In Part 1 of a series on the future of fast casual, Green Circle laid out its thesis for why it is bullish on the segment coming out of the COVID-19 pandemic and economic crisis. In Part 2, it explores where it believes investors and operators can find the best opportunities for value creation.

Part 2: Where Operators and Investors Should Converge Within the Fast Casual Segment to Create the Most Value for All

Better-for-You Brands

Green Circle focuses exclusively on better-for-you brands, given its belief that these are best aligned with changing consumer preferences that we expect to continue for decades to come. These companies also tend to embrace shared values that are well aligned with the company’s personal ones, in regard to social responsibility, sustainability, etc.

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However, in addition to the well-established, better-for-you wave that CPG and restaurant brands have ridden over the past decade, we see specific opportunities coming out of the COVID-19 crisis that will drive further demand for better-for-you restaurant companies.

Better-for-You Food: Nothing has brought the health of our citizenry to the forefront in such a compelling manner as this most recent pandemic. Coming out of this crisis, we anticipate an even greater emphasis on health and wellness from consumers who are anxious to resume healthy, active lifestyles. The renewed focus on health will be a boon for better-for-you fast casual concepts, which have an opportunity to become a part of consumers’ weekly routines once again.

While meat prices have seen recent spikes as a result of temporary supply disruptions, forecasts from the USDA call for more muted commodity price inflation over the next year. Within a more modest commodity price inflation environment, restaurants should be able to source high-quality, sustainably raised ingredients without hurting margins or forcing significant price increases.

Health and Safety: In a post-COVID world, better-for-you food goes beyond ingredients. Companies throughout the industry, large and small, have implemented new health and safety policies and guidelines, widely following guidance and directives from governmental authorities. In order to win trust with guests, it is crucial for businesses to update their operating procedures, including but not limited to: employee temperature checks before each shift, masks for employees, and more stringent food safety and sanitization protocols. The brands that most quickly and thoroughly implement these operational overhauls will be better positioned to earn the trust of a fragile U.S. consumer base.

Better-for-the-Planet Brands

Over the past decade, there has been a proliferation of environmental consciousness and activism that goes hand in hand with the better-for-you movement. This trend has been apparent in the restaurant industry, where brands have put their environmental bona fides on display to build stronger connections with environmentally conscious customers. These themes resonate deeply with millennials and Gen Z consumers, and it bears consideration that millennials are now becoming the generation with the greatest purchasing power in the country. As they hit prime spending years, millennials are looking to put their money where their values are.

Coming out of the crisis, we anticipate an even greater affinity from customers for brands with a better-for-the-planet ethos.

Sustainable Agriculture: In recent years, younger consumers have exhibited some rebellion against America’s broken factory farming system. Research suggests that “they have the highest consumption rates of organic and non-GMO food and beverages, demanding authenticity, freshness, and purity. They, in part, reflect some defining characteristics of their millennial parents, who took issues such as animal welfare, fair trade, sustainability, ethics, and the environment, and focused them on food and agriculture.” This trend toward sustainable agriculture is likely to accelerate, with the COVID-19 crisis further exposing how our broken food system is putting the world population in danger from infectious, zoonotic diseases, as well as other health crises and the adverse effects of climate change.

Building an Employee- and Community-Centric Culture: There has been a spotlight on employment practices within the restaurant industry in recent years. Many have noted the difficult work environments and substandard wages, among other challenges. In response, many restaurant brands have made it a priority to foster employee-centric cultures with better employee benefits (higher pay, education reimbursement, vacation/sick leave, flexible scheduling, etc.). Many of these brands have taken similar strides to be good corporate citizens by becoming part of the fabric of their local communities. Particularly in light of the hardships caused by COVID-19, brands that demonstrate a commitment to their employees and communities stand to benefit from increasing customer affinity.

Charitable Giving: Some of the most inspiring stories to come out of the crisis have been the outpouring of support for healthcare and essential workers, along with other community initiatives. Riding this wave of charity and gratitude, customers are likely to actively seek out brands that invest in programs that have a positive impact on their communities and the planet at large. This includes initiatives such as supporting impoverished and food-insecure communities, food banks, farm-to-table trends, and hospital/service workers, among others.

Better Tech-Enabled Brands that Can Flourish in the Post-COVID-19 World

Green Circle’s third criteria for success requires us to seek out brands that are better tech-enabled and, thus, better equipped to navigate a post-coronavirus world. While many of these tech trends were already at the forefront of the restaurant industry pre-crisis, we anticipate that they will take on a new, more urgent meaning post-crisis. We believe that in the new normal, many more innovations will arise. From this chaotic period, we will see creative scientists, engineers, and businesspeople solve some of these novel dining-out challenges with new and inspiring tools.

Off-Premise Innovations in Delivery, Contactless Pickup, and Drive Thru: The off-premises channel (delivery/takeout) has become a driving force for brands working to survive the disruptions caused by the pandemic. When we discussed this topic with Nick Stone, founder and CEO of Bluestone Lane, an Australian-inspired coffee, café, and lifestyle brand, with over 50 stores in the U.S., he says, “Prior to COVID, delivery was 5 percent of our total sales mix. Currently, it’s 50 percent of total sales, reinforcing how dramatic the change in operations has been in this new world.”

