Limited-Service Restaurants: Weathering the Storm
By: Koji Bratcher
Tags: Venture Capital, Valuation, Private Equity, Restaurant, Investing

Over the last six months, much has been written of the restaurant industry’s woes. Social distancing and economic shutdowns have been all but disastrous for an industry that relies heavily on foot traffic and people congregating around a meal. For many small operators, the pandemic has reduced their enterprise to a state of ruin from which they may never recover. However, the pandemic has not been as distressing for larger, publicly-traded companies with the capital resources to endure the downturn.

In this article, I will describe the broad trends observed in limited-service restaurant groups and explain what may be driving their valuations. This will be the first installment of three articles focused on the restaurant industry. Part 2 will examine full-service restaurant companies, while Part 3 will demonstrate how the interpretation of industry trends can be clouded when analyzing limited-service and full-service publicly-traded restaurant companies in aggregate.

This article was first posted in the ValuInsights Industry Blog. Visit us for more valuation insights and resources and follow me on LinkedIn!

Important notes: This article briefly investigates what may be driving valuations in the industry from a financial statement perspective. An actual valuation of a company requires an in-depth analysis of the business operations and associated risk factors that cannot always be directly considered through the data on the financial statements. Also, in order to keep the length manageable, this article will focus on what I interpreted to be the primary value drivers and will not touch on every observation in the data. For a quick read on the basic concepts of risk and return and how they apply in the context of this article, please visit: What is Value? and Risk and Return in the Market Approach.

The industry constituents for this analysis are listed below. I focused on U.S. companies that were traded on major exchanges for at least a year with a stock price equivalent of $1 or more. I excluded companies with significant operations outside of the restaurant industry (e.g., manufacturing foods for distribution in a retail environment, etc.). The effective date of this analysis is December 31, 2020.

The limited-service restaurant groups’ median enterprise value (“TEV”), median revenues, and median EBITDA are summarized in Figure 1. Latest fiscal year is notated “LFY” and “LTM” means latest 12 months.

Figure 1 shows us that values associated with the limited-service restaurant industry generally performed well over the last several years, including at the end of 2020. The growth in enterprise values in this chart contrasts with a modest decline in revenue and EBITDA. This is likely attributed to the fact that limited-service restaurants were relatively well-suited to adapt to social distancing requirements and government-mandated restrictions on indoor dining. Drive-through capabilities, delivery-friendly menus, and smaller physical footprints (i.e., lower fixed costs) along-side access to capital have made it possible for these publicly-traded companies to successfully weather the COVID-19 storm.

If you have been tuning in to the industry and the rise of the fast-casual segment, you may be wondering why historical growth in Figure 1 appears flat. This is because the limited-service restaurants broadly analyzed include the traditional fast-food players, as well as the fast-casual, gourmet burger, and pizza delivery segments. The significant growth that has recently occurred in companies like Chipotle, Domino’s Pizza, and Shake Shack have been largely offset by declines in traditional fast-food giants, such as McDonald’s, Yum! Brands, and Wendy’s.

When changes in financial metrics are outpaced by changes in enterprise values, valuation multiples will increase. This can be viewed in Figures 2 and 3 below, which compare the historical revenue and EBITDA multiples for the limited-service restaurant companies. In this case, EBITDA multiples increased sharply in the LTM period due to the increase in enterprise values relative to the slight decline in EBITDA.

The Growth Story

Growth often has a strong influence on how multiples differ among companies in an industry. A summary of the consensus forecasts for each group is presented in Figures 4 and 5 below (note that “NFY” means next fiscal year; NFY = calendar 2020 for most companies).

It makes sense to focus on growth after the NFY (2020) period. Limited-service restaurant groups are expected to generate notable revenue and EBITDA growth following the NFY period, even exceeding projected growth rates as of 12/31/2019. This high growth may reflect an expectation that companies that survive the challenges triggered by the pandemic will benefit in the longer-term due to the absence of smaller businesses wiped out by social distancing and economic shutdowns (i.e., less competition). This appears to be a consideration in how these companies are priced.

LTM EBITDA multiples are presented relative to projected EBITDA growth rates in 2022 in Figure 6 below.

The data presented in Figure 6 shows some correlation between growth and EBITDA multiples. Higher multiples are generally associated with companies that generate higher levels of growth. There are, however, some inconsistencies in the data, which suggest other factors are at play in how these companies are valued in the market. Interestingly, I did not observe a meaningful correlation between revenue growth and multiples. As will be seen below, revenue multiples appeared to be more closely aligned with profitability.

The Size Story

Larger companies are generally perceived to have lower levels of risk relative to smaller companies. This can be due to a number of factors, including improved product or geographic diversification, deeper management teams, access to a variety of distribution channels, and better availability of capital. In this case, I did not observe a discernable relationship between size and LTM EBITDA multiples. However, the LTM revenue multiples of the smallest companies (enterprise values of less than $1 billion) appeared to be correlated with their sizes. This makes sense, as a relative lack of geographic and product diversification tends to impact the smallest companies more significantly than their larger counterparts. See Figure 7 below.

The Profitability Story

Revenue multiples are typically heavily influenced by profitability since higher levels indicate more return generated per dollar of revenue. Investors are usually willing to pay more per dollar of revenue and, thus, higher revenue multiples can be observed in companies with higher levels of profitability. This relationship between LTM revenue multiples and LTM EBITDA margins can be observed in Figure 8 below (although I did note the inconsistencies in the data points).

Tying it All Together

The trends observed in this article would tend to suggest that valuations of limited-service restaurant companies are impacted by growth and profitability. Market multiples for smaller players in the industry appear to be more significantly impacted by size as compared to their larger counterparts. However, in general, it appears that the market expects a turnaround in limited-service restaurants to occur in 2021 and 2022.

I hope you found this analysis helpful. What are some other more qualitative considerations impacting valuations in the limited-service restaurant industry? Are the growth expectations for the industry summarized in this article consistent with what you’ve seen/heard from your contacts/experiences? Leave a comment, I would love to hear from you!

Any and all input, feedback, suggestions, and questions (including disagreements with my high-level analysis) are welcome! Have a suggestion for a future industry analysis? Leave a comment! Thanks for reading.

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Restaurants are complex organizations with numerous value drivers. The valuation of a restaurant company requires an understanding of its risks and that of the industry as a whole, as well as proper interpretation of capital market evidence. Helios Consulting, Inc. is a full-service valuation service provider with the experience needed to guide you through your valuation requirements.

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