Why Has Restaurant M&A Activity Slowed Down in 2022?

    Investors are chasing concepts with better unit economics and wiggle room to deal with margin compression.

    Finance | April 12, 2022 | Danny Klein

    Fatburger

    FAT Brands spent nearly $900 million in five months on deals last year.

    Last year marked one of the more frenetic M&A calendars on record for restaurants. FAT Brands alone spent nearly $900 million in five months to acquire Global Franchise Group, Twin Peaks, Fazoli’s, and Native Wings and Grill, bringing its total suite to 17 concepts, 2,300 franchised and company-run locations globally, and systemwide sales of roughly $2.3 billion. The other major swing came in November when Burger King parent Restaurant Brands International agreed to purchase Firehouse Subs for $1 billion, adding a 1,200-unit sandwich chain to its lineup alongside Popeyes and Tim Hortons. Jack in the Box also announced its $585 million scoop of Del Taco in December, a deal that closed in March 2022.

    But while it might have felt inevitable, the notion 2021’s flurry of deals would carry into 2022 wasn’t a given. The Restaurant Finance division at Mitsubishi UFJ Financial Group released a report earlier in the year suggesting the opposite was likelier. Nick Cole, head of finance at MUFG, said strong sales industry-wide were tracking alongside margin erosion, thanks to higher food, fuel, labor, and transportation costs. And those weren’t transitory, or at least near-term, realities.

    Indeed, according to Bureau of Labor Statistics released Tuesday, menu price inflation hit a new 40-year high in March. Food-away-from-home inflation soared 6.9 percent, year-over-year, the largest 12-month jump since December 1981. Full-service restaurants saw their menus hike 8 percent, year-over-year, while quick-serves upped 7.2 percent. Food-at-home (grocery) prices were 10 percent higher and the consumer price index overall increased 8.5 percent—a 40-year high for general inflation.

    To Cole’s prediction, restaurants are taking price to recover margins in face of commodity, supply, and labor dynamics. Wage rates at restaurants are presently 11 percent higher, year-over-year.

    According to the recent Producer Price Index (PPI) report, also released by the BLS, food prices rose 12.8 percent over the past year, including major upticks for ingredients vital to operators like beef and veal (43.9 percent), grains (22 percent), shortening and cooking oils (36.4 percent), and eggs (40.9 percent).

    “The M&A market depends on a well-capitalized banking system flush with liquidity, which we currently have, but cash flow—and the price acquirers are willing to pay for that liquidity—are the primary drivers that attract buyers, so unless we see an improvement in margins, we expect the pullback to be significant,” Cole said.

    Quinn Hall, who leads loan underwriting and portfolio management at MUFG, added aggressive financing realities are shaky at this COVID turn. This, too, walks back to the supply chain. “In addition to vacancies for waiters, cashiers and kitchen staff, restaurants have had to cope with the effect of supply interruptions and worker scarcity among commodity producers and transporters that pushed up labor and food costs,” Hall said.

    Brand stories in recent months reflect Hall’s note. Starbucks said in February staffing shortages in the supply chain skyrocketed distribution and transportation costs. Supply chain-driven inflationary prices, which kicked up in December, impacted the coffee chain’s U.S. business by more than 170 basis points on margin.

    On the front lines, labor is becoming more expensive and wide-ranging. “Since it’s not enough to just offer higher salaries, restaurant businesses will need to consider a range of enhancements to their benefits packages and employment offerings—from health benefits to flexible work schedules—that would raise costs as well,” Hall added.

    Early in the year, Hall pointed out, financing conditions for restaurants were riding a tailwind from healthy supply of capital and record financial performance—particularly in quick service. Banks were accepting a higher leverage profile among borrowers and offering loose amortization, pricing, and covenant terms.

    Yet if margins kept eroding, Hall felt financing terms would tighten in 2022, especially if interest rates lifted and borrowing costs grew.

    So how has this evolved?

    FAT Brands CEO Andy Wiederhorn told analysts in March the company would likely slow down its acquisition pace this year to digest “what we already acquired realizing the synergies.” But he also didn’t rule out doing so, saying FAT Brands remains “active in evaluating additional accretive acquisition candidates that augment our existing brands.”

