If we take one message from recent trading statements, it’s that UK consumers are feeling the strain. Of the fourteen profit warnings we’ve recorded in the last ten days, nine are from consumer-related sectors and four are from companies in the FTSE Travel & Leisure sector.
This week’s blog focuses on restaurants, a sector that’s previously shown considerable resilience to the discretionary income squeeze. But, the casual dining market in particular is facing an especially difficult set of economic, sector and capital dynamics – and the early signs of distress are already there.
The shift in tone is palpable. Clearly not all consumer-facing companies are struggling. But in the last ten days, almost two-thirds of profit warnings have come from consumer-related FTSE sectors, with falling consumer confidence and the disposable income squeeze chief amongst the reasons for warning. This isn’t all that surprising given weak economic and survey data. Average monthly growth in Visa’s consumer spending index is just 0.2% in 2017, which now look set to be the weakest year since 2013. This week brought further bad news, with the Consumer Price Index hitting 2.9%, well ahead of the 2.1% average increase in wages. Plus, it seems interest rate increases are back on the agenda. Overall, the run into Christmas feels just that little bit tougher for consumers than it did just a month ago.
The current trend for consumers to prioritise spending on ‘experiences’ over ‘things’ should support spending on holidays and leisure – and these areas should continue to show resilience. People still want little treats and this includes having meals out. But, with less disposable income to go around, the competition for the consumer pound is heating up. Moreover, the restaurant sector – and casual dining in particular – faces an exceptional set of further headwinds, beyond the consumer squeeze, that leaves it vulnerable to distress.
Food, glorious food?
One of the most fundamental issues is market crowding and, crucially, the amount of debt that has funded recent market expansion. Growth in ‘fast causal’ and ‘casual’ dining has been the main driver within the restaurant sector since 2010. Much of this expansion has come from brands rolling out concepts, expanding rapidly from one or two successful local sites to create a group with UK-wide locations. This expansion has often come with the assistance of private equity. Since 2010 there have been over 20 significant private equity acquisitions in the sector and the multiples paid in restaurant sector deals have jumped significantly, rising from an average EV/EBITDA of 11.4x between 2010-2014 to 13.5x since the start of 2015. These deals have often relied on substantial levels of debt finance. At least five transactions since 2014 have been backed by debt levels of over £100m.
But, in many locations, the market appears to have reached saturation point and the problem isn’t limited to a larger number of locations sharing a smaller consumer wallet. Food and labour are two of the sectors biggest costs and both are expanding. Brexit’s hit to sterling has raised food import prices and threatens to increase wage costs already raised by the National Living Wage. EU citizens born outside the UK represent around a quarter of all UK hospitality staff. The increased influence of online delivery services adds another layer of cost and complexity. Restaurants lose margin in commission – which is usually around 10-15% – but they also need to ensure that they have capacity to meet demand and can only really benefit if they have a menu that is suitable for delivery. Meanwhile, restaurants still require the same high level of capital spending to maintain and refit their sites to retain market identity and customers, whatever the economic climate.
We are by no means ringing the death knell for an entire sector. But, many groups – especially those with high operating leverage – are struggling to grow profitability and cash generation in line with their investment cases. Those with heavy debts will find it increasing difficult to service those costs. We’re already seeing early signs of distress in profit warnings, in reports of site sales and closures and in insolvencies. Investors are taking note, which limits the investment and exit options. Average multiples for listed restaurant businesses have fallen from approximately 15x EV / NTM EBITDA in December 2015 to 10x EV / NTM EBITDA as at July 2017 as the sector falls out of favour.
Problems are often compounded by the lack of viable options to improve the top or bottom line. Struggling groups lack the capital to revamp old sites or open new locations. Discounting can drive volumes, but its prevalence has lowered price expectations in a similar manner to retail – and the sector has very little margin to give away. Cutting ingredient or staff costs risks a loss of quality. Property costs are generally fixed and tough to renegotiate. Closing sites involves a fixed upfront cost, selling is tough in this market and, in most cases, losing a site means losing close to 100% of revenues. There are very few operators in this segment with so much brand loyalty that consumers will go out of their way to find them.
Tapping the well
So, how can restaurants stay on the winning side? By inspiring that kind of brand loyalty! These are undoubtedly tougher times with headwinds outside of restaurants’ control. We expect to see more restructuring and portfolio reduction – especially amongst those with heavy debts. But, there is still potential for restaurants to tap into that resilient well of consumer spending on experiences and treats. A well thought-out brand concept and menu, excellent service and a memorable customer experience aren’t dependent on the economic climate. The price does still need to be right, so businesses need to be operationally excellent and as savvy as possible on locations and costs, especially leases. With the right concept and operational and capital base, plenty of restaurants can maintain or even grow their value – even in this environment.