Season 2 Episode 1: What to Expect in 2020 for Restaurant Sales and Profits?

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02.05.2020

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Welcome to the Restaurant Boiler Room, episode 27. I'm your host, Rick Ormsby, Managing Director at Unbridled Capital. Today in the Boiler Room, we talk about The Habit being acquired by Yum! Brands. Yum!'s history of M&A activity over the last 25, 30, or so years. Krystal just declares for bankruptcy. What does that mean for the industry? What do we expect from sales and transactions in the franchise restaurant space in 2020? The announcement of Jay Rutherford as Chief Operating Officer at Unbridled Capital. And two deals that have recently closed in the KFC and Burger King system.

The Restaurant Boiler Room is a one-stop shop for multi-million dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations, and risk delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on a monthly basis. Feel free to find our content at Unbridled Capital's website at www.unbridledcapital.com.

Now let's enter The Boiler Room. So we had The Habit, the announcement just recently The Habit Burger Grill actually was acquired by Yum! Brands. Interesting acquisition for Yum! Just to give you a little bit of what The Habit is and what they do, they're about a 300 unit franchise based in the California area. I believe their headquarters is in Irvine, California.

They're known for open kitchens, outdoor patios, and interiors enhanced with natural light, polished stone, and hardwood accents, and has a balanced daypart mix of about 50/50 with lunch and dinner. They're big in online ordering, mobile apps, kiosks, and drive throughs. They have a char-grilled preparation technique is what I'm reading here from some article on QSR magazine that talked about cooking over an open flame with an open kitchen, a variety of burgers, chicken, tuna steaks served in sandwiches and salad, which are made to order using fresh ingredients.

I thought it was interesting. They're a big player in California. They have average-unit volume evidently of about $1.9 million. The same store sales look to be about 3.1% recently. Yum!! is evidently excited about it from Greg Creed's outgoing message about the start of the new year and the acquisition of The Habit restaurants. Yum! evidently is going to pay $375 million for the brand. To strike my earlier comment, there's actually 270-ish restaurants in 13 states, again, with a heavy concentration in California.

Just thinking about the acquisition a little bit, Yum! corporate and the people there seem to be excited about it. I have a couple of comments. On the positive side, I could say, "Hey, I could see where it could be a nice fit." It's a fast casual concept that's gained a lot of popularity on the West Coast. It probably has a lot of room to grow across the country, but isn't in a lot of markets back East or in the Midwest.

So what's a way to get that engine of growth moving forward? It's to link up with a big company like Yum! through both their franchisor and through franchisees. Since Yum! is a KFC, Taco Bell, and Pizza Hut portfolio, they don't have a burger concept. So I suppose franchisees, if they liked the unit economics and investment potential of The Habit Burger in their towns, might decide to build this thing organically in their markets, and you could see some decent growth.

I would make the forewarning that if that's what ends up happening, we don't want it to go the way of A&W. When Yum! acquired Yorkshire Restaurants, and Long John Silver's, and A&W, and started putting A&W restaurants somewhat haphazardly in KFC's that needed a remodel across the country. So back at that time in the early 2000s... and I'm getting to a point here, so be patient with me... but you would have corporate KFC might've owned, I don't know the number, maybe it's 20% of the restaurants at the time, but they're in various markets.

You'd see a KFC come up for remodel. The store was doing marginally well with profit. You didn't know if it was worth a two or $300,000 remodel. So the idea came up of making a multi-brand restaurant, so that it would do more in sales, and then the remodel could be more easily justified, and more profitability could come out of the restaurant.

That was a great idea in theory. Of course, you have a lot of KFC, Taco Bell multibrand still in play throughout the country, and a lot in vibrant communities, especially in smaller towns. What essentially was happening was the strategy was a poor one, frankly. You drop an A&W into a KFC in Orlando, and then you drop an A&W into a KFC in Phoenix, and then you're doing another remodel of a KFC in Norfolk, Virginia, and you do the same thing.

That strategy over time created 150 or so, let's call it maybe more, maybe less, KFC/A&Ws, but they're shotgun spread throughout the country and there's no marketing potential. In other words, there might've only been four or five KFC/A&Ws in Phoenix, not enough marketing clout to be able to give a really strong brand message. Then because of that, it just got marginalized, both at the operational level, but at the sales and marketing level. The A&W brand within the KFC only would do 10, or 11, or 12, or 13% of sales. It was difficult to make these products work. It was very complicated for a manager to manage two types of concepts.

