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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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BRINKER INTERNATIONAL UPDATE WRITE-UP

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CONCLUSION:

A great deal of progress has been made over the last year or so in terms of stabilizing traffic and sales. This is a result of the improved service, simplification of the menu, accompanied by their focus on value. The 3 for $10 meal (a starter, entrée, and non-alcoholic beverage) has apparently been a major contributor to Chili’s effort to “differentiate” their offerings. Their other efforts have been typical of virtually every chain, build on Loyalty Programs, enhance To-Go efforts, try to “break the code” on Delivery. (that means, satisfy the customer without undermining your brand or your margins). Putting it all together, though, store level margins are materially lower (necessary as the changes have been) so the progress has come at a cost. EPS is basically flat over the last four years to end 6/30/19, and that holding pattern is due to fewer shares outstanding and lower taxes. It is all Chili’s, and many others in the industry, can do to hold market share, let alone build profits. EAT has improved their position versus a year or so ago but basic store level economics do not allow them to build new stores today with attractive store level economics. With a 5% yield a year ago, at a decade long low stock price, in a ridiculously low interest rate environment, EAT has since proven to be an excellent investment. Today, with a 3% yield, when investors can earn 2.8-2.9%  in 2 year US Treasury securities, Brinker stock, without above average predictable organic growth in operating earnings, is not a compelling value.

 EAT: COMPANY OVERVIEW

Company Background and Long-Term Strategy  Brinker International operates two restaurant brands, Chili’s Gill & Bar and Maggiano’s Little Italy.  Chili’s is one of the largest casual dining brands in the country and accounts for more than 85% of the Company’s revenues.  As of the end of Q3’18 (Q1’fiscal’19), there were 1,634 Chili’s (up 12 in the last 15 months) operating in 31 countries and two US territories.  Domestically, there were 1,250 Chili’s (down by 2), 945 (up 5) of which were Company-operated.  Of the 384 international Chili’s (up 14), 5 (down 9) were Company-operated.  Acquired in 1995, there were 52 Maggiano’s in operation (no change in 15 months), all by the Company and located in the US, as of the end of Sept.’18.  Overall, in the last 15 months, the 1686 restaurant count increased by the 12 Chili’s locations. Clearly, the modest growth is coming from the international side, while the Company invests capital to improve the productivity of the domestic fleet.

During the late 1980s and 1990s, the Company pursued a multi-concept growth strategy and teamed up with Phil Romano, a restaurant entrepreneur, to develop new brands.  Macaroni Grill, Cozymel, Spageddies, and Eatzie’s were concepts developed in conjunction with Mr. Romano.  Acquisitions included Regas Grill (renamed Grady’s), On the Border, Corner Bakery and Maggiano’s, the latter two brands having been developed by Lettuce Entertain You.

Founded by Larry Levine, the first Chili’s opened in Dallas, Texas in 1975.  Norman Brinker, one of the most highly regarded restaurant executives, bought the chain in 1983 and the Company, then named Chili’s, went public in January, 1984.  The original Chili’s menu was limited and consisted of burgers, chili, and tacos, along with fries.  Under Mr. Brinker’s leadership, the menu was broadened, with one of the first additions being fajitas, a highly successful offering that is a staple on the current menu.  In the fall of ‘17 the Company announced it was reducing the items on the menu by some 30-40% in order to focus more on quality and improve speed of service.

For both brands, management is committed to strategies that produce long-term sales and profit growth, enhance guest experience, and enhance team member engagement.  Objectives include brand differentiation, operating cost reductions, and strong brand presence in key markets.  Current market conditions have obviously been challenging and the Company has developed both short and long-term strategies to address those challenges, including:

Simplifying the menu and back of house complexity by reducing the number of menu of items by 30-40%.  This has resulted in reduced ticket times and more consistent food quality.  This strategy also resulted in increasing the quality of the chicken crispers offering, implementing a new “smash” burger cooking process for burgers, adding a “smokehouse” menu platform, and a new line of craft beers.

Providing “every day value” through the core menu.  Bundled offerings could continue to be part of this strategy, but the Company is unlikely to have limited time only offerings.

Leveraging technology to engage guests.   A new on-line ordering system has been implemented, and the Chili’s app has been upgraded to enable curbside service where guests can order, pay, and notify the restaurant of their arrival, never having to leave their car.  Table top technology is being further leveraged to power loyalty programs that are likely to be a significant part of the future marketing strategy.

New prototype for Maggiano’s.  A smaller restaurant with a flexible dining area that can be used for banquet space will enable development of markets that were not appropriate for the prior prototypes.

Unit Growth. While 6 company operated Chili’s and 1 Maggiano’s opened in fiscal ’18, only 2-4 company Chili’s are planned in fiscal ’19, and no Maggiano’s. A total of 39 franchised Chili’s opened in ’18 (34 int’l and 5 domestic) . For ’19, a total of 37-42 franchised Chili’s are planned (33-38 int’l and 4 domestic). One franchised Maggiano’s is expected to open.

