Understanding Trends and Consumer Tastes in the Restaurant Industry
The restaurant industry has many compelling qualities that have attracted both public and private investors over the last decade. Industry demand has grown steadily as the economy has recovered from the Financial Crisis, and the best performing restaurant companies have rewarded investors handsomely on a total return basis. According to the U.S. Commerce Department, Americans are now spending more money at restaurants than grocery stores, a shift that took place in 2015.1 In a study conducted by the USDA, researchers found that Millennials eat out more than other generations,2 which is noteworthy since Millennials are entering their peak spending years and are becoming a more important demographic to the restaurant industry and the overall economy than Baby Boomers. These secular trends should bode well for the restaurant industry for the foreseeable future and continue to attract capital. Despite the attractive attributes of the industry, we remain selective in our investment choices, as we believe the influx of competition into the industry will continue to disrupt the weakest competitors. As restaurant delivery gains popularity, it is challenging to evaluate companies in this industry, since the ways in which restaurants compete for customers is ever-evolving. To keep pace with changing consumer preferences, companies will be required to partner with third-party delivery services, invest more in technology and logistics, or both. With the restaurant industry trading at a premium valuation relative to the market, we are finding few companies trading at attractive discounts to our estimates of intrinsic value and we believe patience is warranted.
The Current Landscape of Restaurant Revenue Growth
Our process for analyzing industries and determining the intrinsic values of companies is comprehensive. Rather than discussing every facet of our process, we will provide a glimpse into how we think about restaurant revenue growth, which helps explain our industry view.
Restaurant industry demand is determined by many macroeconomic factors, such as employment, wages, and gas prices. We are interested in how the industry responds to demand and where the individual restaurant brands we follow fit within the overall industry. Analyzing the components of revenue growth is just one way we determine the relative attractiveness of a restaurant company. Unit growth and same restaurant sales are the primary components of the revenue growth equation for individual restaurant brands. Unit growth, or new restaurant growth, is an important source of revenue growth, particularly for brands that are expanding rapidly. Every growing restaurant brand eventually reaches a saturation point, but it can be challenging to forecast when a brand will reach this point. Restaurant management teams are often optimistic about a brand’s growth potential, and they can run into trouble by overbuilding restaurants, cannibalizing the sales and profits of existing restaurants. Therefore, we spend considerable time analyzing the health of a brand’s existing restaurants to gauge the likelihood of growth plans coming to fruition. Same restaurant sales measure the dollar change in sales of the mature and comparable restaurant base (typically restaurants open for a year or more) and excludes new restaurants, which have different sales patterns than mature restaurants. If same restaurant sales are healthy, we believe there is a greater likelihood a restaurant brand has room to grow.
Same restaurant sales can be broken down into two primary parts: traffic and ticket. Traffic measures the change in guest counts or entrée counts over a measurement period and provides insight into how a restaurant resonates with consumers. We view a restaurant brand that increases guest counts to have a more sustainable sales trend than one that does not. Ticket measures the change in sales due to price changes and changes in sales mix (i.e. the variety of items on a restaurant’s menu). Historically, restaurants have consistently charged more for their food year-over-year, so price changes have been a meaningful contributor to same restaurant sales in the industry. Consumers also purchase more expensive or less expensive items on a restaurant’s menu over a comparable period, contributing either positively or negatively to same restaurant sales via this shift in preferences. All else equal, we prefer to see positive traffic over positive ticket, as it indicates stronger consumer preference for a restaurant brand.
Over the last decade, the restaurant industry has battled poor traffic trends, with particularly weak traffic at chain casual dining restaurants, such as Applebee’s and Chili’s. We believe these trends are the result of, among other things, restaurant overbuilding and the industry increasing prices at a faster rate than that of grocery prices. Restaurant management teams are eager to grow their brands, and we believe the result has been industry oversaturation. Because the industry has relatively low barriers to entry, we believe oversaturation is a persistent challenge despite the slowdown in industry unit growth we have witnessed recently. We continuously monitor unit growth and would view additional restaurant closures positively.