Okay, so what in the heck am I trying to say? I'm trying to say that if The Habit Burger grows through Yum! franchisees in their various markets, my forewarning to Yum! would be to be careful about how quickly you spread it thinly throughout the country because it's difficult to market a brand that's not national in scale that needs market specific marketing. You really want to try to build a contingency of stores in one place, where the customer really knows about it, and you can drive all kinds of great marketing and advertising programs. That's my comment.

Now, that being said, great distribution mechanism through Yum!, a lot of money through Yum!, the Yum! franchisees don't currently, many of them at least, have burger holdings, so that'll be interesting. As an aside for Yum! franchisees, it may have a negative play on their ability to get into brands like Wendy's, and Burger King, and some of these other burger brands. We'll have to see what the non-compete will look like there as we move forward.

The other piece of it for The Habit Burger Grill that I like is I'm sure Yum! has got all kinds of purchasing power synergies that are going to be able to reduce food costs, particularly for The Habit Burger franchisees and corporate locations. My understanding is that most of the location, I think it's like more corporate locations, I believe. Yeah, 237 corporate run locations and 28 franchise locations, so there might be some re-franchising, who knows, that happens out of this transaction as well.

Now on the negative side, I guess my comment is I don't know the exact numbers, but I would be guessing that The Habit Burger only represents one or 2% of Yum!'s operating profit. It's such a small acquisition that I think you have to build in some really aggressive targets over the next four or five years, just to get to a meaningful level of interest for the overall revenue and profit capability for Yum!'s company.

It's a small company. I've seen a lot of this in the past. McDonald's did it, and several big restaurant chains did it in the mid 2000s with the advent of the fast casual industry, where they would buy some up and coming, interesting fast casual company. It would be so meaningfully small as a part of their total revenue and operating profit, maybe 1%, or even less than 1%, that it just over time ended up being more of a distraction than it was value for the long-term company. Then they flounder with it for five or six years and they sell it. If they're lucky and sell it in a good market, they sell it at a good price. Maybe they've done a good job with it, but it didn't fit the overall strategy.

Frankly, I see this a lot on the franchisee side. I just talked to a franchisee today. He's got 100s and 100s of locations. His comment to me was, "I've got three or four brands that I've got 50 to 100 locations in, but I've got all these other brands that operate where I've got 10, or 15, or 20 locations. It's more of a distraction to me than it's worth anymore. I want to get rid of the ones where if I have 20 of something, but I own five or 600 restaurants. 20 of something just isn't worth my time. It's too small of a percentage of what I do and what I control."

So I hope that doesn't happen to The Habit Burger with this acquisition, but by all means, I wish The Habit Burger folks success. I think Yum! is a fantastic company, no doubt about that, great leadership, wonderful brand story. The last thing I would say is with a heavy concentration in California, that brand needs to diversify. California's got high minimum wage and really just incredibly difficult, just very litigious environment.

Someone once commented to me a big, big 1,000 unit or more franchisee that their legal team, probably 10% of their units are located in California, but 80% of their legal actions and such are in California. So moving outside of California is clearly in The Habit Burger's best interest while building on their core there. Hopefully, Yum! can give that delivery mechanism for them, so that's good news.

Then I was just opining about, and talking a little bit about, and thinking a little bit about Yum! Brands, and I say to myself, "Okay, well, let's take a walk down Yum! Brands lane over the last, call it the last 20 or 30 years." What about them? They got them over 50,000 units across the world and lots of units, both domestically in the U.S. KFC is obviously the biggest with only 4,000-ish restaurants in the U.S., but just a ton of stores in China and throughout the world.

If you look back to Yum! just in some recent history, it was for those of you who didn't know, it was owned and controlled by PepsiCo, and there's still a big PepsiCo culture within Yum! Brands. Pepsi acquired Pizza Hut in 1977. Then they bought Taco Bell in 1978. Then they bought KFC in 1986. They decided to spin off the restaurant business into a new entity in 1997 and became a publicly traded company, Tricon Global Restaurants. I Only imagine Tricon, Tri, being three, would be for KFC, Taco Bell, and Pizza Hut, particularly.

