Restaurant professionals will tell you that industry conditions move in cycles and the current cycle is extremely challenging. While there are signs of hope, the industry may need to go through a period of indigestion to find a balance, and weaker less differentiated brands will need to close or be absorbed. This is a normal and healthy environment for a consolidating industry that needs to rationalize current excess. Ultimately, innovative technology will drive the leadership to expand with greater efficiencies while dynamically adapting to customer needs. The outcome from this consolidation could be an acceleration of growth and further customer adoption, but it will be led by the restaurant leaders who are looking at the future business model, not the past. 

What Investors Need to Know

According to the National Restaurant Association (NRA), the restaurant industry’s economic impact on the U.S. economy accounts for 4% of GDP.  For the most recent seven-year period the industry is projected to have expanded revenues to $800 billion, growing by more than $210 billion in that time. And revenue is not the only metric; the NRA claims that for every dollar spent at a restaurant, $2 are spent in the economy, tripling the economic impact. Today the industry is the second largest private employer in the United States, accounting for 14.7 million jobs, and is expected to add more than 1.6 million jobs by 2027. That job growth may seem low compared to overall growth estimates and hints at how the industry is expected to grow. Shaking out the weaker players unwilling to automate will be important to the economy and will have a tangible impact on jobs.

The USCF Restaurant Leaders ETF (MENU) seeks to track the price and yield performance of the Restaurant Leaders INDXX Index (iMENU), before fees and expenses. In developing the Restaurant Leaders INDXX Index, asset management firm Access ETF Solutions spent a significant effort analyzing what common factors drive economic performance, according to Managing Director of Access ETF Solutions Dan Weiskopf. “Unfortunately, there is no magic bullet as the restaurant industry is not homogeneous in its business models,” Weiskopf says. “Even looking across the coffee category has its challenges.  For example, Starbucks (SBUX) mostly does not franchise, but Dunkin’ Brands (DNKN) is almost 100% franchised.” 

The use of capital is also very different, as are the leverage ratios. The aggregation of iconic brands by certain companies also presented issues in the analysis. There are about 60 publicly traded companies in the universe, but the index methodology that Access built across the 10-year back test held between 30 to 34 names. Execution risk also is something that needs to be managed. When the index is rebalanced quarterly, six companies are replaced on average because of two quantitative screens that identify the weaker relative price performers,” Weiskopf says. 

In researching the broad sector, USCF found that the Quick Serve category (QSR), which includes fast casual, outperformed full-service restaurants (see “Where to eat?” right). As a result, the index menu is comprised of 70% QSR and 30% full service. restaurant firms. Three reasons contribute to this success, according to Weiskopf. “First, QSR during the past seven years has undergone a massive re-alignment of resources. Most of the leading restaurant companies with franchise networks refranchised their store operations by selling to private equity or aggregators of brands. Capital has been readily available to such operators who over time can build a diversified business and therefore can afford to maintain the capital expenditure requirements to upgrade the system.”

Restaurants need to stay fresh-looking. Technology has become more important and regulations more complicated. All this makes for real challenges for the mom and pop operators. 

Weiskopf’s second reason is revenue growth at the franchisor level is earned by franchise sales, increases in price and same-store sales, which can come from foot traffic or upselling. 

However, at the franchisor level, the business model becomes asset light and costs become more predictable. As a result, free cashflow has been aggressively returned to shareholders via dividends and repurchase programs with confidence in the business model leading to multiple expansions. 

“Third, international growth and technology has provided leverage for most large scale operators of brands, which has attracted significant institutional high profile money like Carlyle Group (CG), CITIC Group, Warren Buffet and Bill Ackman,” he says.

Full Service

The challenges for the full-service category are more extreme. Localized and operating costs are harder to manage to scale. Besides, in today’s restaurant world, it is all about the experience, and the fight for foot traffic is very challenging. Demographics present an additional issue. The younger generation, which arguably makes up about 100 million people, is less interested in sitting around a table at a restaurant and more about delivery. Restaurants historically have a high failure, but the failure rate is higher in the full service area. There are more dominant franchisors in the QSR category than there are in the full-service category and franchisors are regulated to file a Franchise Disclosure Document (FDD) that details certain fundamental metrics that help buyers of franchises access the success of the brand. Therefore, successful franchise companies protect against high failure rates or run the risk of losing growth momentum. For this reason, the probability of success is greater in the QSR category. 

The $220 Billion Opportunity in Delivery 

Restaurant leaders in the QSR category are positioned to adapt to changing demographic trends through the use of big data, delivery and digital marketing, which could make them more efficient operators. In a June 28 report, “Is the online food delivery about to get amazoned?” John Glass of Morgan Stanley raised his forecast for the Total Addressable Market for delivery from $60 billion to $220 billion. The research states that since QSR customers consume meals off premises 60% to 80% of the time, the category is positioned well to benefit by this trend. The report also noted that digital delivery could be $30 billion in five years based on 15% annual growth continuing at a similar pace through 2022. Morgan Stanley’s expectations are that online delivery could increase from 6% today to 11% of industry sales by 2022.

Why is the QSR category positioned well against so many alternatives? From a top down perspective, almost all of the QSR brands have a lead in terms of testing and rolling out plans for delivery. Amazon (AMZN) may be moving into the space, but QSR leadership knows that this is a battle that they cannot afford to lose and most companies have aggressive plans to compete.

“Even Amazon will be challenged to deliver profitably against the large QSR franchise networks who can earn incremental profit from delivery and a potentially expanding pie is expected to lead to higher same store sales growth,” Weiskopf says.