Is the Middle Ground Disappearing for Restaurants?

Savvy menu engineering is separating the winners from pretenders.

Finance December 2018 By Danny Klein

McDonald's

Delivery has played a big role in McDonald's recent surge.

The third quarter of 2018 punctuated what’s been a consistent trend for chain restaurants this calendar year. Higher menu pricing, a slowdown in promotional discounting, and widespread improvement to the top-line. According to BDO’s The Counter Report, which measures the performance of publicly traded brands, same-store sales upped 1.4 percent across the board in Q3.

Beyond the figures, a few trends emerged. It appears the industry’s middle ground is disappearing. Successful concepts either embrace new approaches or stand steadfastly by established concepts, BDO said. One way to look at this: Despite a 1.3 percent decline in traffic, some brands lifted same-store sales through the rapid expansion of delivery capabilities.

“Restaurants, especially those in the fast casual sector, faced increased pressure to offer a seamless delivery experience—and quite a few appear to have risen to the challenge. This enabled these brands to offset declining store traffic with an influx in delivery sales, resulting in positive same-store sales figures,” BDO said.

In this change, it’s not as simple as raising prices and relying on delivery. Adam Berebitsky, leader of BDO’s Restaurant practice, says savvy menu engineering is increasingly defining success for those winning brands.

“Menu engineering has been around for years, however, in light of the recent decrease in traffic counts and rising labor costs, revisiting this concept is more important than ever,” he says. “While the industry now celebrates overall 1.4 percent same-store sales growth, as reported in BDO’s The Counter report for Q3, the flow through will not offset higher operating costs unless those sales mostly consist of ‘star’ menu items.”

Is it even an option now to stick to the same pricing structure responsible for a brand’s growth to date?

“Menu engineering, such as strategically pricing higher-cost items or reevaluating prices for popular items, is a necessity,” Berebitsky adds. “It all starts with costing out your menu to understand the profit margin for each item. In order to optimize menus effectively, restaurants have to be strategic about the placement of items on their menus that help direct customers to their most profitable offerings. In order to achieve this, the least profitable dogs’ need to be removed.”

Berebitsky offered some advice for balancing the decline in traffic.

“Prudent operators are strengthening their delivery and digital capabilities while also maintaining their focus on quality customer service. Managing in-house labor costs, menu engineering, optimizing delivery capabilities and upgrading digital infrastructure are all tactics restaurants can adopt to manage this shift in consumer preferences,” he says. “At the end of the day, however, restaurants should not overlook the value of excellent in-house customer service—consumers still enjoy quality dining experiences and reward such service with their loyalty.”

BDO

The publicly traded fast casuals turned in a strong Q3 in regards to same-store sales, recording a 2 percent uptick. Fiesta Restaurant Group’s Pollo Tropical and Taco Cabana did some heavy lifting. Both were riding rebrands and lapping a very difficult 2017. They also invested in higher-quality offerings and added price in favor of promotional discounts. The Q3 gain at Taco Cabana consisted of a 12.1 percent increase in average check, inclusive of 7.7 percent in pricing and positive sales mix associated with higher-price promotions and new menu items with higher food costs. At Pollo Tropical, the comps growth comprised of a 5.2 percent increase in average check, inclusive of a 4.9 percent gain in pricing, and a 1.3 percent increase in comparable restaurant transactions.

BDO also noted Wingstop’s strong performance lately, credited in part to innovative digital advertising campaigns and delivery.

Quick service generated 1.2 percent overall same-store sales growth. Delivery played a larger role here as well, especially in regards to Taco Bell and McDonald’s. In Q3, McDonald’s said it currently offers delivery from more than 15,000 restaurants. It expects to reach thousands more by the end of the year, CEO Steve Easterbrook said, including a total of 9,000 in the U.S. In the U.K., Australia, and France, delivery represents as much as 10 percent of sales in restaurants that offer the platform.

The pizza segment slipped a bit, reporting a 0.8 percent decline. The overall performance was softened by the continued struggles at Papa John’s.

On the full-service side, casual dining posted a 1.6 percent overall growth thanks to a sales resurgence from Applebee’s and the consistent success of Texas Roadhouse.

Upscale casual achieved 1.4 percent growth, double the performance reported through Q2.

BDO

Commodities play a role

Through September, BDO reported that beef prices rose a modest 1.7 percent. Cheese was up 5 percent. Due to recent tariffs associated with trade tensions, and a reduction of U.S. pork exports to China and Mexico, the cost of pork dropped 6 percent over the quarter. Egg prices lifted 33 percent, although its typically a low-cost commodity so the rise isn’t as drastic as it seems.

A higher cost of sales through Q3, up to 28.8 percent, also led many restaurants to strategically raise menu prices to offset higher labor expenses.

As for labor …

The costs of labor average 31.2 percent through September as restaurants faced pressure from competitors to pay their employees above minimum wage. “This comes at a time when restaurant workforce turnover continues to increase, and restaurants are beginning to offer perks like maternity leave and mentorship programs in order to both attract and retain qualified talent,” BDO said. This is even more pronounced in urban areas where many companies have drastically raised entry level wages to compete for skilled workers.

Moving forward

BDO expects restaurant IPO and M&A activity to continue at a healthy pace. Sonic Drive-In’s deal to Inspire Brands and Bojangles’ sale to Durational Capital Management and The Jordan Company are two recent examples. Jack in the Box and Del Frisco’s Restaurant Group are also exploring “strategic alternatives” that might include a sale.

“As a result, however, acquisition premiums are expected to decrease, making expensive buyouts much less likely,” BDO said.

Moving forward, it is important that restaurants consider their customers’ shifting priorities and the unique challenges posed by expanding their delivery and digital capabilities,” it added. “Facing intense pressure from competitors, restaurants may feel the need to charge toward innovation—but for innovation to be sustainable, sound financial and operational management must come first.