With the restaurant industry in a cyclical downturn, investors have moved their attention to more promising sectors of the economy. However, even amid an intensely promotional operating environment, some casual dining chains are making important improvements in efficiency that will pay off when the industry hits a cyclical upturn.
Efficiency is king
Operating a restaurant is similar to operating a retail storefront. Toy stores sell toys, bookstores sell books, and restaurants sell food. Like toy stores, restaurants sell a somewhat differentiated product, but the inventory is close enough to a commodity that price competition plagues the industry and makes it difficult for companies to build lasting competitive advantages.
Although certain well-known brands -- such as Cheesecake Factory , Brinker International's Chili's, and Darden Restuarants' Eddie V's -- earn a degree of brand loyalty, the vast number of branded restaurant chains makes a strong brand necessary to compete rather than something that provides a competitive advantage.
When a company has no durable competitive advantage, the only way to compete is by becoming the most efficient operator. One of the best ways to determine the efficiency of any retailer -- or restaurant -- is by looking at how quickly a company can sell its inventory after taking possession of it.
The Cheesecake Factory is one of the best examples of inventory efficiency in the casual dining industry. On average, it takes the company just eight days to sell all of its food. Brinker International, however, has vastly improved its inventory management over the last two years and is now two times more efficient at managing inventory than Cheesecake Factory. Darden brings up the rear by taking 16 to 20 days to clear its inventory. This is likely due to its larger portfolio of restaurants that can make inventory management less lean than smaller companies'.
The importance of inventory management becomes obvious when you compare it to how quickly these companies turn inventory into cash. Cheesecake Factory pays for its inventory (food) about three days after it sells it to customers. Meanwhile, Darden Restaurants has to pay for its inventory about four days before it can sell it to customers.
When Cheesecake Factory sells its inventory at a premium to what it has to pay for it, the whole system looks a lot like a great insurance underwriter like Progressive, which essentially gets paid to hold its float.
However, the most impressive cash flow management is at Brinker International, which receives cash from customers about 20 days before it pays for inventory (on average). But Brinker's advantage comes not from superior inventory management -- although its inventory management is great -- but from negotiating with suppliers to extend days payable.
Efficiency is king in the restaurant industry. The most efficient operators tend to do the best over time. While Cheesecake Factory has been the long and steady efficient operator, Brinker has had its moments as well.
Brinker and Cheesecake trade at 18x and 20x earnings, respectively. Considering that the industry is in a cyclical downturn, these multiples could well turn out to be fair prices in the long run.
Meanwhile, Darden trades at just 15x earnings. Although it is not as efficient as the other two, it has a long history of stable profitability. The major upside for Darden comes in the form of increased efficiency; a small improvement in its ability to manage inventory would be a major boon for this stock.
So, while the best restaurant is not always the one that is most efficient today, efficiency will ultimately determine the long-term fate of all restaurants.
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