Finding Performance Gaps in the Three Financial Statements
Restaurant finance, or any commercial finance, can help inform a myriad of decisions. From restaurant performance measurement and management analysis to strategic planning and due diligence and feasibility studies, modeling the three financial statements and benchmarking and analyzing performance gaps hand in hand with operational key-performance indicators provides with insights to solve questions like:
- Are there other ways to spur growth in our target markets?
- Is it time to look for greener pastures?
- Is our portfolio performing as well as it could? What steps can we take now to maximize value in the next five years?
- How many sales per hour are lost in slow drive-thru lines? Could back-of-the-house operations be made more efficient? What about labor models?
- What are the food costs for the newest locations? How do they compare to the highest- and lowest-performing units in that region? How does that region compare to the system as a whole? What are sales per square foot? Sales per employee? Sales per labor hour?
Margins are being compressed for many restaurants and foodservice operators around the world. But the choice between driving revenue and improving margins does not have to be binary; both can be improved while catching a wider net of performance improvements.
We encourage our clients to think of restaurant business plans on both time frames: short-term wins are necessary to gain momentum and fund longer-term initiatives, but lasting organizations that transform the industry look past the next earnings call to three-, five-, and ten-year horizons — and beyond, and combining restaurant finance with operational goals and feasibility.
Insights Across the Income Statement
Restaurants’ top-line or gross income mostly consists of the sale of food and beverage. In franchised systems, a large portion of revenue could be derived from royalties and franchising fees. Restaurant finance reveals many metrics related to revenue that allow foodservice organizations to assess their top-line performance and set targets for their restaurant business plan.
- Revenue Growth Showing the Strength of Emerging Markets: Consensus forecasts for twenty of the largest publicly traded foodservice companies around the world favor emerging markets. In this group, three of the five fastest growers (based on annual revenue for FY 2019) are in emerging markets: Xiabuxiabu Catering (a QSR hot pot chain), BK Brasil (Burger King franchisee), and Alsea (multi-concept operator of brands including Domino’s Pizza, Burger King, California Pizza Kitchen, Chili’s Grill & Bar, PF Chang’s China Bistro, and Starbucks). It’s worth noting that revenue growth may differ from sales depending on the organization’s franchise level, and some of the weakest growers, like McDonald’s and Yum! Brands, have recently undertaken re-franchising initiatives.
- Restaurant Sales per Square Foot a Key Metric for Benchmarking: Among U.S. fast-casual restaurants, top-quartile performers are achieving 44% higher sales per square foot than the category’s median. For casual dining and quick-service restaurants (QSRs) these differences amount to 29% and 10%, respectively. A deep understanding of the forces driving consumer behavior and competitive performance allows to identify where and why variances in performance exist, and to obtain answers for how much and how long it would take to make the transformations to turn restaurant brands and operations from average to the top.
A deep understanding of the forces driving consumer behavior and competitive performance allows to identify where and why variances in performance exist and to obtain answers for how much and how long it would take to make the transformations to turn restaurant brands and operations from average to the top.
Restaurant Cost of Sales
- Food and Beverage Costs: in restaurants, F&B costs or COGS (Cost of Goods Sold) typically represent about 30% of sales. For coffee and snack chains, however, food costs can be much lower. Menu engineering and performance optimization can help lower food costs without affecting quality. The gross profit margin is usually calculated as revenue minus COGS.
- Restaurant Labor Costs: Wages increased in 2019 in the Americas (including the U.S., Canada, and potentially Mexico), Europe (Denmark, Germany, Greece, Ireland, Poland), MENA (Algeria, Qatar, Tunisia), Africa (South Africa, Uganda), and Asia (Hong Kong, Malaysia, Vietnam), to name just a few. In the U.S., minimum wages went up in 21 states in 2019, creating significant cost increases for restaurants (payroll represents about 30% of sales), which could see declines of up to 19% of four- wall EBITDA margins. Because of the type of service, full service restaurants typically have higher labor costs than QSR and casual-dining.
- Restaurant Occupancy Costs: Restaurant rent usually takes around 8% of sales but it’s not unusual for some chains to have large swings between high-traffic and low-traffic locations. Location strategy is key to optimize occupancy costs, especially when opening a restaurant.
- Restaurant SG&A: Selling, General, and Administrative expenses for publicly-traded restaurant chains in the U.S. reach a median of 28% of revenue. However, the bottom quartile (those with the lowest SG&A) sit at 13% or less.