    According to Aaron Allen, CEO and chief global strategist of his eponymous Aaron Allen & Associates, U.S. acquisitions are driving nearly 30 percent of revenue growth among publicly traded restaurant companies today. It’s why consolidation keeps popping up and why it’s likely to pulse again. Think Panera Brands, which sprung up in August as a combination of Caribou Coffee, Einstein Bros. Bagels, and the cafe giant, a 4,000-location suite with 110,000 employees; and Inspire Brands, perhaps the fastest-growing foodservice company yet.

    Given the challenges at hand, the leverage of shared resources (and the ability to offer franchisees multiple brands and entry points) is alluring to many surveying growth potential in the wake of COVID. Inspire, which runs Dunkin’, Baskin-Robbins, Sonic Drive-In, Rusty Taco, Buffalo Wild Wings, and Arby’s, eclipsed $30 billion in total global system sales in 2021—a double-digit year-over-year increase that saw it spread to 70 markets globally, including further expansion into Asia, the Middle East, and Latin America. The company, formed February 2018 following Arby’s Restaurant Group’s $2.9 billion purchase of Buffalo Wild Wings, also generated U.S. digital sales growth north of 35 percent, year-over-year, to $6 billion-plus—good for more than 20 percent of domestic system take. The company surpassed $1 billion in sales via third-party marketplace. Overall, digital sales now represent over $7 billion of Inspire’s global business. And on the point of data and digital cross-fertilization, Inspire has a loyalty base company-wide of nearly 50 million members. It opened north of 1,400 stores in 2021, including more than 500 U.S. franchise-led units and 800 outside the country.

    Yum Brands!, between Taco Bell, KFC, Pizza Hut, and Habit Burger, debuted a net of 1,259 restaurants in Q4 2021, pushing its year-end total to 3,057 net new openings. The previous company record was 2,040 in 2019. Overall, Yum! added 4,180 gross units, which CEO David Gibbs called the strongest growth year in our history and setting an industry record for unit development.”

    It bears asking if the big will look to get bigger in 2022, or if mid-sized/smaller chains will seek out mergers and investments in hopes of strengthening their bargaining power. A recent example being Dave & Buster’s $835 million deal for competitor Main Event, which interim CEO Kevin Sheehan (Main Event’s Chris Morris will take over upon close) described as a "transformational combination," noting Main Event's model, footprint, and asset quality align well with Dave & Buster's. The two concepts don't cannibalize each other either; while Main Event targets families and children, Dave & Buster's goes after young adults. 

    The rationalization brought forth by pandemic closures revealed new battlegrounds for market share. And consumer demand is there, with rising costs as the constant hurdle. Yet like 2021, restaurants that outperformed conditions, and built more resilient, diverse business models through it, could be poised to grow, or become targets for investors and larger companies. On another side, brands unable to combat costs, and perhaps headed for covenant defaults with lenders, might spark deals as they search for relief.

    Morven Groves, vice president of 10 Point Capital, a firm fueling the growth of Tropical Smoothie Café, Slim Chickens, and Walk-On’s Sports Bistreaux, chatted with QSR about the state of M&A in the business, and where the industry might be headed on that front.

    Slim Chickens

    Slim Chickens, a 10 Point Capital portfolio brand, expects to open a record number of stores this year.

    So let’s start with the acquisition and investment elephant in the room. Why haven’t there been more of either thus far in 2022?

    I think there are several contributing factors. Valuation expectations remain high, driven by some of the transactions over the last 18 months—deals at these levels need companies to deliver robust growth. However, there is a lot of uncertainty surrounding ability to deliver on growth projections given supply chain challenges, competition for real estate (especially drive-thru), and inflation across the board. Additionally, a lot of third-party providers needed to complete a transaction (accountants, consultants, financing sources) were so busy at the end of the 2021 that many of the potential transactions ended up delayed into 2022.
     
