Opportunities & Value traps in US Restaurant franchisors
Over the past year and a half, we have been actively analyzing the restaurant industry as well as various companies within it. We have created two guides on the sector, one focused on Operators (a practice followed by Chipotle, Texas Roadhouse, etc.) and another centered on the franchisor model (the standard of McDonald’s, Starbucks, …..).
As a quick recap, we discuss some of the basic characteristics of both business models:
Operators – These are companies that operate their restaurants. Since we are talking about large companies with (in some cases) thousands of restaurants, we classify them as such when the majority of their restaurants operate under this model. They are characterized by:
- Much higher sales than Franchisors, as the revenue of Franchisors is a percentage of the sales of the Operators.
- Margins are significantly lower than those of Franchisors (Gross, EBITDA, and Net).
Franchisors – Once the model works and gains traction, the important decision is whether to franchise or not. Franchisors “lend” their brand and business model to the franchisee, to whom they also provide support with marketing (which is often done centrally) in exchange for an initial fee and an annual percentage of sales—usually between 4% and 6% (and often a portion for marketing as well).
- COGS are minimal since expenses fall below the gross margin on the P&L; for example, SG&A expenses tend to be significantly higher than in Operators.
- As a result of the above points, EBITDA margins tend to be considerably higher.
- With more predictable revenue (and EBITDA), it is characteristic for these companies to have higher levels of debt than Operator companies.
At the beginning of this year, taking advantage of the restructuring of market trends brought on by the arrival of Trump, we wanted to revisit the restaurant sector in search of potential opportunities. This is due to the relatively poor performance of small caps over the past two years, the loss of purchasing power among households, and the increase in minimum wages (affecting some states more than others, but generally impacting the entire restaurant industry, which relies on less-skilled workers). Companies are quite attractive in terms of valuations.
Specifically, the group most impacted in terms of valuation has been small-cap franchisors (between €400MM and €1,500MM), which have dropped on average more than 40% in the last twelve months, with several trading at five-year lows. In today’s analysis, we include:
- Papa John’s, Jack in the Box, Denny’s, Wendy’s, Dine Brands, and El Pollo Loco.
Today, we analyse the situation of each of these companies individually to try to distinguish between potential opportunities and value traps.
To do this, we examine the evolution of their sales, number of restaurants (franchises/owned), capital allocation, capital structure (as we believe debt plays a fundamental role in this economic environment), corporate decisions made in recent years, and corporate strategies.
As a result, we provide our opinion on the situation of each of these companies and identify one (and a half) opportunities among them, as well as significant value traps—companies that, when the cycle turns, will continue to lag behind the market (for reasons that are more or less obvious).
To support this, you can download an spreadsheet, which includes all the data used in the analysis.