Limited-Service Restaurants: Weathering the Storm

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.

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.