US Franchise Restaurant Sector Outlook: The End of the Rollercoaster Ride?
As the economy continues to feel reverberations from the COVID-19 crisis, the restaurant industry has been on quite the rollercoaster ride. From a total shutdown in early 2020 to pivoting to drive-thru and delivery-only service to navigating PPP loans, minimum wage hikes and rapid cost inflation, business owners have experienced significant speed bumps, to say the least. The companies that have performed best against these challenges have uncovered new ways to mitigate these difficulties, most notably by raising prices and operating with skeleton crews.
Today, we’re hearing concerns over tightening fixed-charge coverage ratios due to margin compression and continued interest rate hikes. Companies can only increase prices so much to offset increased costs, and many are now experiencing traffic declines as consumers’ wallets are being pinched across the board.
So far in 2023, the ride hasn’t quite yet stopped, but there are signs that it has slowed.
Recent Trends
Borrowing costs have continued to increase throughout 2023
The Federal Reserve continued to increase interest rates in 2023 to combat inflation. As of late October, interest rates have been raised four times this year, totaling 100 bps. That followed a more aggressive 425 bps of increases delivered through seven rate hikes in 2022. The Federal Open Market Committee (FOMC) has lifted interest rates 11 times over the last 13 meetings, the most rapid rise in rates since the Fed began targeting the federal funds rate in the 1980s. The target range has climbed from 0-0.25% to 5.25-5.50%, the highest level in more than 22 years.
For restaurant borrowers, financing costs have increased significantly over the past 18 months as the Secured Overnight Financing Rate (or SOFR, the interest rate benchmark for business and consumer lending) has moved above 5%, causing them to focus more on a mix of variable and fixed-rate debt. With uncertainty surrounding if and when rates may decline, interest rate swaps have become the topic du jour given the yield curve inversion, triggering borrowers to lock in swaps to reduce floating-rate costs.
While inflation has been moderating in recent months, it is still well above the Fed’s 2% target. The CPI rose 3.7% in August after running 8.3% a year ago and 4.3% when excluding food and energy. Fed members will continue to monitor inflation and labor market data to assess whether we’ve reached the terminal policy rate, as well as how long to maintain rates at this level before easing policy. Fed officials now seem divided on whether the FOMC should put the brakes on rate hikes.
Bank failures and market instability
The rapid climb in interest rates caused the market value of banks’ investments in long-term Treasurys to drop significantly in 2023. As alarmed uninsured depositors (the federal government only insures deposits up to $250,000) began pulling funds from banks perceived to be unstable, they were forced to sell these investments at significant losses. Between March 9 and May 1, First Republic Bank, Silicon Valley Bank and Signature Bank had collapsed, representing the second-, third- and fourth-largest bank failures in U.S. history, respectively.
The market instability has had a profound impact on restaurant borrowers. Borrowers are now more aware of their banks’ strength and deposit mixes (over 85% of Silicon Valley Bank’s deposits were uninsured compared to 43% of total U.S. bank deposits at the end of 2022), and many have moved their deposits from small and regional banks to large banks, given that these institutions are already held to higher regulatory standards.
Loan market continued to tighten
Given the recent regional bank failures, economic uncertainty, higher funding costs, increased stress on portfolios, and growing liquidity constraints, the lender risk-reward balance has shifted. Lenders now have lower risk tolerance, tighter credit metrics and higher profitability return hurdles. For restaurant borrowers, this means less loan availability, tighter covenants, lower leverage, smaller hold sizes, increased pricing, and a greater focus on total share of wallet as lenders are being more selective with their capital. Given tighter cash flow and the increase in total debt service, borrowers are concerned with their fixed charge coverage ratios for the first time in a long time.
Food inflationary pressures easing
Average unit volumes for many chains are hitting all-time highs in 2023, driven by continued price hikes designed to offset the swift rise in nearly every cost associated with operating a restaurant over the last 18 months, particularly food and labor. That said, some protein items have posted declines through YTD July 2023. USDA data shows YTD decreases in prices for pork, chicken and wings through July 2023 after increases across the board in 2022, and a nearly 100% increase in chicken costs on a two-year basis in 2021 and 2022.
