Company operated: there were 1,061 domestic and 5 int’l Chili’s, plus 52 domestic Maggiano’s. Franchised: there were 171 domestic and 364 int’l Chili’s plus 2 domestic Maggiano’s.
CONCLUSION
Brinker’s most important Chili’s brand has been managed well in recent years, including the last twelve months, and results should improve further, but the longer term expectations at Maggiano’s remain uncertain. The introduction of It’s Just Wings as a virtual concept is promising. However, Brinker’s ability to defend its competitive position over time in this niche is not assured. Other large full service, or even QSR, chains with excess kitchen capacity could presumably compete just as well and Wingstop is not going away. Activists could be attracted by the cash flow and the re-franchising potential but the balance sheet, even with debt coming down, is already leveraged to a large degree. Net Lease Adjusted Debt, currently, at about 4x the run rate of Adjusted EBITDA is not excessive for a pure franchisor but is adequately high for a company operated chain.
FIscal ’21, ending June 30th, has become a “transition” year, and FY 6/30/22 is increasingly uncertain. The estimates of EPS for the FY ending 6/22 range from $3.60/share to almost $5.00, with the top end of the EBITDA guess at about $450M. The current stock price, at about 13x the high end of EPS with an Enterprise Value of about 9x EBITDA allows for some modest upside if the high end of performance expectations actually happen, but we have our doubts. On balance we feel that Brinker (EAT) is fairly valued, with a great deal of the post pandemic recovery potential adequately discounted.
OPERATIONS AT CHILI’S ARE STRONG, MAGGIANO’S NOT SO MUCH
According to a National Restaurant Association survey, more than 17% of all US restaurants are now permanently or temporarily closed. That is more than 110,000 businesses and Chili’s seems to have been one of the beneficiaries. On the recent second quarter conference call, management stated that Chili’s had increased its two-year trend of taking market share with a category leading 18% beat in sales and a 25% beat in traffic according to KNAPP-TRACK. The company’s broad menu and specials such as 3 for $10 and $25 Dinner for Two resonated with diners looking to dine out without spending a great deal of money.
In the second quarter, ending 12/23/20, Chili’s reported that same store sales only declined 6.3%. This compares favorably to other national chains that have announced results so far such as Olive Garden (-19.9%) and Longhorn Steakhouse (-11.1%). We expect that these results will also compare favorably to results at companies such as Bloomin’ Brands, Cheesecake Factory, Dine Brands and BJ’s when they report in the coming weeks.
OPERATING RESULTS
While sales have held up fairly well, cost control at Chili’s has been even more impressive. Food and beverage and labor costs as a percentage of revenue were flat year over year. Occupancy and other expenses are up about 90bps due mostly to the costs associated with delivery fees. As a result of this cost control, operating income declined only $1.6M to $50M on a $45M decline in sales.
Because of the occupancy restrictions due to the pandemic, there has been a dramatic shift in the percentage of sales that are coming from to-go and delivery orders. The off-premise business at Chili’s has grown over 225% since 2018 and the pandemic has accelerated this trend. Historically, Chili’s, to-go and delivery sales were 14-17% of sales with 74% coming from to-go and 26% from delivery. However, in the first two quarters of FY21 off-premise sales were approximately 46% of sales, with 60% coming from to-go and 40% coming from delivery. Some of the shift has come from the addition of the virtual brand It’s Just Wings, to be discussed later. For comparison, Olive Garden to-go sales as a percent of revenue is 37%. This ratio will decline for all full service casual dining chains as dining room capacity increases, but demonstrates that Chili’s food is apparently holding up relatively well when delivered.
DEMAND PROBLEM AT MAGGIANO’S
Not well positioned to deal with social distancing, Maggiano’s emphasis is on family style dining and has a large banquet and group meeting business. For example, 17% of sales come from banquets and group meetings. The second quarter is the busiest time of year for this part of their business and sales were essentially zero this past quarter. The restaurants are much larger than a Chili’s restaurant, with 3X the square footage of a Chili’s and average unit volumes before the pandemic were $7.9M compared to $2.8M for a Chili’s. A sales decline such as almost 50% in Q2 predictably creates a huge deleveraging of occupancy costs. Restaurant expenses other than labor and CGS rose 1000bps to 35% of sales. Chili’s comparable expenses were only 28% of sales.
Another disturbing trend is that the average check declined significantly. Before the pandemic, the average check at Maggiano’s was about $28 (compared to $15 at Chili’s). The average check is now running around $22. This decline caused deleveraging on food and labor costs as well. All these factors are manifested in the huge decline in both sales and operating income. In spite of having sales that are $600M per quarter less than Chili’s, Maggiano’s saw a loss of $56M in sales compared to a $45M loss in sales at Chili’s. Operating income dropped $22M to a loss of $1M. As we discussed earlier, Chili’s operating income only dropped $1.6M.