- Restaurant Marketing Costs: As the battle for diners intensifies in the U.S., top restaurant chains are paying even closer attention to their marketing efforts. Based on franchisee contributions, the largest chains allocate an average of 3.9% of sales to marketing. Some of the largest pizza chains — such as Papa John’s, Domino’s, and Little Caesars — have the heaviest spend reaching marketing costs of almost 8% of sales. Thorough marketing plans and audits are required to optimize the marketing budget allocation.
Restaurant Profit Margin
- Restaurant EBITDA: Restaurant profit margins are being compressed for restaurants and foodservice operators around the world. Nearly every geography, cuisine, and operating model is being hit with increased costs relative to rent, labor, commodities, demands of modernization, competitive pricing and promotional tactics designed to take share, and a more fickle and demanding consumer with rapidly evolving dining behaviors. In the U.S. in particular, the increase in labor costs over the last five years came at a faster pace than restaurants were able to increase prices. This resulted in a margin squeeze for many operators (showing up in restaurant financial statements). While some hold their breath waiting for something to change, others are out-performing by out-working and out-investing their competition. Strategic capital allocations can improve productivity and restaurant margins while winning the hearts and minds of employees and consumers alike. It takes money to save money.
- Restaurant Net Income: The Net Income is significantly different than Operating Margins. The net income-to-revenue ratio (or net profit margin) for restaurant portfolios with three or more brands reached a median of 3.3% in 2017. Companies with fewer brands were more profitable, with median bottom lines more than 50% higher. SG&A and other expenses seem to be adding up in tandem with the number of brands. There are several rations that use the Net Income in their calculation, including EPS (Earnings Per Share) and Return on Assets.
- Restaurant EPS: Earnings Per Share are another way to measure restaurant profit margins. U.S. publicly traded restaurant companies have a median basic Earnings Per Share of $1.0 (as of 2017). The top quartile, however, reaches more than twice as much, and some companies -like limited service Domino’s, Chipotle, McDonald’s, and Casual Dining Cracker Barrel and Biglari Holdings have EPS higher than $5. There is a large swing as well. The difference between 2017 maximum (Biglari Holdings with an EPS of $40.8) and minimum (Dine Brands with an EPS of -$18.3) was close to $60.
Restaurant Cash Flow Statement
- Restaurant Capital Expenditures: Among publicly traded foodservice companies in the U.S., leaders are investing at least three times as much in CAPEX (as a percent of revenue) as the median. While the majority of businesses are decreasing CAPEX investments and debating over where they should be allocating funds — whether to infrastructure improvements or buybacks or dividends — market share winners are gaining traction with investments in guest experience enhancements, technology, infrastructure, and other competitive moat-building strategies.
Knowing how and where best to place CAPEX dollars to ensure the dominance of your brand and secure territories (and market share) requires solid plans around strategic capital allocations. Every dollar in your CAPEX arsenal is like a soldier on your competitive battlefronts.
Restaurant Financial Ratios
- Basic Earnings Power: For every $100 dollar invested in assets, restaurant chains in the U.S. and Asia generate more than $8 in EBIT (as a median). The effectiveness for generating profit margins is not as high in Europe, where the Basic Earnings Power is $5 (per $100 invested in assets). Every restaurant bleeds — it’s simply a question of where and how much. Just as banks and governments occasionally conduct stress tests to model scenarios and validate the stability of their systems under pressure, restaurant chains (and their investors) should endeavor to objectively pressure test their P&L — with increasing rigor and frequency. By performing a gap analysis and applying industrial engineering practices across functional areas, it’s possible to uncover areas of opportunity and quantify where value is trapped or hidden in a business.
- Earnings Per Share: Among U.S. publicly traded restaurants, Domino’s and McDonald’s were among the highest Earnings Per Share of 2018. As a median, restaurants reached and EPS of $1.3. As important as these metrics are (and we salute those at the top of EPS while making investments to improve the guest experience and achieve top quartile performance), in many cases investors are more focused on quarterly returns than multi-year plans. We encourage our clients to think and plan on both time frames: short-term wins are necessary to gain momentum and fund longer-term initiatives, but lasting organizations that transform the industry look past the next earnings call to three-, five-, and ten-year horizons — and beyond.
- Debt Ratio: Leverage can be a relevant tool to finance restaurant growth, and many chains are able to find sustainable ways to use restaurant loans. In the restaurant industry, the median Debt Ratio as resulting from balance sheets (debt as a percentage of assets) for U.S. traded companies (public and OTC) is 0.70 – meaning debt is equivalent to 70% of total assets. With interest rates still at historically low levels, it is a good time to assess options for financing the business, obtaining new lines of credit, and refinancing (or evaluating existing or potential partnerships). Being prepared for what questions lenders and investors will ask (from “Does the company have an optimized portfolio?” to “How are investments in technology paying-off?”) is the first step to harness this opportunity era of cheap capital.