This protein deflation is reflected in the reported year-over-year cost of goods sold (COGS) margin decrease in several publicly traded $1 billion+ chains that operate company-owned locations. These chains, as outlined below, saw an improvement in Q2 commodity costs to the tune of -1.9% year over year. This margin improvement on a percentage basis may be largely driven by price increases that have taken place over the last year. But should price points remain, margins should continue to improve as purchasing contracts start to reflect deflation reported by suppliers. In its fiscal Q4 earnings call
, Sysco’s management reported rapid disinflation during fiscal 2H 2023, followed by deflation within its core U.S. broadline business toward the end of fiscal Q4. Sysco expects that deflation will continue within U.S. broadline during fiscal 1H 2024. Similarly, Performance Food Group reported foodservice cost deflation of -1.2% year over year during its fiscal Q4 earnings call .
Strong operators that have focused on portion size, minimized shrinkage and improved order accuracy should be able to reap the benefits with the expected COGS deflation.
Elevated labor costs continue
With employers battling other industries to retain entry-level talent, the average hourly wage within the leisure and hospitality subsegment continue to rise and is significantly higher than the mandated federal minimum wage. The hourly wage hit $18.85 as of Aug. 1, an increase of 4.72% compared to a year prior, and a whopping 26.7% increase from Jan. 1, 2020, prior to COVID-19 pandemic. The increase was more than twice the prior three-year period (12.9%, Jan. 1, 2020 vs. Jan. 1, 2017). On a positive note, the increase has slowed to a more manageable level in the last six months versus the prior six-month period, at 5.3% vs. 7.26%, respectively.
To offset this swift rise in wages, restauranteurs have had no choice but to continue to increase prices to offset higher costs. Furthermore, employers of most restaurants, including QSRs, have implemented tip screens as part of their POS systems. This has resulted in increased wages, but with the costs borne by the customer. The implementation of this has led to happier employees and better retention rates, with limited increased costs for the owners. That said, while wage inflation has lessened, labor costs continue to significantly impact restaurant margins when compared to pre-COVID-19 levels.
Price elasticity vs. traffic
Given the unprecedented steep ramp-up in commodity and labor inflation, restaurant brands have offset these costs with significant menu price increases. Many of these companies are still raising prices into the second half of 2023. This is evident in the year-over-year increase in the Consumer Price Index measurement for both limited service (6.7%) and full service (5.2%) through August. According to the Commerce Department, consumer spending, which accounts for about two-thirds of economic output, grew at just a 1.6% rate in Q2, down sharply from a 4.2% rate in the first quarter. Is this an indication that restaurant pricing has been too much to bear, and that consumers are exploring other dining options?
Companies have been on the razor’s edge in balancing continued elevated pricing to retain margins in a deflationary commodity environment at the risk of traffic declines or passing those cost savings on to the customers to retain loyalty. Are we at or near the inflection point for consumers where traffic may be impacted? Case in point, Noodles & Company had increased pricing approximately 14% between Q4 2022 and Q1 2023, only to have traffic decline 9.5% and sales dip 5.5% in its Q2 2023 report. With inflation decreasing, restaurant chains must now strive to build back traffic.
Near-Term Outlook
Looking forward, we see a few bright spots.
Technology. Brands have incorporated a few strategies to offset the aforementioned rise in costs. Technology-based capital expenditures, such as AI-based ordering and digital signage to improve order accuracy and promote upselling, have been spotted in Popeyes and Panera Bread. The chatbots take customer orders, ask follow-up questions as needed, and can promote the upsell of drinks, desserts and sides—all of which maximizes labor productivity. In a test market for Popeyes, one franchise reported the AI voice assistant took orders at 99.9% accuracy and increased high-margin soda purchases by 150%.
