Labor costs and possible recession stoke fear among operators

At the Restaurant Finance & Development Conference, a sense of concern about the state of the economy prevailed, even as technology provides opportunities, says RB’s The Bottom Line.
Photograph by Jonathan Maze

The Bottom Line

Cheap money has fueled a lot of restaurant industry growth over the past decade, helping operators build thousands of restaurants, add hundreds of thousands of workers and develop new ways of serving prepared food to customers.

Yet, at the Restaurant Finance & Development Conference this week, there was a sense that perhaps the industry has hit something of a turning point. There are rising labor costs, declining traffic and a potential recession. And the cheap money spigot might not flow so freely in the near future.

That’s especially true if other costs, such as commodities, add to the profit pressure many operators are feeling.

“The U.S. dollar has been saving us,” said Kevin Burke, managing partner with Trinity Capital, at the conference. “When these things start to turn, a lot of [profit-and-loss statements] are in trouble. Banks are watching. It’s important to focus on this now.”

To be sure, the restaurant industry is remarkably strong. Technomic data says this year has been the best for chain restaurants since 2014. Same-store sales, particularly for quick-service chains, have improved in 2019. Popeyes Louisiana Kitchen, Chipotle Mexican Grill and Wingstop all generated double-digit same-store sales last quarter.

Meanwhile, retail closures are on a record pace this year, and other consumer sectors have been hammered as internet-based businesses from Amazon to Uber to Netflix render them obsolete. That has made the restaurant industry a safe haven for lenders, private-equity investors and entrepreneurs.

A number of chains have received strong valuations as a result, including Sweetgreen, Cooper’s Hawk Winery & Restaurants and Chicken Salad Chick, the latter of which received a multiple “in the high teens,” sources said.

But that investment isn’t created equal, and in recent years, investors have started shying away from anything less than stellar. As consumers have chosen winners and losers, investors have followed suit.

Houlihan’s, Perkins & Marie Callender’s and Restaurants Unlimited all filed for bankruptcy recently after spending months or years working to find buyers, demonstrating the weakness in many sectors of the market.

“It’s really created a situation where we have winners and losers,” Damon Chandik, who leads restaurant investment banking for Piper Jaffray, said at the conference.

The biggest concern echoed throughout the conference was the impact of labor costs. Restaurant operators’ top fear, by far, is labor. That’s assuming they can even find labor, which many operators can’t.

Minimum wages are rising in many states and localities, and even when they’re not, operators are finding they have to pay up to attract a dwindling group of workers. “In some high-wage jurisdictions, over the next three years, some operators are going to lose all their cash flow to higher wages,” Burke said.

The response has been to raise prices. Menu prices are up 3.3% over the past year, 230 basis points higher than the rate at which grocers are raising prices, according to federal data. There is evidence the industry has lost its pricing power.

For instance, McDonald’s same-store sales are up 5% so far this year, but traffic remains down. Chains such as Del Taco and The Habit Burger Grill are also reporting higher sales and lower traffic. The Black Box index has repeatedly shown higher sales and lower traffic.

Restaurants’ response has been to push for technology. Delivery and ghost kitchens were major themes during the conference, as were topics ranging from insects on the menu to artificial intelligence.

The push for technology holds some promise to make a labor-intensive business more efficient. But at the same time, it’s giving a major advantage to the large chains with the financial power to add technology. Few companies can afford to spend $300 million on fancy drive-thru screens, which is what McDonald’s did when it bought Dynamic Yield earlier this year.

Keeping pace will require size. And with growth harder to come by in what is largely a saturated industry, that is leading to more industry consolidation. “Consolidation is definitely on the rise,” Chandik said, noting that companies looking for growth and rising cost pressures are major factors. “Technology is also driving consolidation.”

But maybe the biggest concern at the conference was the potential for a recession. During a debate between two economists, neither disagreed that a recession was coming. The only question was when.

“We are going to have a bear market, and we are going to have a recession at some point,” said Brian Belski, senior chief investment strategist for BMO Capital Markets.

“It’s out there, and it’s happening sooner than many people think,” said David Rosenberg, senior economist with Gluskin Sheff. “Thirty percent of the economy is already in a recession.”

And even growing chains are bracing themselves for that inevitability.

Scott Svenson, who founded MOD Pizza with his wife, Ally, said the company is keeping price increases to a minimum. “That last thing is to be leaning too heavily on price when the consumer is going to be looking for value,” he said.

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