    One prediction I heard heading into the year was despite strong sales, many (if not most) restaurant companies actually saw margins erode because of higher food, fuel, labor, etc., costs. Couple that with difficulty hiring people, and you potentially have a conservative industry not looking to take on new assets. Essentially, cash flow—and the price acquirers are willing to pay for liquidity—were the primary drivers attracting buyers. So given the margin issues, it’s leading to a pullback. Have you seen that?

    I think there is overall optimism that margins will improve toward the end of 2022 as many of the supply chain issues are resolved. We have seen a retreat to quality recently as investors chase concepts with better unit economics and wiggle room to deal with any margin compression. If a concept was marginal in terms of economics before, it’s certainly not in better shape now. However, stronger brands tend to attract better capitalized franchisees or investors, and for many of them, they see this as time to continue their growth, and potentially to access some great real estate opportunities. For example, two of our portfolio brands, Slim Chickens, and Walk-On’s Sports Bistreaux, both expect to open a record number of locations this year.
     
    Do you expect things to change? There appear to be plenty of firms and brands, and banks, with flushed balanced sheets coming out of the crisis. Are they simply biding their time?

    I think so. Firms, brands, and banks are all looking to deploy cash. Additionally, there is more committed capital in the restaurant market than ever before—there are more PE firms and non-bank lenders who will remain investors in restaurants despite the point in the economic cycle. We’ll continue to see those firms put capital to work this year.  

    How do you see this unfolding? Is more consolidation on the table for companies looking to diversity, like RBI buying Firehouse? 

    There are still some great brands and as you point out, there’s money out there to fund acquisitions. I expect that some of the big umbrella brands like RBI and Inspire Brands will continue to add to their brand portfolio. They’ve made investments in building out common platforms, so it only makes sense to continue adding to their portfolios to leverage these investments. This bundling of concepts and then subsequent unbundling of concepts seems to have been a trend in restaurants over the last 40 years (and longer)—we are at a point where the capital is available to support bundling.

    Have digital capabilities, like ghost kitchens and virtual brands, made acquiring different concepts more attractive to larger groups? 

    The restaurant industry is incredibly competitive. While I’m sure there will be some success stories amongst the ghost kitchens and virtual brands, I think they will be the exceptions. For a larger group looking to acquire, they’re looking for brands that can scale quickly, delivering a consistent, differentiated brand experience. With ghost kitchen and virtual brands, you lose some of the ability to control all aspects of the experience; similarly, you’re not quite as close to your guests, and their feedback.

    What about investments versus acquisitions? What will drive the first over the second, for some brands hoping to grow?

    At least in our experience, investment versus acquisition is more specific to the situation of a particular company. At 10 Point Capital, we’re typically the first non-friends-and-family money into a high growth brand. Generally, the founders are looking for some liquidity or capital to grow. However, they also firmly believe in the prospects for their brand and want to be an integral part of the growth, and to financially benefit in the future. In other instances, the business is at an inflexion point where either the founder or the management team capabilities aren’t as well suited to driving the brand to the next level. In these cases, acquisition can be a better route to pursue. We also see acquisitions where the founders are ready to retire or there is already private equity investment and a need for an exit event.

    How do you size up the growth potential for the industry, especially quick service, at this point in the recovery? It sure seems like a lot of brands are throwing massive targets out there, or expanding previous plans, such as Chipotle and Wingstop, which each added 1,000 units to their recent guidance. What kind of concepts are poised to expand?

    On the whole, the restaurant sector is generally correlated to GDP. However, as we all know, the actual performance of specific brands and segments can be chaotic. There are usually winners and losers in segments that vary wildly despite the segment growth. Quick service, and brands with drive-thrus more generally, are certainly well poised for growth. COVID has shown that people want to keep getting food away from home, and that they love convenience; even as the world has opened up again, convenience has continued to be highly valued. A brand like Slim Chickens, a better-chicken quick-serve concept, has seen tremendous demand over the last two years from guests and investors alike—many of these units are still under development.
     
    In particular, where do you think fast casual fits in?

    Fast casual remains an attractive segment. However, both fast casual and casual are looking to quick-service restaurants for what they can learn to drive growth. Curbside, digital ordering capabilities, take-home meals, working with third-party delivery companies will all be important pieces of the toolkit, and where there’s an ability to add a drive-thru, many will look to do so