Prototypes. Taking this one step further, brands are revisiting their formats in order to shift operating rhythm to more closely mirror consumer preferences and manage build-out costs. These new prototypes are focused on smoother online order pickup, higher-capacity kitchens to facilitate throughput (Wendy’s Global Nex Gen design), and some even limit indoor seating to focus on preferred (and more profitable) drive-thru business.
Marketing. An increased focus on targeted digital marketing through apps and preferred customer channels, increasing late-night hours to expand sales, and rolling out lower-priced/snack-size items to help promote value (BK Royal Crispy Wraps) are among the recent trends. Brands are utilizing this less-expensive strategy to increase loyalty within their customer base to drive sales.
M&A activity showing signs of life. There have been recent signs that the loan market is starting to expand due to a pickup in mergers and acquisitions over the last couple of months. Private equity firms have been accumulating capital throughout 2022 and 2023 (U.S. private equity dry powder is $1.1 trillion), and they are expected to begin utilizing some of that war chest in the near term as interest rates stabilize and valuation expectations are reset. According to the Refinitiv LPC Quarterly Survey, leveraged loan M&A deal flow is expected to edge up, albeit selectively, in 2H 2023. A prime example is the recent announcement that Subway agreed to a $9.6 billion sale to private equity firm Roark Capital.
Interest rates stabilizing. BMO economists expect rates to remain at current levels through Q2 2024 before cautious rate cuts commence. The consensus from economists is that interest rates have stabilized, and rate cuts could begin in 2H 2024. However, in the Fed’s September 2023 press conference, Fed Chairman Jerome Powell said that the policy decisions will depend on the “totality of the incoming data”.
While 2023 has been challenging for many restaurant operators, there seems to be light at the end of the tunnel for the industry. Food costs continue to moderate, interest rates appear to have stabilized and are projected to fall beginning in the back half of 2024, M&A is accelerating, and good operators continue to use any available tools necessary to improve the bottom line. The last three years have provided plenty of ups and downs, but operators have shown continued resilience. Going forward, we are hopeful that resilience will reap benefits as headwinds turn into tailwinds.
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Allen Johnson
Managing Director
As the Commercial Leader for BMO's Franchise Finance team, Allen Johnson leads a team of relationship managers focused on serving the needs of companies in the …(..)
View Full Profile >As the economy continues to feel reverberations from the COVID-19 crisis, the restaurant industry has been on quite the rollercoaster ride. From a total shutdown in early 2020 to pivoting to drive-thru and delivery-only service to navigating PPP loans, minimum wage hikes and rapid cost inflation, business owners have experienced significant speed bumps, to say the least. The companies that have performed best against these challenges have uncovered new ways to mitigate these difficulties, most notably by raising prices and operating with skeleton crews.
Today, we’re hearing concerns over tightening fixed-charge coverage ratios due to margin compression and continued interest rate hikes. Companies can only increase prices so much to offset increased costs, and many are now experiencing traffic declines as consumers’ wallets are being pinched across the board.
So far in 2023, the ride hasn’t quite yet stopped, but there are signs that it has slowed.
Recent Trends
Borrowing costs have continued to increase throughout 2023
The Federal Reserve continued to increase interest rates in 2023 to combat inflation. As of late October, interest rates have been raised four times this year, totaling 100 bps. That followed a more aggressive 425 bps of increases delivered through seven rate hikes in 2022. The Federal Open Market Committee (FOMC) has lifted interest rates 11 times over the last 13 meetings, the most rapid rise in rates since the Fed began targeting the federal funds rate in the 1980s. The target range has climbed from 0-0.25% to 5.25-5.50%, the highest level in more than 22 years.
For restaurant borrowers, financing costs have increased significantly over the past 18 months as the Secured Overnight Financing Rate (or SOFR, the interest rate benchmark for business and consumer lending) has moved above 5%, causing them to focus more on a mix of variable and fixed-rate debt. With uncertainty surrounding if and when rates may decline, interest rate swaps have become the topic du jour given the yield curve inversion, triggering borrowers to lock in swaps to reduce floating-rate costs.
