Web Exclusive: Jim Parish on Buying and Selling
A financial guru ponders the outcome of the rush to buy and sell.
By David Farkas, Senior Editor -- Chain Leader, 4/1/2006
On the rush to own a restaurant company:
The word may not get out for a while that the industry isn’t all low-hanging fruit at prices recently paid. Usually when a public company runs into a tough period, it becomes obvious pretty quickly. It isn’t quite that way in the private sector, and until some of the companies run into difficulty, and their new owners exhaust their recuperative skills and come to terms with a lower return (or even a loss on their investment), will the froth diminish.
Perhaps Wendy’s experience with Baja Fresh should be a warning to investors of the dangers in overpaying. Wendy’s paid an exorbitant price for Baja Fresh, and despite having a pretty sophisticated team of people addressing the Baja Fresh problems, the general thought is that the investment has failed, and the business will be disposed of at a considerable loss. Perhaps the price they paid was fair in their minds at the time, but it certainly doesn’t look like a successful move at this point.
On the criteria sellers should keep in mind:
My specific list looks like this:
- It is fundamental that the unit-level economics provide a superior return on sales and on investment, which of course is tied to consumer relevance and acceptance.
- It is fundamental that the guest is treated to an exciting, dynamic environment; greeted and served by motivated, knowledgeable and capable personnel; and served food prepared with care, with quality ingredients and sold at a fair price, i.e., execution must be flawless!
- Transactions and sales and products and surveys all are analyzed for the guests’ impressions, in order to keep the product squarely in the guests’ zone of preference.
- Marketing and promotional programs should be regularly reviewed and measured to keep guests coming and sales growing.
- Margins should be worked on relentlessly, and costs should be judiciously managed, but not at the expense of the guest experience.
- Real estate should be carefully and responsibly selected.
- It’s better to have some operating experience in more than one market, to give credibility to projections of expansion.
- It is very helpful for the R&D work on the building configuration and dimension to be complete, so the variables associated with accelerating growth are minimized wherever possible.
On determining ROI:
The most successful restaurant companies are those with the highest revenue per square foot and the highest returns. Pretty much across the spectrum of concepts, regardless of format (quick service, casual or upscale), the companies with the best unit economics are the highest valued. Usually that means that revenue per square foot is higher than average and margins reflect the capture of more of that revenue than other companies in the competitive set.
Recently, the industry has been in a downward spiral in terms of investment return over the past few years, which makes the higher prices being paid recently more than a little curious. Some of the top-tier companies have been able to grow revenue at a rate that holds their own against rising costs, but by and large the return on unit investment has been slipping. Inflation in building materials, delays in project approval, increased competition for sites, smarter landlords and aggressive municipalities seeking offsets for their own infrastructure dollars are all contributing factors. Lower costs of capital (due to lower interest rates and higher leverage ratios, and lower equity capital costs due to higher valuations) have masked this decay to a large extent.
When allocation of capital takes place, I recommend looking at the unfinanced returns on investment of a property first. Unfinanced return means earnings before financing and lease expenses. Total investment means all development costs, including capitalized leases, pre-opening costs and a reserve for remodeling on a three-to-four-year cycle. If the property doesn’t produce a return on that basis above 25 percent, it is not very interesting to me. The individual unit return is fundamental to successful long-term development of a brand. There is no doubt that we are in a period of low financing costs and high equity valuations, which helps the return equation. Not so long ago, and I predict not so long from now, interest rates will be higher and equity values will be lower. If you aren’t competitive with your unit returns now, you won’t be able to attract capital then.
On the outlook for the industry:
My belief is that these matters will sort themselves out, and the net result will be positive. After all, capital is being made available to some fine management teams who will use it wisely, I am certain. Some others have and will get money that will be wasted, and that won’t be a happy time. But that has been happening in this industry for as long as I can recall.
If the new participants in restaurant investment are half as savvy as the few firms that have been steady and consistent players in the business thus far, they will come to discriminate between good companies and bad, and their investments will be directed to support the good companies.
Unless none of the recent transactions are successful (which I find unlikely), the heightened exposure and visibility for the industry will be a significant benefit to the companies in the industry, and indeed to the investors themselves as they become more knowledgeable.
Perhaps the greatest benefit I see is that successful restaurant investments in larger companies will encourage capital to flow to the entrepreneur and startup ventures. More small chains will arise, managed by folks who learned how to be successful from the leaders who have produced many of the finest companies today. Since the late ‘90s, private capital has turned away from the very small restaurant chain, by and large. The dot-com era pulled much capital away from restaurant development, as it did from many industries.
Some of the larger portfolio companies filled the gap for a time, by investing in smaller regional brands. But most of the multiconcept companies are divesting brands now, so my hope is that private equity will find a sliver of their portfolio to fund some of these promising new companies. The development of new brands will be the most positive outcome I see from the current interest in the restaurant business.
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