- Debt-to-EBITDA: Restaurant finances show that pre-crisis, the debt-to-EBITDA ratio for the U.S. restaurant industry sat at 2.7x (as a median, based on public companies). At this rate, debt repayment would take close to three years (assuming all EBITDA is applied to debt repayment). The most susceptible companies are those in the Casual Dining segment that were hit in the last recession had relied on financial engineering to stay afloat for the last decade. Those with strong balance sheets are more likely to survive, but for those that were overextended or carrying too many restaurant loans pre-COVID crisis (and now having to make even more intense use of revolving facilities and other credit lines) are gonna be in trouble in the next 60 days. A lot will depend on the category, the company, and the value proposition. We expect a silver lining to come in Q3 for operators and investors who can weather the storm through the balance of Q2.
- EBITDA-to-Interest Coverage Ratio: As a median, restaurant companies trading in the U.S. have a 4.5 interest coverage ratio (4.5 times as much EBITDA as needed to cover interest payments).
- Book Interest Rate: There is large variability in the interest rates paid by industry, and restaurants are below the median. Book interest rates average 4.25% for restaurants, while the median for close to 100 industries in the U.S. reaches 4.75%. In the same way there is large variability among industries, there are large swings within the foodservice industry. Chains paying high interest rates could get additional percentage points in Net Income by refinancing debt at a lower rate (some of the materials that would be requested prior to refinancing would be CPA-prepared historical financials, detailed explanation of deal sources and uses, ownership and management team bios, a store location list, etc.).
- Current Ratio:The higher the Current Ratio (Current Assets to Current Liabilities), the more able a company is to pay short-term loans. Current Assets include: Cash and Short-Term Investments, Accounts Receivable, Inventories, and Other Current Assets. They exclude fixed assets. Current Liabilities include: Short-Term Debt and Current Portion of Long-Term Debt, Accounts Payable, Income Tax Payable, and Others.
In the restaurant industry, the current ratio reached a median of 0.72 (FY 2019 for publicly traded companies in the U.S.) and for three-quarters of the industry, the current assets are not enough to cover all short-term debt. Some foodservice companies in the bottom quartile had current ratios lower than 0.50 (current assets covering less than half of current debt). Restaurant owners can use these same numbers (current assets and current liabilities) to calculate the working capital.
While liquidity pumping into the economy is buying time, many restaurants won’t be able to sustain their existing debt levels or access financing options and business funding. This scenario will affect restaurant financing and likely lead to plenty of distressed restaurant assets and restaurant bankruptcies in the near future, which will spur activity as the global pause on M&A lifts as travel restrictions are loosened.
- EV-to-Sales Ratio (Valuation): In the U.S. and Canada, the median valuation for publicly traded restaurants (measured by EV/Revenue) is 1.5x. However, the top quartile is valued at a 176% higher multiple. While supporting with both buy-side and sell-side mandates we’ve seen that valuation multiples can actually be increased during the holding period. When the right components are combined within a platform, the whole can be much greater than the sum of its parts (and this is reflected in valuations).
- EV-to-EBITDA Ratio (Valuation): Valuations among U.S. publicly traded companies climbed by 15% even with the economy shutdown and many restaurant chains taking a substantial hit. The median valuation (measured by EV/EBITDA) was 11.1x as of FY 2019 and stands at 12.8x as of April 2020. Wingstop, Papa John’s, Shake Shack, Chipotle, and Domino’s are reaching valuations above 20x. For those sitting on dry powder, this is going to be an extraordinary time to put capital to work by Q3 — finding the right concepts (based on format, location strategy, technology, moat building, etc.) and at the right valuations.
Relevant Insights to Restaurant Finance
ABOUT AARON ALLEN & ASSOCIATES
Aaron Allen & Associates works alongside senior executives of the world’s leading foodservice and hospitality companies to help them solve their most complex challenges and achieve their most ambitious aims, specializing in brand strategy, turnarounds, commercial due diligence and value enhancement for leading hospitality companies and private equity firms.
Our clients span six continents and 100+ countries, collectively posting more than $200b in revenue. Across 2,000+ engagements, we’ve worked in nearly every geography, category, cuisine, segment, operating model, ownership type, and phase of the business life cycle.