While inflation has been moderating in recent months, it is still well above the Fed’s 2% target. The CPI rose 3.7% in August after running 8.3% a year ago and 4.3% when excluding food and energy. Fed members will continue to monitor inflation and labor market data to assess whether we’ve reached the terminal policy rate, as well as how long to maintain rates at this level before easing policy. Fed officials now seem divided on whether the FOMC should put the brakes on rate hikes.
Bank failures and market instability
The rapid climb in interest rates caused the market value of banks’ investments in long-term Treasurys to drop significantly in 2023. As alarmed uninsured depositors (the federal government only insures deposits up to $250,000) began pulling funds from banks perceived to be unstable, they were forced to sell these investments at significant losses. Between March 9 and May 1, First Republic Bank, Silicon Valley Bank and Signature Bank had collapsed, representing the second-, third- and fourth-largest bank failures in U.S. history, respectively.
The market instability has had a profound impact on restaurant borrowers. Borrowers are now more aware of their banks’ strength and deposit mixes (over 85% of Silicon Valley Bank’s deposits were uninsured compared to 43% of total U.S. bank deposits at the end of 2022), and many have moved their deposits from small and regional banks to large banks, given that these institutions are already held to higher regulatory standards.
Loan market continued to tighten
Given the recent regional bank failures, economic uncertainty, higher funding costs, increased stress on portfolios, and growing liquidity constraints, the lender risk-reward balance has shifted. Lenders now have lower risk tolerance, tighter credit metrics and higher profitability return hurdles. For restaurant borrowers, this means less loan availability, tighter covenants, lower leverage, smaller hold sizes, increased pricing, and a greater focus on total share of wallet as lenders are being more selective with their capital. Given tighter cash flow and the increase in total debt service, borrowers are concerned with their fixed charge coverage ratios for the first time in a long time.
Food inflationary pressures easing
Average unit volumes for many chains are hitting all-time highs in 2023, driven by continued price hikes designed to offset the swift rise in nearly every cost associated with operating a restaurant over the last 18 months, particularly food and labor. That said, some protein items have posted declines through YTD July 2023. USDA data shows YTD decreases in prices for pork, chicken and wings through July 2023 after increases across the board in 2022, and a nearly 100% increase in chicken costs on a two-year basis in 2021 and 2022.
This protein deflation is reflected in the reported year-over-year cost of goods sold (COGS) margin decrease in several publicly traded $1 billion+ chains that operate company-owned locations. These chains, as outlined below, saw an improvement in Q2 commodity costs to the tune of -1.9% year over year. This margin improvement on a percentage basis may be largely driven by price increases that have taken place over the last year. But should price points remain, margins should continue to improve as purchasing contracts start to reflect deflation reported by suppliers. In its fiscal Q4 earnings call, Sysco’s management reported rapid disinflation during fiscal 2H 2023, followed by deflation within its core U.S. broadline business toward the end of fiscal Q4. Sysco expects that deflation will continue within U.S. broadline during fiscal 1H 2024. Similarly, Performance Food Group reported foodservice cost deflation of -1.2% year over year during its fiscal Q4 earnings call .
Strong operators that have focused on portion size, minimized shrinkage and improved order accuracy should be able to reap the benefits with the expected COGS deflation.
Elevated labor costs continue
With employers battling other industries to retain entry-level talent, the average hourly wage within the leisure and hospitality subsegment continue to rise and is significantly higher than the mandated federal minimum wage. The hourly wage hit $18.85 as of Aug. 1, an increase of 4.72% compared to a year prior, and a whopping 26.7% increase from Jan. 1, 2020, prior to COVID-19 pandemic. The increase was more than twice the prior three-year period (12.9%, Jan. 1, 2020 vs. Jan. 1, 2017). On a positive note, the increase has slowed to a more manageable level in the last six months versus the prior six-month period, at 5.3% vs. 7.26%, respectively.
