US Franchise Restaurant Sector Outlook: Commodities & Labor Pressures

While topline revenue has most likely held throughout over the last two years, this is largely attributed to price increases, which were required to offset the impact of 40-year high inflation on labor, commodities and operating costs. Despite significant price increases, however, most brands have not been able to outpace rising costs, placing increased pressure on operating cash flow.

Following the broader CPI inflationary trends, restaurant cost of goods sold, or COGS, have increased across nearly every input.While the major inputs (chicken, beef, dairy) have been highlighted across mainstream media, lesser-other inputs (such as cooking oil and eggs) have also been a significant contributor to rising COGS.

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  According to BMO Capital Markets, chicken breast has seen a notable year-over-year increase, 55% to 70%, due to strong demand (chicken sandwich wars anyone?). A rare bright spot is the decreasing cost of chicken wings, with prices returning to early 2020 levels.

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  Beef as a favorite of consumers has remained relatively stable, with BMO Capital Markets reporting about a 5% increase throughout 2022. This stability is likely because of higher-than-anticipated production of beef supplies throughout the year.

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  Dairy has been impacted across all relevant subsegments, with year-over-year increases on cheese (25%), butter (50%) and milk (34%), according to Restaurant Research.

As U.S. unemployment rates return to historical lows, all segments of the restaurant industry are dealing with wage inflation.

While it has taken the restaurant industry a long time to recover from the employment lows of April 2020, the resiliency and creativity of restaurant operators to attract employees has resulted in staffing slowly approaching pre-pandemic levels. According to the Bureau of Labor Statistics, as of July employment levels within food service and drink places are up about 8% from year-ago levels, while still down approximately 6.5% from the February 2020 peak.

During the push to get restaurants restaffed, it has become commonplace for the prevailing hourly wage to be much higher than the state or federal minimum wage. QSR operators are commonly paying $14 to $16 an hour compared with the federal minimum wage of $7.25 an hour, placing increased pressure on labor margins. BLS data supports this trend. In July, the average hourly wage of production and nonsupervisory employees in both the leisure and hospitality and restaurants and other eating places subsectors was $16.66 an hour, an 8% increase from July 2021. Even as staffing slowly returns to a more normalized state, restaurant operators continue to be pushed to find alternative ways to attract and retain employees. A notable shift is employees looking for more than just an hourly rate, making it necessary for operators to focus on training, education subsidies, recognition programs, financial literacy education, retirement plans, vacation and health insurance.

Technology is rapidly changing customer experience and engagement.While the restaurant industry has been notoriously slow to embrace new technology, the pandemic accelerated adoption across multiple fronts. This became evident in the QSR sector when the historical model of ordering via two channels—in-store dining and drive-thru service–quickly evolved into an omnichannel experience for the guest, adding mobile orders and third-party delivery to the mix. A perfect example is the Taco Bell Defy concept restaurant in Brooklyn Park, Minnesota, owned and operated by franchisee Border Foods. The two-story restaurant features a four-lane drive-thru that handles traditional, mobile and QR-code, and third-party delivery orders. It also features dining room kiosks, digital check-in screens using QR codes for mobile orders, a vertical lift to send orders down to cars, and two-way video communication with restaurant staffers on the unit’s second floor.

Looking further into the future, expect to see more utilization of drive-thru artificial intelligence chat bots for order taking. This technology has been most widely publicized by way of McDonald’s partnership with IBM to implement natural language processing using AI to handle drive-thru orders. Given that between 70% and 80% of QSR orders are drive-thru, this technology has the potential to reduce ordering errors and processing time across the QSR industry. In light of increasing labor costs and all-time low unemployment rates, this could have a significant impact on restaurants’ top and bottom lines.

Borrowing costs have increased at a historic pace throughout 2022. In an effort to wrangle inflation at 40-year highs, the Federal Reserve has taken an aggressive stance on raising interest rates. By late September, the Fed had raised the target range for the federal funds rate by an additional 75 bps. This year’s five consecutive increases, totaling 300 bps, is now the most aggressive seven-month period since the Fed began using the Fed Funds Rate as its primary monetary policy tool. This hawkish approach to control inflation has resulted in the prime rate index increasing 300 bps to 6.25% and the 30-day SOFR increasing 302 bps to 3.07%. While the current Fed Funds Effective Rate is lower than the long-term average of 4.60%, the pace of rate increases caught many operators flat-footed. In light of the recent increases and additional anticipated increases, many operators are taking a look at their mix of fixed versus variable-rate debt and having strategic conversations with their interest rate management teams on options for managing their interest rate risk in the months and years ahead.

