By Nick Setyan, Managing Director of Equity Research, Restaurants
How low interest rates prevent unit growth in restaurants instead of promoting unit growth.
Peter Lynch lamented about the relative dearth of growth companies (sustainable annual revenue growth of 15%+) in today’s public markets in a recent Barron’s interview. “I wonder if he’ll go into the reasons why,” I thought, as I tried to put names to other prominent investors who I’ve heard echo Mr. Lynch’s frustration in recent years. “I hope he ties it to the distortion from the Fed’s ‘lower for longer’ interest rate policy.” No luck.
The fact is that the dearth of growth in today’s public markets, particularly consumer growth, is a very common complaint I hear from our growth oriented mutual fund and hedge fund clients. As the managing director of restaurants equity research at Los Angeles-based Wedbush Securities, the lack of growth in one consumer vertical—restaurants—is a reality I have come to accept in this painfully slow decade-long economic recovery. Half-jokingly, I’ve come to call it zombie-plus economics.
Today, out of approximately 30 publicly traded restaurants, only one, Shake Shack (SHAK), is expected to meet the 15%+ top line definition of organic growth in 2020. In the 2000’s, 6 of the 30 hurdled that definition, and four (BJRI, BWLD, CMG, Teavana) boasted revenue growth of 20% or higher.
Why? There are too many restaurants open in the United States. Low interest rates allowed large chains to restructure their business models from predominantly company-owned and operated businesses to primarily franchised businesses. “Refranchising” has been the favorite buzzword of restaurant investors for years, and it’s as popular as ever today. Think Wendy’s (WEN), Jack in the Box (JACK), Denny’s (DENN), Taco Bell (YUM), and KFC (YUM).
Essentially, as the profitability of a certain unit declines below a certain threshold, it no longer makes sense to operate. Historically, these units were shuttered. Today, they are sold to franchisees. Once sold to franchisees, the franchisors simply collect royalties, typically a flat 5% of sales – no matter how much the franchisee made in profits.
Here’s the dense part.
The franchisees lever up to 3x+ annual cash flow, making the levered returns on investment palatable even on units that have four-wall profit margins in the high-single digit percentages (by comparison, shareholders prefer to keep only the units that have four-wall margins in the mid- to high-teens). The franchisees that buy these units have little room for error. For any reason, should interest rates increase, sales decline, or margins come under further pressure from labor or food cost inflation, the franchisees face financial hardship.
In the meantime, corporate collects royalties on sales of units that would otherwise have closed. With input costs no longer a worry, both shareholders and lenders have come to view these royalties as more stable and predictable than the traditional profits generated by operating the units. Domino’s (DPZ) pioneered the securitization of future royalties, allowing the subsequent deluge of lending to ‘primarily franchised’ names up to 6x annual cash flows (EBITDA). Companies made refranchising accretive to shareholders by using the cash proceeds from the sale of the units to franchisees and the incremental borrowing to repurchase shares. Over a number of years, these repurchases could be meaningful, adding up to as much half of the original shares outstanding.
Given the predictable nature of royalties and limited capital expenditure needs, shareholders refer to the ‘primarily franchised’ set of publicly traded restaurants as ‘bond proxies’. Over the last decade, valuations of these bond proxies have soared, currently commanding free cash flow yields under 5% on average. Relative to the 10-year treasury yield of 1.9%, these free cash flow yields are understandably attractive.
Ironically, just as the zombie-plus economics of franchising is being rewarded with higher valuations by shareholders, the concepts healthy enough to hold onto their units are being punished with lower valuations. Relative to company-owned publicly traded restaurants, the primarily franchised set commands an average EV/EBITDA multiple that is almost double. Far from being encouraged to maintain double-digit growth rates, smaller concepts with more attractive unit economics and once-bright prospects like The Habit Burger Grill (HABT) and Potbelly (PBPB) are under increasing pressure to refranchise, not grow. In an environment where interest rates are poised to remain lower for longer, and the weak, instead of the healthy, are being rewarded, the dearth of double-digit unit growth is unlikely to change. Talk about distorted economics.