PepsiCo did that in 1997 with KFC, Taco Bell, and Pizza Hut. Then they had other brands like Chevys Fresh Mex, and some other ones that were sold off separately. Then Yum! operated in 1997, pardon me, Tricon did in 2002, and I was actually working at Yum! at this time. Tricon bought Long John Silver's and A&W restaurants from Yorkshire Global Restaurants located in Lexington, Kentucky actually, which is right down the road from Louisville, just about 70 miles to the East.

At that point, Yum! was formed, ticker symbol, YUM. I think it had been ticker symbol, YUM, before that, but the company was renamed Yum! Brands, which is the current name of the company. They've had a couple of other partnerships, and acquisitions, and things like this over the year. In 2003, Yum! acquired Pasta Bravo. Do you guys remember that name? They co-branded it with a couple of Pizza Hut locations. Then they developed the Wing Street chain, which was a branded wings chain that was at a time really prevalent in some of the Pizza Hut restaurants across the country, especially delivery units.

I'm trying to think, in 2011-ish timeframe, Yum! sold Long John Silvers and A&W to the franchisees and a franchise group here in Louisville. Long John Silver's is still located here in Louisville, Kentucky. Its corporate headquarters is, but the brand is has shrunk quite a bit over the years due to poor performance.

During that time, sometime I can't remember exactly when, there was a bit of a partnership with Backyard Burger and Yum! Brands too, if some of you guys remember that. I think Backyard Burger was a Memphis based chain, potentially. They had some good burgers and some interesting sandwiches. There were some multibrand locations in Louisville, and then throughout between Louisville and Tennessee, that popped up over some time, but they didn't really hold and do well. I don't know exactly what happened with that partnership.

In 20126, Yum! spun off its Chinese business to a separate entity called Yum! China Holdings, a publicly traded New York Stock Exchange company, YUMC. I believe a lot of analysts say, and I'm not an expert in this, but I believe a lot of analysts say it's one of the few places where you can make a pure play China investment and still be buying stocks in the U.S. Then here we have Habit Grill at the end of 2019, early 2020. So that's a poor man's history of Yum! Brands over the last 30 or 40 years.

Another thing that caught my eye, maybe you guys saw this, was talking this, it's like the 22nd of January, just a couple of days ago, the Krystal organization filed for bankruptcy. It's the second time, I guess, they've done it in the last 30 or so years. In 1997, they did it. In the past 12 months, Krystal has evidently, and this guy from QSR magazine as well, so I'm just reading from one of their articles. Krystal shuttered evidently, through this article, 44 locations over the past 12 months. They've reported assets between 10 and $50 million and liabilities between 50 and 100 million dollars, evidently. They made the bankruptcy filing in Atlanta.

They used to be obviously formed and started in Chattanooga. Now they're located in Atlanta, their corporate headquarters moved there recently. They're owned by Atlanta based Argon Capital. There are 182 corporate units across nine states, primarily in the Southeast and a heavy concentration, obviously, around the Tennessee, Florida, Georgia area. Then franchisees own another 116 stores. What I found, I guess, in the article, it said their customers are going to continue to enjoy the same food. They're just redoing their debt and seeking relief.

I saw in this article on QSR magazine, that there was just a couple of things that caught my attention, and I'll read directly from the article. One of the people quoted here, which I think is someone who works for the Krystal's organization said in chapter 11, "That the chain experienced strong industry specific headwinds due to a combination of shifting consumer tastes and preferences, growth in labor and commodity costs, and increased competition, and unfavorable lease terms."

I just wanted to pause there for a minute, and this is not a Krystal specific comment, but it's more of a broad comment for the industry as we look into 2020 and beyond. The industry specific headwinds, shifting consumer tastes and preferences, and that is no doubt the case. I make the case all the time that today's younger generations, and I see it in my own kids, and I see it in the guys that work for Unbridled Capital, guys, and gals who worked for Unbridled Capital, who are younger than me, that they typically like spices, and flavors, and different combinations, and different tastes, and preferences than maybe my generation or a generation older than me. So I see that. Of course, that has been shown to be true with the proliferation of fast casual restaurants and really some of the cool hipster-like independents and local establishments that are gaining in popularity too.