Source: BMO Capital Markets, Bloomberg

M&A activity slowed significantly in 2022 after elevated levels in 2021. After a whirlwind end to 2021, the dramatic slowdown in M&A activity was felt across the industry. As the Q1 2021 EBITDA high-water mark fell off trailing-12-month operations, the question of sustainable EBITDA levels became top of mind for acquiring parties and lenders alike. This uncertainty led to a disconnect in the bid-ask spread between sellers and buyers and in some cases drove down EBITDA purchase multiples. While there were certainly brands that were more immune to margin compression and trades continued in 2022, overall there was a significant shift year-over-year.

Increasing stress on restaurant lender portfolios. The combined effect of elevated EBITDA in the first half of 2021 with higher M&A EBITDA multiples, followed by compressed EBITDA margins in the first half of 2022, has put pressure on restaurant lender portfolios not seen in quite some time (aside from the COVID-19 pandemic). Operators that have partnered with a seasoned restaurant lender will find this was a wise choice, as prior experience with volatile economic cycles tends to lead to patience and consistent support during a downturn.

Looking forward, we see a few key themes emerging in 2023.

Elevated Borrowing Costs. Fed Chair Jerome Powell has been very clear the Fed will remain aggressive in using the Federal Funds Rate to slow inflation, noting that the FOMC is not yet at the point where it’s “appropriate to slow the pace of increases.”

Uncertainty on the Labor Front. Most notably, the passing of the California FAST Recovery Act has resulted in heightened concern and uncertainty within the restaurant industry.The notion that a subsector of the restaurant industry would be subjected to different employment standards (including a $22-per-hour minimum wage and employee input on working conditions), all governed by a unique council, has triggered heated debates regarding the overall impact on companies that fall under the law, as well as restaurant companies not subjected to the new legislation and, ultimately, consumers. The general consensus is such that if the groups fighting the legislation, including the National Restaurant Association, the U.S. Chamber of Commerce and large national franchisors, are not successful in overturning the law, similar legislation will likely be adopted by states with an ethos similar to California’s, such as Oregon and Washington.

Separately, while it’s certainly less of an immediate threat to smaller restaurant operators or franchised restaurant models, the recent unionization movement within large corporate brands should be acknowledged as a recent shift in the hospitality landscape that ultimately adds to the complexity of managing the workforce.

M&A Activity.The consensus is M&A activity will most likely resume once EBITDA is deemed stable by both buyers and lenders. Anecdotally, we’re hearing talk of pent-up demand by operators looking to grow and an equally motivated number of sellers looking to exit.

Remodels and New Development. It has become abundantly clear that restaurant operators have grown frustrated with elevated labor and material costs, as well as extremely long lead times for equipment when remodeling or building a new restaurant in strong operating environments. Add on the current environment of compressed margins, elevated leverage ratios, and increasing borrowing costs, a disconnect is likely to form between operator willingness and brand mandates. While development and remodels are key to brand relevance and top-line success, it’s during the difficult operating environments that require a franchisee, franchisor and lender to support the “three-legged stool” that is critical for long-term success.

There are certainly reasons for optimism within the restaurant industry, including increased staffing levels, moderation in commodities, lower crude oil prices and lower price inflation of food away from home compared with food at home. Regardless of what challenges the restaurant industry faces, the creativity, resiliency and overall entrepreneurial nature of its restauranteurs will adapt to the new normal operating environment.

Allen Johnson, Managing Director on BMO's U.S. Franchise Finance team, contributed to this article.

Note: The opinions, estimates and projections, if any, contained in this article are those of the author. BMO endeavors to ensure that the contents have been compiled or derived from sources that it believes to be reliable and which it believes contain information and opinions which are accurate and complete. However, the author and BMO take no responsibility for any errors or omissions and accepts no liability whatsoever for any loss (whether direct or consequential) arising from any use of or reliance on this article or its contents. This article is for informational purposes only.