Buy-side investment teams look closely at a restaurant target’s balance sheets, also known as statements of financial position, to get a quick snapshot of the organization’s financial health.
The largest players’ balance sheets contain some important lessons for operators of all sizes. Intangible assets and goodwill make up about 15% of assets — no small sum for organizations with millions of dollars in assets — so it’s worth paying attention to intellectual property and reputation. Many big chains are taking on debt to buy back stock or increase dividend payments, which could threaten long-term stability. High franchising ratios seem to correlate with lower shareholder equity ratios. The decisions that the balance sheet documents can have profound effects on a restaurant chain’s present and future performance.
Restaurants Often Have Lower Accounts Receivable and Higher Cash & Cash Equivalents Than Other Industries
The accounting equation at the heart of the balance sheet shows the relationship between assets (what economic resources the company controls), liabilities (what the company owes), and equity (what the shareholders collectively own), as follows:
Assets = Liabilities + Equity
The ratios between line items in each category provide important information about the business and industry: manufacturers have high levels of plant and equipment assets; retailers have high inventories; service companies keep almost no inventory on hand.
Restaurants tend to have low-to-moderate inventory levels, though this will depend on the type of operation. For example, a company marketing fresh juice or salads will keep lower levels of par inventory than an establishment that serves wine or liquor, which have longer shelf lives.
The amount of plant and equipment will vary based on a foodservice operation’s ownership system. Lightly franchised foodservice operations — those with two-thirds or more company-owned units — often allocate a significant portion of their capital to property, plants, and equipment. But heavily franchised chains, like McDonald’s, which is aiming to hit 90% franchised in 2018, require their franchisees to make major capital investments, alleviating the corporate CAPEX burden.
Heavily franchised systems also often have higher levels of intangible assets than lightly franchised operations, since they expand by selling rights to franchisees for use in specific locales.
Restaurants usually have high levels of cash and cash equivalents, since payments are made at the time of service. But they also tend to have high levels of current liabilities, implying limited working capital.
Intangible Assets and Goodwill Account for Up to 92% of Total Assets
Foodservice companies’ intangible assets typically include their trade name, trademarks, franchise relationships, and reacquired franchise rights. Goodwill represents the premium over the market value of net assets required to acquire the company.
These items on a restaurant’s balance sheet have an indefinite life and are not amortized, but they are tested for impairment annually — or more often in the event of a crisis that might impair their value (say, for example, a protracted foodborne illness outbreak).
Companies in the S&P 500 have a high rate of intangibles-to-total assets, reaching 84% of total value in 2015, mostly from intellectual property. Only two restaurant companies surpass that percentage: Bojangles’ (85.5%) and Papa Murphy’s, with 92% (worth $226.4m in 2017) of its total assets being intangible assets and goodwill.
The majority of Papa Murphy’s goodwill was generated in May 2010 when affiliates of Lee Equity Partners acquired all of PMI Holdings’ equity interests in the pizza chain, though the company has also recognized goodwill after acquiring stores from franchise owners.
Only five companies don’t report any intangible assets or goodwill on their balance sheets. Three of those — Cracker Barrel, Kona Grill and The ONE Group — are lightly franchised, with 0%–6% franchise locations.
Domino’s Liabilities Are 4.3 Times the Value of Its Assets
Foodservice companies tend to have high liabilities-to-assets ratios, with a median 63.5%. The top quartile, however, consists entirely of companies with more liabilities than assets, making this set highly leveraged.
Domino’s Pizza’s has primarily used its snowballing leverage to support a substantial stock repurchase program, spending $1.06b on this initiative in 2017, one of the largest in the industry relative to market cap. This leverage ratio greatly increases the company’s risk of default in economic downturns.
Several other top-quartile companies, such as Yum! Brands, McDonald’s, Jack in the Box, and Brinker International, have also used their access to low-interest debt to fund share repurchase programs or support growing dividend payments.
These companies may fall into the trap of pleasing their investors at the expense of their long-term financial health. A quick boost in share prices thanks to dividend distributions or share buybacks could easily be offset by deteriorating financial health and poor reported results down the road if the companies fail to service this debt.
While most companies in the top quartile of liabilities-to-assets ratios are heavily franchised, the majority of operations in the bottom quartile have majority company-owned locations. These lightly franchised systems don’t have access to a stable flow of cash from franchisees, which makes them more hesitant to take on liabilities.
More than Half of Public Companies Use Debt — Not Equity — for Financing
As a median, U.S. publicly traded restaurants have 42.5% of assets financed by equity. For the top quartile, equity reaches 62.1% of assets or more, indicating that they are more often locked up with debt than equity.
But 25% of public companies are in a riskier position, with negative shareholder equity, which indicates that a company owes more than it owns. Domino’s shareholder equity ratio sits at ‑326%, and Yum! Brands has a -119.3% ratio.
The number of companies with negative shareholder equity ratio goes down as the percentage of franchised locations decreases: the majority (69%) of heavily franchised systems have a negative shareholder equity ratio, whereas only 20% of moderately franchised operations and just 4% of lightly franchised public restaurants have negative ratios.
McDonald’s and other heavily franchised chains are relying on the relatively stable cash flow from their franchisees to meet their debt obligations. These systems also have relatively minimal capital requirements and open fewer company-operated stores, implying that cash flow will likely be used to cover interest expenses, dividend distributions, and share buybacks.
Starbucks Claims Highest Net Worth; Yum! Brands Has the Lowest
Starbucks’ $5.5b net worth, calculated by subtracting all liabilities from a company’s assets, is 47x the foodservice industry’s $113.9m median. The company’s giant nest egg indicates that its executive team prefers to pay for expenses with equity rather than debt financing.
Further, in 2015, the company had a 2-to-1 stock split, making shares more affordable for smaller investors. Reducing stock price usually sparks investor interest, consequently driving up prices per share and enriching existing equity holders.
Though balance sheets for all companies will include the same line items, understanding what a restaurant’s balance sheet says about the company requires in-depth knowledge of how the foodservice business works, what forces are shaping the industry, and what motivates executives to pursue certain reinvestment, payout, and buyback strategies.
With that kind of knowledge, a balance sheet will not only give buy-side investment teams a clear picture of the organization’s present financial health but important insights into its past and potential future performance.
ABOUT AARON ALLEN & ASSOCIATES
Aaron Allen & Associates is a leading global restaurant industry consultancy specializing in growth strategy, marketing, branding, and commercial due diligence for emerging restaurant chains and prestigious private equity firms. We help restaurant operators and investors make informed decisions, minimize risk, and maximize sustainable value. With experience on both the buy- and sell-sides of transactions, we have a robust understanding of trends and factors impacting restaurant chains and private equity funds around the world. We help protect, enhance, and unlock value throughout every phase of the investment lifecycle. Collectively, our clients post more than $100 billion in annual sales, span all 6 inhabited continents and 100+ countries, with tens of thousands of locations.