Investors who buy stock in fast food and casual dining chains have the potential to make a great deal of money. After all, Americans spend a lot of money each year eating out. According to the National Restaurant Association, the restaurant industry brings in $1.7 billion on a typical day in 2011.
But in order to get a share of the wealth in this industry, would-be investors need to understand how it works. In this article, we'll serve up some of things investors must consider before putting their money on the table.
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A Distinct/Unique Concept
The best advice is to think like a consumer. When you go out for a meal consider what piques your interest and what is likely appeal to the masses. For example, ambiance might play a role. So might location, décor, menu offerings, price, the amount of service staff on hand and the general theme of the establishment. Look for something that stands out and that you think has growth potential.
Think about how you perceive the establishment and how you think others might perceive it. And remember that a unique concept - or one that has a unique feel to it - will, in many cases, have the best chance of drawing in foot traffic.
Take the Cheesecake Factory (Nasdaq:CAKE), for example. It has often been listed as "best of breed" stock since its 1992 IPO. Between 1998 and 2003, the stock tripled in value. This could be based on its 200-item menu, which most other restaurants were unable to top, its ambiance and, of course, the dessert menu. Keep in mind that consumers eventually grow tired of what were once "hot" concepts, but if you get into a unique restaurant stock at the right time, you could be in for a tasty return.
Look for Companies that are Well Financed
The restaurant industry can be a fairly capital intensive business. In other words, a large sum of money is often needed to acquire land or large leases, and to erect a viable location. To that end, investors should try to only seek out companies that are well funded or that have access to capital.
The first step is to take a look at the balance sheet, specifically the company's total cash position. Is it large enough to build out many new locations or to expand at the rate management is suggesting? The cost of every restaurant chain location is different, so you'll have to answer that based on the situation you are analyzing. Common sense dictates that if the company in question is losing money and has little cash on its balance sheet, it probably isn't in expansion mode.
Another place to check is the cash flow statement and cash flow from operating activities. Is that number higher than the last quarter and larger than the comparable period last year, or is it negative? The company's ability to generate dollars from its business will help determine its ability to fund growth. (For more insight, read The Essentials Of Cash Flow and Analyze Cash Flow The Easy Way.)
Also, check out the footnotes and the management discussion and analysis (MD&A) section of the quarterly and annual filings. Here, management may detail its plans to raise cash (through the issuance of new shares or debt). It may also talk about its general access to capital and/or revolving credit lines.
Beware of Getting Too Big, Too Fast
Companies that grow at a super-fast clip have the potential to generate big bucks for their shareholders. However, growing at an accelerated rate also has its risks. For example, if something goes wrong (such as the restaurant industry has a bad year or a particular location falters) the company may see its entire organization suffer. (For more on this topic, read Is Growth Always A Good Thing?)
To determine, "How fast is too fast?" let's take a look at what happened to Manhattan Bagel in the mid '90s. Manhattan Bagel, a chain that sells bagels and other breakfast and lunch products, was experiencing very rapid growth in the mid-'90s. In 1996, the company reported that it was on track to roughly double its store count.
Then, the bottom dropped out and the stock plummeted 34% in one day as a result of accounting irregularities. At the time, analysts believed the issue to be relatively minor and expected the company to be able to put the issue behind it. However, because Manhatten Bagel was spending so much on new store openings, it started to bleed red ink and was ultimately forced to file for bankruptcy in 1998.
Once a chain is up and running, the selling, general & administrative expenses (SG&A) line should be watched closely. Labor costs are almost always on the rise in the restaurant industry and tend to an important variable in restaurant success.
The cost of goods sold, which includes food costs, is also important. The price at which a restaurant buys its food will ultimately determine how much it will have to spend on things like salaries and expansion. It will also have a huge impact on the bottom line results. So keep close tabs on the prices of foods that particular restaurants use most often. For example, an Italian restaurant will use more cheese and dairy products, while a steakhouse will be highly dependent on beef prices.
Changing with the Times
Restaurants need to evolve - they can't simply do the same thing every day, day after day and expect to see their stock prices rise.
Take McDonald's (NYSE:MCD), for example. In the early 2000s, many of its stores became run-down in appearance, its menu offerings hadn't changed much and, not surprisingly, its stock sunk. Once it started to spruce up its décor, add menu with new burgers, offer higher-end coffees and extended its hours, its foot traffic increased and its stock soared again rising 43% between 2010 and 2011 alone.
While total sales and bottom line numbers are vital to a restaurant's success, so are its same-store sales numbers. This metric tells the investor how certain stores are doing on an apples-to-apples basis by representing sales at stores in existence for more than one year.
Look for companies that are showing both sequential (meaning quarter-to-quarter improvements) and year-over-year improvements. It also makes sense to look for companies that are showing positive comparable sales while their competitors are showing negative comparable sales.
Check Out Book Value
The restaurant business operates in cycles, which are often seasonal. To mitigate risk during the slower times, it makes sense to invest in companies that trade at a low multiples of book value. Book value shows what the company is worth when its liabilities are subtracted from its assets. Companies that trade at a low multiple of that number may be safer bets because they have assets that might help cushion a downturn or provide a floor. (For more insight, read Digging Into Book Value.)
Some companies will trade at a low multiple of book value for a reason: because nobody wants them and because their future earnings potential is bleak. Therefore, it's important to understand that book value is just one of the tools used to measure a stock, and should be combined with other traditional evaluation metrics such as price-to-sales and price-to-earnings.
Dining chains can be a terrific investment assuming that one knows what to look for, and what to avoid. There's more to making your decision than just choosing what you want to eat for dinner. But, if you notice that your restaurant of choice is full of people enjoying their meals, then you might be on to a profitable trend. Next time you enjoy a great dinner at a happening new restaurant, make sure you chew over their financial numbers to give yourself some tasty returns.