Since 2012, tepid food-at-home inflation has made dining out, or food away from home, less appealing on a relative value basis. Consumers visit restaurants for convenience, to celebrate special occasions, or to enjoy unique dishes. They know a meal made at home is likely less expensive than ordering food from a restaurant, but they still demand value even if they cannot explicitly calculate the value received. The graph below shows that food-away-from-home inflation has consistently increased and remained above food-at-home inflation for the better part of six years. We believe there is a significant value gap between eating at home and eating at restaurants, contributing to the challenge of attracting consumers. To combat this dynamic, the most efficient operators, such as Olive Garden’s parent company Darden Restaurants, have been successfully competing on value and pricing menu items below food-away-from-home inflation. While there are many factors that determine food-at-home inflation, we view Amazon’s disruption of the grocery industry as a primary source of pressure that is likely to keep prices low in the short to medium-term. All else equal, we would view restaurant industry traffic more positively if the inflation gap between food away from home and food at home narrowed further or if the trend reversed.
FOOD INFLATION (JULY 1998 – JULY 2018)
Source: Bureau of Labor Statistics.
Third-Party Delivery Services
Consumer habits are changing, and more consumers are now opting for the convenience of restaurant delivery. Pizza restaurants have traditionally controlled the $26 billion delivery market, which accounts for around 5% of the overall restaurant industry in the United States,3 but we believe this could change as third-party delivery services, such as Grubhub, DoorDash, and UberEats, expand consumers’ delivery options, providing restaurants with a low-fixed-cost delivery solution. The growing demand for delivery presents the industry with both opportunities and challenges. Given the industry is battling weak traffic trends, delivery demand is welcomed, and restaurants are competing to capitalize on the non-pizza delivery market that is growing in the low-teens percent range.3 Early adopters of delivery have an advantage and seem to be gaining market share from restaurants not offering viable delivery solutions. As third-party delivery continues to gain popularity, scale will be a competitive advantage and the largest restaurants could dominate the delivery market, as they could have the sales base to negotiate reduced fees from third-party delivery services. Large restaurant brands will also have the resources to build in-house delivery solutions if third-party delivery services gain too much power and negotiation is not possible, whereas smaller competitors may not have that ability.
Restaurant management teams must make the choice to invest in a delivery fleet, work with a third-party service, or both. Utilizing third-party delivery services does not require significant upfront investment, but these services charge fees as high as 30% per transaction, and the restaurant loses control of the customer experience and customer data. Fees paid to third-party delivery services work like a discount, where a restaurant operator hopes to make up for the discount through incremental transactions. Early reports from restaurants indicate that sales are incremental, but we believe incrementality should decline as delivery becomes a cost to compete rather a convenient option. Currently, delivery is done well by only a handful of restaurants, such as Jimmy John’s and Domino’s Pizza.
While we are encouraged by secular trends that should benefit the restaurant industry over the long term, we remain selective due to intense competition, tepid grocery inflation, and valuations. Additionally, we view the recent results of restaurant delivery favorably, but believe costs could exceed expectations and its benefit to revenue growth could diminish over time.
As of August 31, 2018, Diamond Hill did not own shares of any company discussed within this article.
1 Bloomberg: Americans’ Spending on Dining Out Just Overtook Grocery Sales for the First Time Ever https://www.bloomberg.com/news/articles/2015-04-14/americans-spending-on-dining-out-just-overtook-grocery-sales-for-the-first-time-ever.
2 Alliance Bernstein Report: Weekend Consumer Blast: The Millennial Menu March 2, 2018. Original USDA Report: Food Purchase Decisions of Millennial Households Compared to Other Generations https://www.ers.usda.gov/webdocs/publications/86401/eib-186.pdf?v=43097.
3 Alliance Bernstein Report: U.S. Restaurants: What does McDelivery mean for McDonald’s and the rest of the industry? August 16, 2017.
Originally published on September 27, 2018.
The views expressed are those of the research analyst as of September 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.