It says also in this quote that, "The growth in the labor and commodity cost markets." That's true. We're seeing some significant increase in labor costs. I think we're now at close to 25-ish states across the country have enacted their own statewide legislation that's higher or different than the federal minimum wage. As these labor costs roll through, I mean, goodness gracious, the cost of doing business is increasing if your labor is. A percentage of sales raises from 28 to 31% or 29 to 32, or 30 to 33, that's a 3% of sales increase in labor.

Let's just say your margins after paying your debt and everything were only five or 6% anyway. Let's say they're 6%. Well, gosh, with that increase in labor, you've just cut your profits in half immediately. That's if your sales are staying strong. What happens if your sales are losing? So that's something to continue to keep watch of in the industry. Commodity costs are experiencing a little bit of pressure, more so in spotted areas like wings and other areas, and not maybe overall. But we're seeing increased commodities, modest increase in commodities across the different areas over the last year.

When we talk about the growth and labor costs... and here I go off on a tangent again... I would say that it's interesting that some clients and friends of mine are now telling me that they're ... These guys are buyers like family office guys, and private equity guys, and large franchisee groups that are looking to buy more units. They're telling me that they are thinking of high labor markets with less jaundice than they used to.

I'm like, "Why is that?" They're citing the Northeast, or maybe some areas in the West Coast, or in the Midwest, where minimum wage has gone up. Their comment to me, it's interesting. It's that, "At least we know that the minimum wage has already been baked into the P&L, and there's not likely in many cases to be more massive wage increases." Most have a cap once they get to a certain minimum wage threshold, either it stays there, or it increases by CPI or something like that, which is maybe much more manageable, a couple of percentage points a year.

So that once you go through the headache and heartache of having to adjust for this huge minimum wage increase, and having to adjust your prices, and raise your prices, and cut your labor, and send people down to part-time, and all the things you have to do to make ends meet, and make a profit, buyers at least are not as negative as they once were on high-wage markets.

Because the flip side of that is, "Hey, Rick, what if I buy 50 locations in Georgia, and next year they raise the minimum wage to $10 an hour over two years? I've just bought an asset that's actually got a lot more risk to it than one that already has taken in different states, has already taken the minimum wage increase." So it's just something interesting to note.

Part of this Krystal's comment, again, was talking about increased competition and unfavorable lease terms. Both of those are big deals. Even though I would submit to you that you see a lot of, if you drive by, a lot of stores being Amazon-ed out of business, retail stores across the country. In just our little town of Louisville, Kentucky, we'll see it as these strip centers that have occasional open spots. I don't know if that's the case in other places.

But even though the Amazon-ing effect is bringing some pressure to the retail space, it is true that these lease terms have gotten very, very difficult and expensive, especially for good restaurant real estate. The terms are unfavorable in many cases. The square footage costs for strip centers and end caps particularly have risen a lot. The CAM costs, the personal guarantee language, the assignment language, the terms on the leases, the increases on leases over a five-year period, all of this stuff has gotten more unfavorable. As franchisees and franchisors have operated these stores and are running into lease increases, 15% after the end of five years, 10% at the end of five years, with flattish sales, it hurts profitability, and competition is another one.

So Krystals, as evidenced in this QSR magazine article said, "Has credited the proliferation of fast casual restaurants, as well as delivery online platforms, in creating new competition for traditional quick service chains. Moreover, quick service restaurants have faced increasing difficulty finding and retaining qualified employees in the current labor market."

Again, I've been saying this for probably the last five years. If you look at our videos or any of our other podcasts or white papers, I talk about this a lot. Fast casual has really, and development placed on traditional QSR brands have put a lot of new units in the ground all over the country. If your new unit growth is a point and a half or 2% a year, and the industry is only growing at one and a half to 2% a year, maybe less, then what you've got is you've basically got a no growth situation in terms of sales and existing restaurants.

In other words, the new restaurants are stealing almost entirely from old restaurants. What that's going to create and has created is a bifurcation of good restaurants, and good brands, and bad ones. I think we'll just continue to see the good brands be more highly valued and more successful because they can staff, and make changes, and invest in marketing.

