The restaurant business is in an uncertain place. Trepidation, about consumers, about the lending market, about regulations and the upcoming election, was the hallmark of the recent Restaurant Finance & Development Conference in Las Vegas this week.
“Consumers are trending toward more anxiousness,” Lisa Miller, a consumer strategist, said at the conference this week. She might as well have been talking about many of the 3,500 or so people in attendance.
Economists were convinced a recession was coming as the Fed raised interest rates, but that recession has yet to come. Nevertheless, consumers appear to be shifting into that anxious and fragile state. Traffic is down. Yet operators, with almost no pricing power, keep raising prices because their own profitability is challenged.
Lenders and investors see all of this. And they reflect much of the same anxiousness being expressed by the consumer as well as their pickiness. Lending costs are up. Standards are tougher. And so, too are mergers and acquisitions. If they happen at all.
And this might be the case for some time. “The next 10 years are going to be far more subdued,” said Gregg Naghan, chairman of Americas equity capital markets for Bank of America Merrill Lynch. “If you’re building a business, thinking of starting a business, have an acute focus on free cash flow.
“A business with great culture where you retain your employees against a tremendous backdrop of innovation. This is the new world.”
Welcome, in other words, to the new normal. And it won’t be as pretty as the old normal.
A tougher lending market
The conference began with an apology from Patrick Doyle, the chairman of Restaurant Brands International, over the trio of bankruptcy filings from franchisees of its Burger King brand. In the middle of it, a Wendy’s operator out of Florida sought debt protection, the latest in a string of Chapter 11 filings from large franchisees or small-scale brands.
The operating environment has been awful for the past three years, and many of these brands—notably Burger King—went into the pandemic with poor operations, too much debt, or both. Some operators had “probably too much” debt on their balance sheets, Doyle said.
Lending standards have clearly tightened in the industry. Lenders are concerned about the industry’s margins and have pulled back. Banks are being “pickier and choosier” about lending, said John Dysart, head of franchise finance for M&T Bank. At the same time, the cost of that lending has increased along with rising interest rates.
That has made life more difficult for many operators, particularly those that have struggled coming out of the pandemic, to get necessary financing and it’s a big reason why the franchisees and other brands ended up in bankruptcy. They had too much debt and refinancing simply isn’t available like it’s been the past decade or so.
With that debt coming due, and many brands and franchisees having yet to recover, that string of bankruptcies seems unlikely to end.
“Everybody has same-store sales growth because they’re raising prices. What we care about are transactions.” -Todd Maldonado.
The traffic conundrum
It’s not good enough to have strong sales when an operator goes looking for financing. They need liquidity, the lenders say, and likely more equity in the business and should prove their ability to keep good workers. Mostly, though, they need traffic.
“Everybody has same-store sales growth because they’re raising prices,” said Todd Maldonado, managing director with BMO. “What we care about are transactions.”
That’s easier said than done. Traffic has been down consistently enough that big chain executives are touting their ability to simply get to “flat” traffic.
It’s not hard to see why. Operators have raised prices some 30% since the start of the pandemic, the result of soaring costs and weakening margins.
And that’s created a perception that restaurants are no longer a good value. Miller said that 31% of consumers now believe that their last visit to a restaurant wasn’t worth it. More than half of consumers say they’ve had “sticker shock” after visiting a fast-food restaurant.
Theoretically, the industry is shifting into a traffic-building and value-focused mode, but the value is far more muted than in previous price wars. The industry simply does not have the stomach for it—fast-food restaurant prices are rising at twice the rate of inflation right now.
And too much effort on traffic can be a killer, too, as Red Lobster recently demonstrated with an all-you-can-eat shrimp deal for $20. That might be worth it for the customer. But it certainly wasn’t for Red Lobster’s parent company that took a bath on the deal.
“I think we’re going to see some pretty good activity in 2024.” -Josh Benn.
A bifurcated M&A market
The M&A market largely froze during 2022 along with the high interest rates and thinning margins. Private equity firms grew choosy, much like lenders did. Many of the bankrupt franchisees this year couldn’t find buyers for all their restaurants. Pollo Tropical spent two years on the market before it finally found a buyer who paid almost no premium on the company’s stock price.
But that doesn’t mean nothing is happening. Indeed, the buyers who are out there are seeking quality, almost to a fault.
Just last week, a 100-unit Wingstop operator received backing from a pair of investment firms who, sources said, received a valuation multiple of over 10 times EBITDA, or earnings before interest, taxes, depreciation and amortization.
That’s high for a franchisee, in a neighborhood traditionally occupied by large chains such as McDonald’s and Taco Bell. But the key point is the brand and the operator’s performance. Same-store sales have ranged from 15% to 20% over the past three quarters, coupled with strong traffic growth.
“Good operators in good brands can access capital in any market,” Maldonado said. And they can certainly fetch strong multiples when they demonstrate consistent, strong performance.
Indeed, while the market remains tough and M&A bifurcated between haves and have-nots, bankers expect it to “recalibrate.” The era of rising interest rates is likely done, and buyers and sellers that had disagreed on pricing will likely come together.
Deals picked up in the third quarter, with $11.5 billion in acquisitions in the restaurant space during the period. To be sure, the bulk of this was the $9.6 billion Subway deal, but that was still 80% of the year’s deals, said Josh Benn, managing director of the New York-based corporate finance firm Kroll.
There are more companies on the market right now, bankers said. But there may be some distressed deals forced on sellers, too. “I think we’re going to see some pretty good activity in 2024,” Benn said.
The uncertainty
All that said, one thing about the past four years is the potential for something to happen that disrupts the market. There was the pandemic. And then inflation. And in the midst of this the war in Ukraine. Could something else happen?
It could. “We are one headline away from something very disastrous,” Naghan said. Could it be the Middle East? If the war there is contained to Israel and Hamas, he said, oil would be $90 per barrel. If Iran is sucked in, oil could get to $130. If oil fields are disrupted, all bets are off. As oil prices go, so goes inflation.
Indeed, one reason there’s so much caution in the markets right now is the fear of that something. “This is the reason portfolio managers and hedge funds are so cautious,” Naghan said. “They’re terrified of the potential of a mass uptick in oil.”
That sense that another “black swan” event that appears to be showing up these days a lot more often than black swans are supposed to show up did indeed pervade throughout the conference. “There are so many variables trickling down to the” profit-and-loss statement, said Sandra McCraren, senior managing director with Wintrust Franchise Finance.
“I wish we had a crystal ball,” she added.
So do we.