A quick look into the QSR industry

Of franchisees, digital enhancements, and levered free cash flow

What is QSR?

Not to be confused by Restaurant Brands International, which is listed on NYSE as “QSR”, QSR stands for Quick-Service-Restaurants, or more commonly know as fast-food restaurants. Examples include McDonald’s, Burger King, KFC, Popeyes, Chipotle and Subway. Typically, the experience is fuss-free, you go into the restaurant (or drive-through), order your food, and get out within 20 mins (quick service). The food is also usually cheaper than full-service restaurants, therefore QSR is oftentimes interchangeably used with Limited Service Restaurants (LSR). Prices are typically $5-7 a meal.

There are many listed QSRs in US, and as an group, they have outperformed S&P500 from 2014-2019 by around ~3% per annum. This might be surprising to you, given the bad press on several QSRs, with phrases such as “junk food”, and also the general shift towards healthier eating.

There are a few factors driving this outperformance, such as a benign macro environment of low fuel prices and wages not rising much at the lower-end (helpful for QSRs), and also valuation multiple expansion as investors are willing to pay more for a dollar of earnings, driven mainly by a shift from company-owned restaurants to a franchise model. Digital investments, easier and cheaper delivery, international expansion and low-interest rates environment helped as well.

How do QSRs make money?

The economics of QSR is quite straight-forward - sales growth comes from two main sources - same-store sales growth (SSSG) and net unit growth (NUG). To grow, you can either sell more products, increase your prices, or sell a higher mix of expensive products at your existing restaurants. You can also grow by increasing the number of restaurants that you own.

Sames-store sales (SSS) basically refers to the revenue generated by a restaurant in a specific time period compared to the revenue the restaurant generated in the comparable period one year ago. It measures growth of sales of existing restaurants. Imagine you own one restaurant which generated $100 of sales in 3Q2018. In 3Q2019, the restaurant generated $110 of sales, which is a SSSG of 10%. The convention for calculating SSSG is to exclude newer units that have been operating for less than 12 months. There are exceptions though, such as Popeyes at 17 months and Shake Shack at 24 months.

SSSG is driven by average cheque value and number of cheques. Average cheque can be further broken down into product mix, price, and number of products per cheque. You can raise prices on your products, sell more products per order, or sell more higher-priced products relative to your lower-priced products per order. Number of cheques is self-explanatory - the number of successful orders going through in your restaurant, including delivery and drive-throughs.

Imagine you have a restaurant that sell only two products: burger (priced at $5) and chicken sandwich (priced at $3). To increase SSSG, you can either increase your prices, and/or increase the number of orders, and/or increase the number of items per order, and/or increase the proportion of burger sold relative to chicken sandwich sold.

In general, investors place a higher value on growth derived from increased traffic and product mix/attach rate, and place a lower value on growth derived from price increases - “lower-quality” growth that is unsustainable in the long run. There is a limit at which you can raise prices before your customers abandon you.

For newer and higher growth restaurants such as Wingstop, unit growth can be a significant driver of growth as well. However for more mature restaurants like McDonald’s, there is a limit to unit growth, and investors will place a premium on growth drive by SSSG over unit growth.

Franchise model

There has also been a trend in recent years to move from a company-owned model to a franchisee model (with Chipotle being a notable exception). Most franchise agreements are based on franchisors taking a percentage of franchisees’ gross revenues (mainly royalties and/or property rentals), and an upfront franchise fee that is amortized over the length of the contract period. Separately, there is usually an advertising fund managed by the franchisor (typically a percentage of gross sales as well), but it flows straight through to expenses, and the franchisor does not earn from the advertising revenues.

Investors increasingly are willing to pay a higher valuation for asset-light, capital-light, high margins, high return on capital businesses, and a franchise model gives the franchisor exactly that. Even though QSR’s revenues have come down, but overall systemwide-sales, profitability and stability of cash flows typically increase. There is a cleaner flow through from top-line growth to bottom line and cash flow, as other operating expenses are rather stable over time. A recent increase in SG&A (2018/2019) is because of an accounting change, and not because QSR businesses have to spend more on advertising. Furthermore, there is minimal capital expenditure (capex) required from the franchisor, as maintenance capex and expansion capex is usually borne by the franchisee.

Due to the low capital intensity and stability of free cash flows (FCF), leverage ratios for the highly franchised QSRs have been creeping up as a whole, from ~3x to ~5x over the last few years. This has led to higher levered FCF to shareholders, but also pose constraints and stress on the balance sheet in the event of a shock (e.g. COVID19, or a food scare) - higher financial risk, and dependancy on access to capital markets.

Since very little reinvestment and capex is required, what do franchisors do with the free cash after paying interest? They pay dividends, buy back shares, or engage in M&A. As an example, Wingstop recently executed a recapitalization transaction, refinancing it’s debt at a lower rate, and used part of the debt proceeds to pay common shareholders a ~4% special dividend. Management is so confident of it’s cash flows that it has decided to raise debt and pay a special dividend of ~4%, on top of it’s current dividend of ~0.5%, all in the midst of a global pandemic!

Even though there are arguably more benefits in the franchise model, there are also certain drawbacks that we have to be aware of.