And oh, by the way, the cost of all this online apps, and kiosks, and all these things is ridiculously high. Only the best companies with the most amount of money are going to be able to hang in there long enough to make it work, i.e., Domino's, and Starbucks, and Panera. They just had such a huge advantage over everybody because they spent so much money, and they did it so much, and they did it so soon. But if you're one of these bifurcated brands that isn't performing well, you can't keep up, and it's eventually going to kill you.

Online delivery is another issue. We all know it's really not all that profitable, but somehow, some way it's going to be figured out in a model or a way that's a little different than where it's currently being offered right now. The companies that are doing the best can hang in there the longest to figure out a profitable model for delivery in a limited format, while the other companies are not going to be able to do that.

I guess lastly, I would say I'm right on with retaining and finding qualified employees. The job market is ridiculously tight. You can go next door to your Target and get paid two or three dollars an hour more than you would in a fast food or fast casual location. The work is easier, so why the heck wouldn't you do it? I know that's a big concern for operators across the country.

Okay, sort of rambling here. Let's see, what to expect in 2020? I put that as a point to talk about today. Really, I just talked about it through this last few minutes, talking about the Krystal's bankruptcy. But I guess I would say November, the sales and comps looked up a little bit per TDn2K research. It looked like November was up maybe a point, point and a half in sales and traffic was down about 1%, which is a significant improvement over this flattish to negative sales trend over the last few months. Then an alarming restaurant traffic of down three to more than that percent.

But we had some timing effects of Thanksgiving that made the November numbers look a little bit better on an overall monthly basis than what the run rate was leading up to Thanksgiving. So while I haven't seen TDn2K's report for December yet... It maybe out there, I just haven't seen it... I think I would expect us to return to a flattish, to slightly negative sales environment in December with traffic going back to its negative 3%-ish rate year over year. Meaning that operators continue to hold sales flat by increasing their pricing.

We all know that game can't last forever. You've got to drive organic, and new traffic, or repeat traffic into your stores long-term in order to have healthy and sustainable same-store sales growth. Just my gut tells me from chatting over the last few weeks in January with operators across the country, and now this is a limited perspective, but my gut tells me that January over last year is not looking all that strong.

So, I guess, it'll certainly depend on what happens with weather across the country. January's always a crap shoot when you're looking year over year, if you're hot in one market, and it was cold last year, you could be selling rotten avocados, and do better if it's warm this year over last year, in jest. The converse is true as well. If it's cold this year and it was warm last year, you could see huge decreases in same-store sales, even when the health of the brand or the concept is not considered. So we'll keep an eye out for that.

Two other things I wanted to talk with you about today I'm proud of. One was I hired Jay Rutherford in our company as chief operating officer. He had a write up in Restaurant Finance in the Restaurant Monitor, and I'll just read that to you, a cool story, so thanks for listening. The article's entitled Former Franchisee Joins Unbridled team. This was in the December issue of the Restaurant Monitor.

"According to Jay Rutherford, he's always found himself in the restaurant business. 'I started in the family business right out of college,' he said. His father, Jay Rutherford, Senior operated a number of Long John Silver's for 17 years before buying into the Taco Bell system. Rutherford Senior also opened up Valvoline Instant Oil Change shops, where the younger Rutherford cut his teeth on that business by managing a store.

"'But we soon found out the investment to get into the Valvoline was the same as Taco Bell and Taco Bell returns were so much better.' He said. They sold the Valvolines and instead focused on building up their Taco Bell business. Later in 2015, he and his dad hired Rick Ormsby, currently managing director at investment banking firm, Unbridled Capital, to sell their eight locations. 'After the sale.' I thought, 'What I want to do now?' Said Rutherford. 'About the same time Bojangles was on a development path in our area, and I knew the market well, and I built that business to five stores finally leaving that in August.'

"His winding road of experience in restaurants brought him to a point where he finally had to move on. He said, 'I had been thinking about my career path for some time. It was a good time to get out for me personally. I'd been keeping up with Unbridled Capital and I've known Rick personally for 10 to 15 years at least. He's been a friend who's always been interested in me,' Ain't that coal, by the way. 'I saw a good opportunity with Rick when he asked me to join the team.'