To offset this swift rise in wages, restauranteurs have had no choice but to continue to increase prices to offset higher costs. Furthermore, employers of most restaurants, including QSRs, have implemented tip screens as part of their POS systems. This has resulted in increased wages, but with the costs borne by the customer. The implementation of this has led to happier employees and better retention rates, with limited increased costs for the owners. That said, while wage inflation has lessened, labor costs continue to significantly impact restaurant margins when compared to pre-COVID-19 levels.
Price elasticity vs. traffic
Given the unprecedented steep ramp-up in commodity and labor inflation, restaurant brands have offset these costs with significant menu price increases. Many of these companies are still raising prices into the second half of 2023. This is evident in the year-over-year increase in the Consumer Price Index measurement for both limited service (6.7%) and full service (5.2%) through August. According to the Commerce Department, consumer spending, which accounts for about two-thirds of economic output, grew at just a 1.6% rate in Q2, down sharply from a 4.2% rate in the first quarter. Is this an indication that restaurant pricing has been too much to bear, and that consumers are exploring other dining options?
Companies have been on the razor’s edge in balancing continued elevated pricing to retain margins in a deflationary commodity environment at the risk of traffic declines or passing those cost savings on to the customers to retain loyalty. Are we at or near the inflection point for consumers where traffic may be impacted? Case in point, Noodles & Company had increased pricing approximately 14% between Q4 2022 and Q1 2023, only to have traffic decline 9.5% and sales dip 5.5% in its Q2 2023 report. With inflation decreasing, restaurant chains must now strive to build back traffic.
Near-Term Outlook
Looking forward, we see a few bright spots.
Technology. Brands have incorporated a few strategies to offset the aforementioned rise in costs. Technology-based capital expenditures, such as AI-based ordering and digital signage to improve order accuracy and promote upselling, have been spotted in Popeyes and Panera Bread. The chatbots take customer orders, ask follow-up questions as needed, and can promote the upsell of drinks, desserts and sides—all of which maximizes labor productivity. In a test market for Popeyes, one franchise reported the AI voice assistant took orders at 99.9% accuracy and increased high-margin soda purchases by 150%.
Prototypes. Taking this one step further, brands are revisiting their formats in order to shift operating rhythm to more closely mirror consumer preferences and manage build-out costs. These new prototypes are focused on smoother online order pickup, higher-capacity kitchens to facilitate throughput (Wendy’s Global Nex Gen design), and some even limit indoor seating to focus on preferred (and more profitable) drive-thru business.
Marketing. An increased focus on targeted digital marketing through apps and preferred customer channels, increasing late-night hours to expand sales, and rolling out lower-priced/snack-size items to help promote value (BK Royal Crispy Wraps) are among the recent trends. Brands are utilizing this less-expensive strategy to increase loyalty within their customer base to drive sales.
M&A activity showing signs of life. There have been recent signs that the loan market is starting to expand due to a pickup in mergers and acquisitions over the last couple of months. Private equity firms have been accumulating capital throughout 2022 and 2023 (U.S. private equity dry powder is $1.1 trillion), and they are expected to begin utilizing some of that war chest in the near term as interest rates stabilize and valuation expectations are reset. According to the Refinitiv LPC Quarterly Survey, leveraged loan M&A deal flow is expected to edge up, albeit selectively, in 2H 2023. A prime example is the recent announcement that Subway agreed to a $9.6 billion sale to private equity firm Roark Capital.
Interest rates stabilizing. BMO economists expect rates to remain at current levels through Q2 2024 before cautious rate cuts commence. The consensus from economists is that interest rates have stabilized, and rate cuts could begin in 2H 2024. However, in the Fed’s September 2023 press conference, Fed Chairman Jerome Powell said that the policy decisions will depend on the “totality of the incoming data”.
While 2023 has been challenging for many restaurant operators, there seems to be light at the end of the tunnel for the industry. Food costs continue to moderate, interest rates appear to have stabilized and are projected to fall beginning in the back half of 2024, M&A is accelerating, and good operators continue to use any available tools necessary to improve the bottom line. The last three years have provided plenty of ups and downs, but operators have shown continued resilience. Going forward, we are hopeful that resilience will reap benefits as headwinds turn into tailwinds.
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