HERE COME THE WINGS, AND MORE
In June 2020, Brinker International announced that it was rolling out a new virtual brand called It’s Just Wings (IJW). IJW offers wings featuring 11 sauces and comes with curly fries and a dessert option of fried Oreos. At this time, customers can only order through DoorDash or the website https://itsjustwings.com/. When the announcement was made, Brinker stated that there were three reasons for deciding to move forward with the concept:
On the second quarter conference call, management stated that IJW is generating $3M in weekly sales or $150M a year. While the profit contribution is not yet clear, these results seem to be a good start when you consider Wingstop took over eighteen years to achieve $150M in systemwide sales. Also consider that these results are being achieved without any major marketing support. Management revealed that the brand is seeing high satisfaction scores and strong repeat usage. However, at this point DoorDash is not sharing individual guest contact information so Brinker is not able to register these customers in their loyalty program. If the company is not able to convert these users to the Chili’s loyalty program that would be a disappointment.
Brinker wants to expand its virtual brands to further leverage restaurant operating costs. One possible concept that has been mentioned is called Plattered and Pies, apparently an Italian concept, which makes sense considering Maggiano’s Italian heritage. Another concept that CEO Wyman Roberts has mentioned in the past is a fast-casual Mexican brand, since the Chili’s menu has a significant number of Mexican food options on it. While the ultimate profit contribution from this effort is unclear, it seems that Brinker does not have to pay a commission to DoorDash, which would help profitability long-term.
CORPORATE LIQUIDITY IS GOOD
To bolster liquidity during the worst of the pandemic, in May 2020 Brinker issued 8.1M shares at $18.25 per share, raising over $146M. In retrospect, of course, considering that in FY19 and FY20 the company spent $200M buying back 4.4M shares at an average price of $45.50, it wasn’t such a good trade. On the other hand, a pandemic was not on anyone’s radar.
The company ended Q2 2020 (12/23/20) with $64M in cash and over $594M available on its revolving credit facilities. Year-to-date Brinker has paid down $66M on the revolver and is well on its way to achieving its 3.5X Lease Adjusted Debt to EBITDA goal next fiscal year (from 4.5X last year). The two outstanding notes totaling $650M do not mature until 2023 and 2025. The company continues to produce significant free cash flow. Brinker has always been able to generate significant amounts of free cash flow. Cash from operations for six months was a strong $130M, down only $12M from last year. Capital expenditures were only $37M, which means the company produced nearly $97M in free cash flow YTD. We would expect the company to resume its dividend payments sometime this year, though the resumption of the $0.38 per share dividend would not be huge at a 2.3% dividend yield.
FRANCHISING IS BECOMING VERY IMPORTANT TO OVERALL PROFITABILITY
As operating income from the owned stores has stagnated over the years, income from franchisees has become a significant source of corporate income and profitability. Franchise revenue generates a reported 90%+ profit margin and requires minimal absolutely required capital to grow. We interject here our often stated concern that too many franchisors short change their systems by not investing sufficiently to refresh the brand, as the same time increasing the franchisee burden with required advertising and operational fees. That said, the table below shows how this extremely high margin income stream has become a significant percentage of operating income for the company. Franchise revenue as a percentage of operating income has risen steadily over the last five years, from under 30% to approximately 50%. In fact, in FY20 it represented over 100% of operating income! While there is significant operating leverage ahead for the company stores as the impact from Covid 19 subsides, the growth in franchises, especially internationally, is going to be a significant source of income growth in the future. While the growth rate has recently slowed significantly, there remains a potential to franchise some of the current company store base.
In recent years, Brinker has been adding about 20-30 new franchise stores a year. Most of these stores are being opened internationally. As mentioned, the global pandemic has caused a significant slowdown in this development. In FY19, Brinker opened 23 franchise restaurants and originally projected opening 31-36 in FY20 (It only opened 25). Through the first two quarters of FY21, the company has only opened six (compared to 18 last year). The company is only projecting opening 9-12 franchise restaurants in FY21. This slowdown will negatively impact the growth in operating income for the next two years.