"As chief operating officer, Rutherford will oversee all aspects of the business. 'A very difficult job,' says Ormsby. Ormsby felt he needed to add the COO position if he wanted to grow the business and do what Ormsby himself, does best, go see clients and drive the business. 'I couldn't have just have a deal guy or a finance guy do this. I knew this role would have to manage the entirety of the business. It's everything from finance and marketing to administration. It's difficult to find someone with that broad of a skillset,' I said or he said.

Ormsby had an aha moment. 'A really successful franchisee is the perfect kind of person to handle the broad responsibilities of managing a business. They balance the checkbook. They develop new stores. They lead HR and they hire and fire. They handle customer complaints and deal with Pepsi and Dr. Pepper. They're good business people. Jay had all of this and I knew he could handle these functions for Unbridled Capital.'

"So six weeks into his new job as chief operating officer, Rutherford says he's still learning, but is excited about what he brings to the table. 'I can understand a franchisee's way of thinking and their processes." Rutherford said. And as he has sold restaurants, which can be nerve= racking, he reports, "I understand their feelings 150%. This is their life work. Maybe they're nervous because they don't know what the next chapter will look like. I can talk through that with them.' For Ormsby, 'It signals to their franchise clients that we believe heart and soul in franchisees because that's the type of person we brought into the company.'"

I totally believe that. If you want to reach out to Jay Rutherford at any time, his number's 502-252-6427. By email. Jay@unbridledcapital.com. Jay's a great guy, pumped to have him on the team as COO. He does have a tough job, but he's the right kind of guy for the job as a former Taco Bell and Bojangles franchisee. He indeed shows that we are committed to the heart and the very soul of the franchise community, so I'm happy to have him. Welcome aboard, Jay.

And lastly, just to report two deals that we recently just closed. We just sold 14 KFCs for Alice J. Schleicher, Inc. In Indiana and Kentucky. Sold those to Houston Enterprises, USA, led by Mike Houston. The Schleicher family will continue to be KFC franchisees in the Southeast. Mike is a franchisee, but he will grow in a new market. MidCap Financial Services provided the financing for the transaction And National Retail Properties bought the real estate as per the January article in Restaurant Monitor. I've just made a quick quote that, "This business was not sold to one of the large consolidators in the KFC system. And as such, I'm just proud of the fact that we brought in a smaller operator and we provided the service of extra focus on financing, due diligence, and corporate approval to get the deal done."

Then in another transaction, we recently helped sell 35 Burger Kings for For Northwest, LLC in the Washington State region and sold them. Fifth Third Bank and Chase provided the debt financing for the buyer. This was our first Burger King closing, I'm excited to say. Really excited about our future within that brand. Really like that brand and excited for it.

In closing today, I'd like to say just came back from a convention in Puerto Rico, and so shout out to the resilient Puerto Rico people. Having been down there for a little less than a week, I'll tell you, they've had a rough go of it. In 2017, Hurricane Maria did some nasty things to that island and some really historic things.

When we were down there, they've experienced a series of earthquakes. While we were there, there were probably 20 or 30 earthquakes, every 24 hours. Now a lot of them were small tremors, but they had a 6.4, and I think a 6.0 on the Richter scale, maybe a couple of 5.9s. The southern part of the Island down near the second largest city called Ponce and in a little resort town called Guánica have been really affected.

You've got 100s of people living in tents, and I think 300 or 400 homes at least that have been in businesses that have crumbled and they're structurally unsafe. So the Island just really continues to try to pull together through some adversity and turmoil. Thoughts and prayers go out to the Puerto Rican people. They're part of our great country as a U.S. Territory, and we wish them the best they try to get through at all.

Well, thanks so much for entering The Boiler Room today. You can find our podcasts on iTunes, Google Play, Stitcher, TuneIn, and Spotify. If you like these podcasts, please listen, rate, and review. I also encourage you to visit our website at www.unbridledcapital.com for the best franchise M&A and financial resources in the industry. Our website includes podcasts, videos, white papers, analyst of our M&A transactions. Please note that neither Rick Ormsby nor Unbridled Capital LLC give legal, financial, or tax advice. These podcasts represent opinions that have been prepared for informational purposes only. We expressly disclaim any and all liabilities that may be based on such information errors therein or omissions therefrom.