Delivery has been an enigmatic, rapidly evolving force in the restaurant industry in recent years, with the potential to unlock significant untapped customer demand, offset by unsustainable costs associated with the service. This is particularly true of third-party ordering/delivery fees. Restaurants can pay commission fees as high as 30 percent on orders delivered by third-party aggregators like DoorDash and Grubhub. While we expect many of the same challenges to persist, we see COVID-19 and the resulting lockdowns as having made delivery incrementally more viable for restaurants.

From a demand perspective, GrubHub and other platforms have reported record numbers of new customers ordering online for delivery during the lockdowns. GrubHub noted on its Q1 earnings release: “We are also seeing record numbers of new diners and new restaurants on the platform.” This opens up a brand-new customer base for restaurants to target when they reopen.

With the likelihood of lingering fear of going out to eat in public, we expect there to be a more prevalent willingness from customers to cover the costs of delivery, allowing restaurants to pass through more of those fees. Additionally, recent caps on third-party fees passed in major urban markets around the country make delivery transaction economics more palatable for restaurants; that said, it remains to be seen the impact these caps will have on delivery volumes. This could also lead to a push by fast casual brands into new ghost kitchen locations, perhaps far more rapidly than previously anticipated.

In a time of social distancing and escalated concern for health and safety, ghost kitchens provide opportunities for restaurants to provide value to consumers while limiting risk. It is crucial, therefore, that fast casual brands have strong systems in place (streamlined online ordering, second back-of-house production lines, speed, reliability, etc.) to handle delivery coming out of the crisis.

Beyond just delivery, the rapid adoption and increased utilization of contactless pickup and the recent move by fast casual brands toward drive-thru lanes will continue to support sales during the transition period while consumers remain less eager to dine in with other customers. Notably, Chipotle has frequently called out drive-thru and pickup as the highest margin sales channels for the brand.

Companies that offer a better, more tech-enabled mobile ordering process stand the best chance of creating a seamless ordering and contactless pickup solution to cater to these customers. Avoiding friction in ordering systems will lead to more orders, and smooth execution at the restaurant will lead to greater repeat orders, as well as a sustained lift in related sales.

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Streamlined Labor Model is Key to Success

For restaurants that have chosen to remain open during the pandemic, the key to success has been a rapid reduction in store labor, often coupled with reduced menu offerings. According to an article in FSR, “Another area of significant simplification has been with the menu. A limited menu that focuses on the most popular sellers allows customers to quickly make a decision and order. It’s also easier and faster to produce with a limited staff so orders can be executed quickly without mistakes. Reducing the menu has also led to a reduction in the number of SKUs in the kitchen, which has made it easier to manage inventory and place orders for ingredients.”

The brands that have been able to execute in this environment are those that had already built their businesses so as to leverage limited labor overhead. In a world that had already seen a rapid rise to a fifteen-dollar hourly minimum wage in many markets, labor costs will remain a key factor in the success of companies in the years to come. The highest-performing restaurant stocks over the past few months during COVID-19 have trended toward being those with the lowest labor costs as a percentage of sales prior to the pandemic—Industry: 30 to 35 percent versus WING: 23 percent; CMG: 27 percent; and DPZ: 29 percent. It will be crucial for brands to optimize their menus and store designs to reduce the amount of labor needed to operate, particularly in times of industry disruption.

Closing Thoughts: Where Do We Go from Here?

Even with the economy reopening in stages over the coming months, restaurants should be prepared for future disruptions. For instance, at the time of the publication of this article, we are seeing significant case spikes in various states amid a new resurgence of the virus. This could conceivably lead to more or repeat shutdowns. It is essential that restaurants use this time to effectively prepare for continued difficult times ahead. This includes becoming better tech-enabled, changing operating protocols for enhanced health and safety, streamlining labor models, paying down debt, and bulking up cash reserves to the best of their ability.

There will be more challenges ahead for restaurants in the months to come, but from chaos comes opportunity.

Green Circle seeks to partner with brands and technologies that are better—better for you, better for the planet, and better tech-enabled—in an effort to navigate the post-pandemic world. We are specifically focused on the $60 billion-plus fast casual segment; in our view, this segment maximizes collective benefits distributed across customers (better convenience and value), employees (better opportunities for growth), and shareholders alike (better four-wall economic efficiency and returns on invested capital). Thanks to a digitally savvy customer base (Millennials, Gen Z), we see immediate opportunities for fast casual brands to accelerate unit expansion and significant white-space potential over the next five to ten years.

Mike Vieten, CFA, is the Managing Director—Restaurants Managing Director. He spent his career analyzing, investing in and operating food & beverage businesses. He began his career as an equity research analyst covering the restaurant and food verticals at Stifel Nicolaus and Cowen and Company. While there, Mike covered 40 publicly traded restaurant and food companies, meeting with management teams and building financial models and investment research reports.

Stu Strumwasser is the company’s managing director. He spent the first 15 years of his career on Wall Street in wealth management at firms including Paine Webber (now UBS AG, where he was first in a class of forty nationwide) Advest, Inc., and finally at Oppenheimer & Co. where his title was Director-Investments. He left the industry in 2006 to found Snow Beverages, a manufacturer of natural soda.

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