Editor's Note: According to Conway MacKenzie’s Jesse York, the picture looks promising for the quick service restaurant industry, yet some challenges remain. York notes that lenders should bear the following in mind before supersizing their involvement in the sector.
Current State of the Industry
At the 2013 Restaurant and Finance Development Conference, held last November in Las Vegas, the tone was that of cautious optimism heading into 2014. The negative effects from five years of persistent high unemployment, low consumer sentiment, deteriorating discretionary income and economic and political uncertainty following the economic crisis of 2008 finally seemed to be abating. Improving economic fundamentals signaled impending release of pent up demand and a return to consumers dining out and spending more. For the companies that survived this period, it was finally time to prosper. Commodity prices were expected to remain relatively stable and the previously large and looming uncertainties around Obamacare and labor costs were assumed to be relatively known. Unfortunately, these companies first had to weather the prolonged and destructive 2013-2014 winter which caused a decline in same store sales (-0.2%) and traffic relative (-2.2%) to Q1 2013.
Winter is over and economic fundamentals seem to be continuing to gradually improve. Same store sales were up 0.6% for April 2014, following a 0.7% increase in March 2014, and all signs point to continued improvement for the restaurant industry as a whole. At the end of Q1 2014, the Restaurant Willingness to Spend Index, as measured by Consumer Edge research, is up 13.6% over last year and continued to increase in April 2014.
However, it is not the time to celebrate and wait for the profits to arrive. While industry revenue may be improving, the cost side of the equation is now becoming problematic as a result of increasing commodity and labor costs. Also, much of the increase in sales is attributed to new stores and concepts, so companies with older concepts that have been unable to invest in new units or renovation are experiencing both declining revenues and increasing costs. Many companies that were heavily impacted by the difficult winter are already operating on the edge or are in default. Even a sales rebound may not be enough to return these companies to profitability in the near term.
Rising Commodity Costs Put Upward Pressure on Food Costs
Food costs (typically 25% - 35% of sales) are the second largest component of the quick service restaurant (“QSR”) cost structure. Increasing global demand, drought, political instability and disease are impacting the prices of cheese, coffee, beef, pork, limes, sugar and soy, among other commodities. Additionally, wheat and corn have been volatile through the beginning of 2014.
A pig virus has also caused pork prices to reach record highs. A recent QSR staple, bacon, is 35% more expensive than last year and could be up to 50% more expensive compared to 2013 by the summer. Drought in California is causing cattle feed to become too expensive, leading ranchers to slaughter cattle early. California cattle supply is at its lowest level since 1951 and prices are at record highs and are expected to remain there for several years. Meanwhile, drought in Brazil is impacting prices for soy, sugar and coffee. Increasing global demand is driving the price increase for cheese; block cheddar hit a high of $2.40 in Q1 2014 before trending back down towards $2.00 recently.
Rising commodity prices are having an immediate impact on franchisees in the form of increased food costs and food shortages. It’s important to understand: what has already been purchased for the year; how the contracts with suppliers are structured; are there substitute products and what; if any, hedging strategies are in place. The end goal is to understand the potential exposure to rising commodity prices, suppliers’ ability to pass on price increases and the ability to mitigate impacts through hedging and/or resourcing. Once the exposure is understood, the company can determine its ability to pass on price increases to customer, change the menu or absorb the cost increase by decreasing costs elsewhere.
One Way or Another, Labor Costs are Going Up
Labor costs, which (typically 30% - 35% of sales) are the largest component of the quick service restaurant (“QSR”) cost structure. Unfortunately, labor costs are also trending up due to difficulty in hiring and retaining employees. Training new employees is expensive and high turnover is costly and inefficient. The People Report Workforce Index measures market pressures on restaurant employment. The index is based on employment levels, recruiting difficulty, vacancies, employment expectations and turnover, and trended up during Q1 2014 to the highest level seen since Q4 2006.
In contrast to the volatile nature of commodity prices and the short term need to mitigate risk, labor is a longer term issue that needs a more comprehensive approach. The combination of an improving economy, declining unemployment and growing industry is going to lead to a long term scarcity of qualified employees. Companies need to simultaneously focus on improving retention while also reducing the cost of recruiting and training new employees. Further accelerating the need to address the labor issue are the actions by the two main restaurant unions, the Service Employees International Union (“SEIU”) and the Restaurant Opportunities Center (“ROC”), to organize strikes and walkouts in protest of low wages and benefits. These actions have garnered substantial press and gained traction as discussions to raise the minimum wage have entered the national spotlight and several states and municipalities have passed laws to raise the minimum wage. Most notably, Seattle recently passed an ordinance to gradually increase the minimum wage to $15/hour.
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