IMPACT OF $15 FEDERAL MINIMUM WAGE APPEARS MANAGEABLE
Now that the Democrats have reclaimed the Presidency and the two houses of Congress, the push for a federal $15 minimum wage has begun. We believe that Brinker has done a good job helping out its employees during this pandemic and has earned some goodwill with its front-line workers. For example, last year the company spent $17M on employee support by continuing to pay hourly employees and managers even though they were not working or reaching their profitability goals. However, that doesn’t mean that Brinker will be able to avoid any increase in the federal minimum wage. Brinker does pay above this rate in many of the states it operates in. This topic remains a political football, and was discussed at length on the recent conference call. As we see it, $15 federal minimum wage or not, labor costs move inexorably higher, but Brinker should be able to cope as well as anyone else.
SIX MONTH CASH FLOW A BIT ENHANCED
One final material detail within the six month 10Q filing (ending 12/23/20) was the relatively large increase in the deferred gift card balance. Over the last six months it has risen by 20% or $20M, not affecting reported revenues or costs, but inflating cash flow over the period. Success in this area indicates that customers are continuing to find value in Brinker’s offerings and should contribute to a rebound in sales, but the cash receipt has already been reflected.
CONCLUSION: At beginning of this article
Roger Lipton
RESTAURANT BRANDS (QSR), TEXAS ROADHOUSE (TXRH), BRINKER INT’L (EAT) REPORT RESULTS — ALL THREE STOCKS ARE DOWN — WHAT’S GOING ON?
Well regarded pure franchising Restaurant Brands, QSR, Best of Breed company operator, Texas Roadhouse, TXRH, mature professionally managed multi-chain company operator/franchisor, Brinker, Int’l.,(EAT) all reported their March quarters within the last 36 hours. What can we learn?
Before we start, because the news is not great and I recently seem to be consistently pessimistic (I would say “realistic”), you should know that I am not “talking my book”. I am neither long nor short two of the three companies discussed, and have a very modest short position in only one of them (which shall go nameless). All three stocks are down since they reported, QSR and EAT more modestly than TXRH, which is down about 10% this morning.
We are not going to provide extensive details, which you can read about elsewhere and which we will discuss in our full writeups to be posted within the next couple of weeks. We will provide just the pertinent highlights as we see them, and our conclusion.
Restaurant Brands (QSR), franchisor of Tim Horton’s, Burger King and Popeye’s, reported EPS down YTY, because of a higher tax rate. Actual Income Before Taxes was up, $302M versus $281M, but it should be noted that Other “Income” this year of $17M was $30M better than Other “Loss” a year ago of $13M. Let’s call it “flat” pretax income, by our simple adjustments. Everybody looks at comps and EBITDA by division here. Tim Horton’s delivered a negative comp of 0.6% in Q1, on top of a negative 0.3% in 2018. Price changes are not discussed relative to any of QSR’s three brands, so we can’t comment on traffic. Adjusted EBITDA at Tim Horton’s was $237M, down from $245M. Burger King had systemwide comps of 2.2% on top of 3.8% in ’18. BK’s Adjusted EBITDA was $222M vs. $214M in ’18. Popeye’s had a comp of 0.6% versus 3.2% in ’18. Adjusted EBITDA was $41M vs. $39M in ’18. The three brands, therefore, had total Adjusted EBITDA of $500M vs $498M a year earlier. Let’s call the results flat, and the bottom line is that, as we have predicted for some time, it will be very difficult to grow the EBITDA and EPS comparisons by more than mid single digits. Combining the “hard” results with the conference call commentary, there is very little happening that will accelerate the cash flow and earnings progress. Readers can refer to our previous commentary regarding QSR, , but, suffice to say: Tim Horton EBITDA growth, which grew from 2015 through 2017 largely by price increases imposed on the distribution chain, is not going to recur, especially in light of the lawsuits by franchisees. Burger King is a steady grower, especially overseas, but the G&A magic has already been imposed on this system so the easy money has been made. Popeye’s is the most rapid growth division, but is too small to move the total needle by much. The dividend of almost 4% supports the stock price, but it has seemed to us for a while that this “mid-single digit” grower is fully priced at 20x trailing EBITDA and 25x forward EPS. It should also be noted that much of the “free cash flow” has been used to buy back partnership interests from their parent, 3G, so this “return to shareholders” has primarily benefited 3G. From 12/31/16 to 12/31/18 the average weighted fully diluted shares outstanding has gone from 470M to 477M to 473M. There is substantial cash flow here, but a great deal of it has been used to buy back exchangeable Partnership interests from 3G. The long term debt was constant at $11.8B in ’18 over ’17 (after $3B was borrowed to buy back Berkshire’s Preferred), and “free cash flow” is not so “free” when debt is over five times trailing EBITDA. The Board of Directors preferred in ’18 to buy back stock from 3G (at 25x expected earnings and 20x trailing EBITDA) rather than reduce the debt. We agree that it seems sensible, from 3G’s standpoint, to lighten up. To be sure, there is a substantial dividend for common shareholders.
