Having An Appetite For Restaurant Stocks

Foreword from ShareInvestor

This article “Having An Appetite For Restaurant Stocks” by Cai Hao Xiang was first published in The Business Times on 06 May 2013 and is reproduced in this blog in its entirety.

Bite into the right stock and you can have your cake and eat it, reports Cai HaoXiang

Visit any shopping mall in Singapore over the weekend and you are likely to see queues forming outside restaurants.

In some popular places selling, say, dim sum, Thai, Japanese, or European food, diners may have to wait for half an hour or more before getting a chance to sit down.

What might not be as well known is that some of these names are actually listed on the stock market. For example, ABR Holdings, the local franchisee of ice cream restaurant chain Swensen’s, has been on the Singapore stock exchange since 1992. Mid-range and high-end Chinese restaurant chain Tung Lok has been listed since 2001. And Din Tai Fung, known for its xiao long baos (steamed dumplings), is operated by the BreadTalk Group, listed since 2003. In the same year, Japanese eatery chain Sakae Holdings was also listed.

Because their operations are so visible, restaurant stocks in Singapore might be a good starting place for investors wanting to try their hand at some fundamental research.

I found at least eight restaurant stocks here after a quick search. This is not counting the numerous food manufacturers and retailers out there – such as curry puff maker Old Chang Kee. Many of these restaurant stocks are considered to be small companies and do not attract much market attention. Liquidity tends to be low.

But ground research is relatively easy to do because the food industry is something we all think we are familiar with.

Through checking out their locations, food, ambience, service, and queues, investors can quickly get a feel of which restaurants are popular and thus have a chance of making money. Some restaurants do corporate catering and make money there, too.

Most importantly, investors should be questioning themselves if the restaurant or brand name they are eyeing has the potential to expand in Singapore, in the region, and around the world.

Just ask Ray Kroc. In 1954, the salesman received a sizeable order for eight of his milkshake mixer machines from a restaurant in California.

Curious about the order, he checked out the restaurant which made the order and talked to the two brothers running it, Richard McDonald and Maurice McDonald.

Their restaurant, named McDonald’s, was already successfully selling a simple menu of hamburgers, cheeseburgers, french fries, and drinks. There were two other franchises operating in California. The menu was limited. Production was efficient.

Mr Kroc offered to help the brothers franchise their operations across the United States. His first McDonald’s restaurant opened in Chicago in 1955. He soon bought world franchise rights from the brothers for US$2.7 million. The rest is history. McDonald’s had 34,480 restaurants in 119 countries at the end of 2012, and 440,000 employees.

It went public in 1965 at the price of $22.50 a share. Today, the company has a market value of over US$100 billion.

An investment in one lot of 100 shares at the company’s initial public offering would cost US$2,250. That would have grown into 74,360 shares today after 12 stock splits, and worth US$7.5 million – a compounded annual growth rate of more than 18 per cent. That’s a return of more than 3,300 times on one’s original investment.

The Franchise Model

Why did McDonald’s grow so phenomenally fast? The reason goes beyond its food, which is quite easy to make, cheap, reasonably tasty, and convenient.

While the company directly operates some restaurants, most of its profits are made through its franchise business model. This means McDonald’s sells the rights to use its brand name and business model to other investors.

The franchise model allows for rapid growth. Those that buy the right to use the business model and brand name, known as franchisees, take on most of the risk and the nitty-gritty day to day work associated with operating restaurants.

The parent company focuses on marketing its brand, developing new food products to suit consumer tastes, and investing in new locations to set up its restaurants.

For McDonald’s, franchisees use part of their money to invest in the equipment, signs, seating and decoration of McDonald’s restaurants.

They pay McDonald’s rent, as the company owns the place they operate out of. They also pay royalties based on a percentage of sales. In exchange, they get to use the McDonald’s brand name to sell a widely-known menu of fast food. The agreement is typically for 20 years. Meanwhile, McDonald’s and its franchisees rely on independent suppliers to get food.

The franchisor gets high margins from successfully franchising its brand out. After paying for expenses associated with rent or depreciation of its franchised restaurants, McDonald’s profit margin from franchised restaurants was 83 per cent of revenue last year, adding up to some US$7.4 billion.

By contrast, for company-owned restaurants, margins were 18.2 per cent after deducting operating costs. They added up to US$3.4 billion.

Investors looking at restaurant stocks need to understand the franchise systems that these companies often use.

The company can be the master franchisor like McDonald’s, meaning they own the rights to the brand, sell them in a limited fashion to others, and get royalties on a regular basis.

Sometimes, the master franchisor sells the rights to franchise the brand in a particular area to companies known as master franchisees. The master franchisee can then in turn franchise the brand’s operations to other entrepreneurs.

Some quality control in deciding who to franchise the brand to is crucial. By franchising, a company will be giving away some trade secrets on how it runs its business. It is trusting its business partners, the franchisees, not to do things that will damage the brand name.

Some companies are franchise operators. This means they own the rights to the brand for a limited period of time, say 20 years. After that time period, if the company has not been too successful, it might not be able to buy these rights again. This is a risk investors must consider.

Evaluating The Restaurant Industry

Food is a necessity. But restaurant meals are not. During an economic downturn, people become more price sensitive. They will eat more home-cooked meals, eat at cheaper hawker centres, and cut back on going to fine dining establishments. Fast food, mass market joints are typically more resilient to economic downturns as their food is cheaper.

Due to intense competition and plenty of substitute products, food cannot be priced too prohibitively. There is an abundance of hawker centres and coffeeshops in Singapore for consumers to turn to.

Higher costs have also affected restaurants’ bottom lines. Rental and labour costs form a big proportion of restaurant operating costs. In an economy operating at full employment, locals also do not want to work as waiters, chefs, and dishwashers. Sakae Sushi made the news when it advertised for people willing to wash dishes for 12 hours a day, six days a week, for $3,000 a month.

Investors also have to keep track of how fast wages are growing, as well as the inflation rate. Increasing consumer spending power caused by wage growth and low inflation bodes well for the restaurant industry.

Rising food costs will also eat into restaurant margins, along with health concerns. A worldwide beef shortage due to a mad cow disease scare will hit steak restaurants hard.

Evaluating Individual Companies

For individual companies, investors need to understand the type of food served, who the regular customers are, food pricing, the company’s relationships with suppliers, and restaurant locations.

Keep tabs on the number of restaurants out there, the number run by franchisees, the length of franchise agreements, and expansion plans.

A string of outlet closures could indicate something gone awry. The company might have expanded too fast before getting its business model right. This destroys shareholder value as the company has to incur losses shutting outlets down.

Another warning sign could be frequent discounts, promotions, or Groupon-like deals. This could indicate falling demand for the restaurant’s food. Discounted sales will eat into margins. Food supplies are perishable so a fall in demand can hit restaurants hard.

Investors should ask management about a statistic known as “same-store sales growth”, or “comps”. This shows the sales growth of outlets that have been open for a specific time period, like a year. This statistic allows investors to differentiate between sales growth that comes from opening new outlets, and growth due to better management of existing outlets.

Hygiene standards are critical in food consumption. A health scare or food poisoning scandal could irreversibly damage a brand name.

Finally, one can evaluate individual stocks through various financial ratios and metrics shown in the accompanying article here.

Restaurants are not a difficult business to understand. As seen here, most have given investors positive returns over the years. Bite into the right stock, and you can buy yourself a nice meal – and more.