1. As compared to company-operated restaurants, QSRs do not have as much control over their franchisees’ restaurants

2. Risk of a single/multiple Master Franchisee becoming too strong and powerful by representing a large number of restaurants in the system. They might have more negotiating power and to negotiate for better terms in the franchisee agreements. The recent announcement by Carrols on renegotations with Restaurant Brands International is one to watch in the near term

3. Individual franchisees will find it more difficult to access capital than compared to franchisors. However, during the COVID19 pandemic, we saw franchisors standing beside franchisees and providing them support, both through reduction/delay in royalties and rents, and also suspending capital expenditure for the franchisees.

Delivery and drive-throughs

Even prior to COVID, delivery had been one of the key drivers of increasing sales in QSRs. Most of delivery sales are incremental rather than cannibalization (I see different numbers from different research and surveys, with a range of 50-80% of delivery sales being incremental). Delivery also opens up other day parts for QSRs, such as dinners and late-night for burger chains.

During and post COVID, delivery has been playing an even bigger role, with restaurants that are better suited and able to deliver (e.g. pizzas and burritos travel better than fries) benefiting more. Most QSRs have placed delivery as a key focus in the near future.

On a related note, drive-throughs have also played a more important role during the pandemic, and QSRs have been investing more into drive-throughs as well, both in technology (predictive and adaptive digital menu boards), and also efficiency (double drive-throughs, faster turnover time etc.).

Digital

Another trend during recent years have been technology and digital (what’s new…). As Andy Grove, ex-CEO of Intel once famously said:

I have been quoted saying that, in the future, all companies will be Internet companies. I still believe that. More than ever, really.

Restaurants that have embraced digital, such as Chiptole (digital orders) and Starbucks (rewards and mobile order and pay), have seen tremendous successes so far. Other large franchises like McDonald’s and Restaurant Brands International have also made digital one of their top priorities going forward, including self-order kiosks, outdoor digital menu boards, and loyalty apps. Loyalty programs and digital apps will give restaurants valuable data which will help drive personalized offers to customers based on their spending habits and preferences.

This initiative is so important that franchisors have been offering to co-pay the digital initiatives on-premise (usually renovation, upgrades etc. are borne 100% by franchisees). And despite the constraints and decrease in cash flow over the last few months, franchisors have been continuing to drive investments into digital.

One thing that I have been thinking about is that given the importance of digital, and its fast-evolving nature, will constant upgrades and increased technological spend be part of the new QSR model. Will investors have to model in higher ongoing expenses going forward, rather than adjusting them out as one-offs?

International expansion

QSRs have typically expanded overseas through Master Franchisee agreements. These Master Franchisees have deeper local knowledge and better local network, and are able to navigate cultural nuances, best practices and legal framework better than the franchisor. Moreover, it is also easier for the franchisor to deal with just one Master Franchisee as opposed to hundreds of franchisees who are located thousands of miles away.

A few successful examples are McDonald’s, Starbucks (China is now a large part of the narrative), Burger King and KFC (also mainly China). Even though average unit volumes are typically lower in International markets, but successful international expansion will be meaningful to growth for most QSRs.

Valuation, capital structure and levered FCF

Most investors use EV/EBITDA as a valuation metric for the more mature companies in this industry, mainly due to the wide disparity in capital structure, and also different franchise mix across the companies. For the higher growth companies, a static EV/EBITDA might not be as relevant.

What drives valuation in this industry? Based on anedoctal experience, I believe the primary driver is SSSG, followed by franchise mix, and for restaurants with a smaller footprint, expansion pipeline. Investors are willing to pay more for higher SSSG and a higher franchise mix. As mentioned, a favorable macro environment, and a general shift from company-operated to franchisee model has led to multiple expansion and higher than market returns over the last few years.

Leverage ratios are relatively high as discussed previously, due to the willingness of banks and investors to lend based on the certainty of cash flows and low capital intensity of the franchise model. In good times, and in a low interest rate environment, this strategy has resulted in higher shareholder returns, as the levered FCFs are used to buy-back shares, pay dividends, and M&A.

However, financial leverage is a double-edged sword. Even though I have pointed out above that most QSRs were able to weather the pandemic storm in 2Q20, but it is worth noting that other than a period in March, credit markets were still open, backed by an “all-in” Federal Reserve. An investment in some of the higher leveraged names will require a deep-dive into their capital structure, and also underwriting the risk that if there is a blow-up (such as a food scare for example), the company can survive without going bankrupt, or losing most of its equity value.

Another point I want to make is on labor and wages. ~90% of restaurant employees earn minimum wage. Technically, any increase in wages will not reflect in the financial statements of a QSR with a 100% franchise model. At least not immediately, as restaurant employee wages do not show up in the P&L. In fact, if restaurant franchisees pass on higher wages to consumers in the form of higher food prices, the franchisor might ironically benefit as their revenues are typically based off gross sales of franchisees.

That said, a spike in wages will not be good for the franchisor in the long run, as even though they do not bear the direct costs, ultimately if unit economics are not good for the franchisees, the franchisor will suffer as well due to less demand for its franchise, leading to slower unit growth. Disgruntled franchisees will also likely lead to a drop in quality, which will affect the franchisor’s brand reputation in the long run

Conclusion

Hope you enjoyed this brief overview of the QSR industry! I first started with a background on the industry, then moved on to how they make money, followed by drilling down into a few important factors, such as the franchise model, delivery and digital. I then ended with a section on valuation and capital structure.

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