Texas Roadhouse (TXRH) is a simpler story. They are truly one of the premier operators in the full service casual dining space, consistently delivering same store sales growth as well as traffic gains. The most recent quarter was no exception, with an admirable comp of 5.2%, including 2.6% traffic. The monthly comps, though decelerating through the quarter were fine, up 7.2%, 4.7%, and 4% in January, Feb., and March. April to date is up 2.9% on top of 8.5% a year earlier. However: Income from Operations was down 6.8%, and diluted EPS was $.70 vs $.76. Restaurant margin (EBITDA) was down 128 bp to 17.9%, and the problem was labor, which cost 118 bp. The discouraging part for investors and analysts is that the Company has predicted ongoing wage pressure, and these guys are not about to disappoint customers by cutting labor. An additional concern, though a lot smaller, is expected commodity inflation of 1-2% for all of ’19. There’s a lot more that could be detailed here, but the results at TXRH demonstrates what we’ve been saying for a while, that it takes more than even 3-4% comps (and now 5.2%) to leverage the higher costs of operations, labor in particular. We don’t know to what extent the Street will lower expectations for ’19 but at $54.37 at the moment (24.7x ’18 EPS) doesn’t seem like a bargain when it is hard to know when EPS growth will resume. FWIW, $54.37 is 14.5x Bloomberg’s estimate of TTM EBITDA.
Brinker International (EAT) reported Q3 (ending March) with somewhat of a “mixed bag”. The headline indicated that EPS, excluding special items, was up 16.7% to $1.26 vs $1.08. Comp sales for Chili’s was up 2.9% (company) and 2.0% (franchised). Maggiano’s was up 0.4%. Operating Income was 8.4% of Revenues, down 50 bp from 8.9%. Restaurant margin (EBITDA) was 14.3%, down from 16.1% but, excluding the effect of a sale-leaseback transaction, would have been flat YTY. (However, the higher rent is a cash charge vs. depreciation which is non-cash, so the true cash EBITDA margin was truly 180 bp lower). Chili’s results are the main driver of results, and, aside from the sale-leaseback penalty, it was pointed out that: “cost of sales increased due to unfavorable menu mix, and commodity pricing, partially offset by menu pricing, also partially offset by a decrease in restaurant labor from lower incentive compensation, which in turn was partially offset by higher wages.” So: CGS was up, wages were up, restaurant labor (hours?) was down, and there was less incentive compensation. That doesn’t sound like the industry wide wage increase is abating, and commodity costs are up, which we also heard at Texas Roadhouse. While it is admirable that comps were up again at Chili’s, with traffic up as well, it should be noted that the gain in after tax EPS was entirely due to a lower tax rate and far fewer shares outstanding. Income Before Taxes was $55.5M, down from $58.9M. Adjusted for an Other Gain of $3.5M this year versus a $2.7M loss, the comparison would be $52.0M of Adjusted Pretax Operating Income vs. $61.6M. The number of fully diluted shares was 38.1M vs. 46.0M. From a financial engineering standpoint, EAT chose to do a sale-leaseback transaction, paying higher “rent” vs. non-cash depreciation of the stores in return for retiring a large number of shares. From an operating standpoint, even with flat EBITDA at the store level, we see that same store sales (and traffic) gains of 2 or 3% are not sufficient to overcome higher labor (and other) expenses.
The Bottom Line:
The above capsulized reports show that the operating challenges have not abated, and will not likely relent in the foreseeable future. Restaurant Brands’ results show how ten years of low interest rates have allowed financially astute executives to assemble a portfolio of franchised brands, but mature (Tim Horton’s and Burger King) chains can only be financially engineered to a certain point, especially in a difficult environment. Texas Roadhouse and Brinker results show how operators ranging from a Best of Breed growth company to relatively mature brands are similarly challenged.
Broader than the Restaurant Industry: There are something like 20M individuals employed in the hospitality industries, including restaurants, retail and lodging and this is a material portion of the entire US workforce. The wage increases that are so evident to us will inevitably start to affect the national averages, and the next step will be price increases. Operators of restaurants and retail stores and lodging will not allow their margins to deteriorate indefinitely. All those surcharges such as baggage fees at airlines, “facility” charges at hotels, and miscellaneous add-ons with car rentals (that add 25-30% to the quote), will increasingly be joined by higher menu prices. It’s not a question of “if”, rather “when”.
Roger Lipton
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