Sources of Revenue Total revenues were $3.14 billion in fiscal 2018 (ending June), with Company sales accounting for 97% of the total and Franchise and other revenues the remainder.  Chili’s accounted for about 87% of Company sales; average unit volumes were $2.8 million, 14.1% of which was contributed by alcoholic beverages and take-out accounted for 11.5% of sales.  The average check was $15.70 (up 2.8% YTY) per person.  Maggiano’s average unit sales were $8.3 million, 15.4% of which was contributed by alcoholic beverages; banquet sales were 17.8%. Maggiano’s offers carryout and delivery services, but the percentage of sales was not disclosed.  The average check at Maggiano’s was $28.40 in fiscal ‘18 (up 1.8% YTY).

Menu  The Chili’s menu (Chili’s Menu) consists of hamburgers, fajitas, ribs, Fresh Mex, Tex Mex and other items.  Maggiano’s  menu (Maggiano’s Menu) offers chef prepared classic Italian-American items.  Guests can order either family style of individually.

Unit Economics  A typical existing Chili’s restaurant is between 4,500 and 6,000 square feet with 150-252 seats.  According to the most recent franchise disclosure document, the current 6,028 square foot prototype seats 246 and is estimated to cost between $2,815,000 and $4,397,000 to develop excluding land but including preopening costs.  Assuming the mid-point of that range ($3,606,000) and Chili’s restaurant operating margin in fiscal 2018 (14.9%) on average restaurant sales of $2.8 million, the cash return on investment is 11.6%.  Current unit economics for Maggiano’s are not disclosed. There has not been a disclosure (that we have found) since 2010, relative to the investment in a new Maggiano’s, which was $7.5M per unit at that point.

Operating Metrics  In 2010, the Company initiated a program to return excess cash flow to shareholders.  Since then, more than $3 billion has been paid to shareholders in the form of dividends and share repurchases.  The share repurchases have resulted in Brinker having negative Stockholders’ Equity so Return on Equity is not a meaningful measure.  The Company’s Return on Assets over the last twelve months has been 10.9%.  Despite the significant share repurchases, Brinker’s total leverage remains manageable, with a lease adjusted debt to EBITDAR ratio of 4.3 times in fiscal 2017, coming down to 3.6x at 9/30/18, expected to be 3.9-4.0% as a result of the sale/leaseback in Q1’19 of 141 Chili’s for $456M.

Shareholder Returns  Brinker’s stock has rebounded nicely in the last twelve months, from a low of about $30/share, as sales and traffic stabilized and most recently moved up. It is still down from a high of about $62/share in early calendar ’15.  The Company continues to repurchase stock, having bought $105M worth in Q1’19 after buying $303M in fiscal’18.  The dividend yield is 3.1% currently and the board has an objective to pay out 40% of earnings.

Recent Developments – Per Q1’19 report  and Conference Call

The GAAP reported results were distorted (positively) by the large gain from the sale/leaseback of 141 properties. Earnings per share, excluding special items were up 11.9%. Chili’s company operated comp sales were up 2.0%, with franchised Chili’s up 1.5%. Maggiano’s comp sales were flat. Company operated restaurant margin was down 150 bp to 11.1%. The earnings release indicated that Maggiano’s store level margin increased, with a lower cost of sales, so the margin decline at Chili’s was a little worse than the indicated 150 bp.

For Company operated restaurants as a whole, Cost of Sales was up 10 bp to 26.3%. Labor was up 20 bp to 35.2%. Other Restaurant Expenses (including occupancy, but not D&A) were up 110 bp to 27.3%. Operating Income, before Interest, and Taxes, was $46.9M, up sharply from $28.6M, However, This year “Other Gains and Losses”, almost all of which was the S/L transaction was $13.3M which normalized this year’s Other Income to $35.8M. This compares to a normalized $42.0M a year ago, down 14.8%, more in line with the lower store level margin at Chili’s.

As expected, only a handful of locations opened, 5 Chili’s in total, of which 4 were international. Without question, the biggest financial event was the sale/leaseback,, generating $456M of liquidity, enhancing the Company’s ability to renovate stores, repurchase stock and pay dividends.

The operational focus, including the various operating initiatives, is steadily, if slowly, gaining traction.Same Store comps at Chili’s have improved in each of the five most recent quarters, from negative 3.4% in Q1’18 to positive 2.0% (with +4% traffic) in Q1’19. We must point out that traffic was down 8% a year earlier, a very easy comparison, but still encouraging that that the tide has turned. Maggiano’s has similarly improved comps each quarter from negative 2.6% in Q1’18  to flat in Q1’19.

Guidance for all of fiscal ’19 included a comp sales increase of 0.75-1.75% (presumably conservative, considering Q1), restaurant operating margin down 160-180bp, a touch worse than the 150bp decline of Q1, a tax rate of 14-15%, and EPS of $3.70-$3.90.

Conclusion: Provided at the beginning of this article.

 

 

 

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THE BAR & GRILL BATTLE – EAT, DIN, RRGB, BWLD, RT – “ROLLUP” OPPORTUNITY?

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

BRINKER (EAT) REPORTS – THE DIALOGUE TELLS MORE THAN THE NUMBERS

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

BRINKER INT’L REPORTS THEIR Q2 (DECEMBER) – FIRST INDUSTRY VIEW

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.