US EQUITY RESEARCH
We see an accelerated pace of market share consolidation in the restaurant sector over the next five years, beginning in earnest in 2019, driven by the compounding pressure of (a) the unrelenting and structural rise in labor costs; (b) a rapidly mutating off-premise and mobile channel; (c) the growing cost of capital and; (d) an elevated promotional environment.
Consolidation Wave: Bottom 5% of US restaurants will struggle to survive the coming ~25% labor inflation over the next five years. While labor availability is cyclical, the legislative impact of both minimum (5th inning) and tipped wage (4th inning) means that the marginal cost of a new hire will continue to structurally rise. We also expect this to prompt accelerated M&A and exits, driving gains for larger operators.
Promotional Crescendo vs Elevated Pricing: Operators are weighing more elevated price hikes in 2019 intended to offset labor costs against a seemingly unrelenting promotional environment, setting up a year of volatile traffic patterns as the gap to retail prices rises again.
Balance of Power is shifting. Consolidation among franchisees has led to more frequent groundswells of resistance. In the last two years, coalitions of franchisees have challenged management decisions at McDonald’s, Tim Hortons Canada, and Jack in the Box, among others. Such franchisee resistance challenges the explicit narrative of the asset-light model as franchisors are pressured to provide more ongoing support, especially given the accelerating pace of evolution in customer behavior, driven by mobile and delivery. As a result, we expect more frequent confrontations, and we believe long-term free cash flow model of the QSR sector must incorporate the risk of recurring capital injections.
Delivery to Accelerate: Restaurants are leaning into comprehensive mobile strategies, where the delivery channel is a key component. We believe this will escalate into 2019 as a number of major chains exit trial phases and fully engage in delivery on a national scale, especially as a rising off-premise mix can function as a key labor hedge. At the same time, delivery operators such as GRUB must invest alongside their partners to fortress their market share. Overall, we expect delivery transaction growth to accelerate in 2019 vs 2018.
A "Silent" War Emerging Between Restaurants and Third-Parties: Pencils are sharpening on the economics and restaurant managers are preparing for incrementality to eventually diminish. As a result, companies are ramping up investment in direct channels, such as a brand’s own app or website, where operators shave off the third-party commission points while still leveraging their network of drivers for delivery. In our view, much of the friction revolves around customer data, which third-parties are reluctant to share and which restaurants increasingly demand as the mobilization of purchasing behavior calls for a more personalized marketing approach. While aggregators have the user advantage, a number of operators are beginning to fast-track loyalty programs in order to complement the mobile ordering experience. These will be expensive, yet necessary, investments in key customer data and commission reduction.
Juice is Harder to Squeeze: Easy Growth is Near Over: A decade of low global rates has enabled cheap support of ambitious development schedules, both domestic and international. Over the next five years, we see shrinking franchisee appetite for unit growth on rising cost of capital and a hangover from the synchronized development boom over the past decade.
China Reassessment: We believe the China opportunity needs to be reassessed. While there’s no doubt that China remains the largest long-term consumer opportunity, the aggressive pace of store expansion over the past five years should began to yield suboptimal returns as the country manages through a macro slowdown.
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