Due Diligence’s New Normal

This article appears in the July 2019 issue of Restaurant Finance Monitor.

Have you ever seen word clouds for restaurants made
from social media ratings? They’re cool, often featuring
words—friendly, delicious, super, love, clean—restaurant
operators like seeing. But it’s investors like CapitalSpring’s
Erik Herrmann, head of the firm’s restaurant investment
group, who have lately been doing the looking—at both
the good and bad. “We pull together word clouds to mine
what people are talking about. Tat has been an area over
last 24 months that has been a real change for our [due]
diligence perspective,” he recently told me.

Word clouds are the result of social media scrapings, typically
performed by aggregators. Yet as much as these scrapings
reveal, restaurant managements evince scant interest in them.
“When we first started scraping and analyzing social media,
I thought I’d be selling to restaurants.” recalled Michael
Lukianoff, a data analyst who specializes in restaurants.
“They didn’t see the value in it. Tat was surprising.”
Said Herrmann: “When we’ve been out in the market
looking at concepts, I can’t recall a time when we’ve been shown
that [data].”

“There’s the perception there’s manipulation [of social
media] by heavy users looking for a free lunch,” explained
Piper Jaffray Managing Director Carlos Sanchez, a sell-side
investment banker, when I asked him why operators didn’t
analyze social media data that applied directly to their
restaurants. “So they take it with a grain of salt.”

Sanchez nonetheless advises sellers to be aware that social
media accounts will be part of the due diligence process. Piper
Jaffray, he added, has already evaluated 50 restaurant brands
via social media in an effort to learn how the brands stack
up relative to their competitors. “Tat’s newer information,”
he said, “and we tell clients to be prepared for that type of
data to be looked at.”

Lukianoff added that investment bankers, private equity
executives and Wall Street analysts, on the other hand,
gobbled up this data. It figures; they’re often responsible for
managing the due diligence process. “In this day and age
when so much of your reputation has to be managed and
people are looking at your scores, it is just another dimension
of the business that has emerged,” Herrmann said.
He along with several other advisors and investors explained
how today’s analyses of social media and third-party delivery
data is influencing—and sometimes confounding—their
due diligence efforts.

To be sure, restaurant investors are still drilling down into
established four-wall economics before writing a check. A
PE executive who requested anonymity described his firm’s
approach in an email. “Certainly cash-on-cash returns
remain the primary focus—north of 50% is important to
us,” he noted, adding “the particulars of store cash fow
margin” also remain crucial. Te labor calculation, for
instance, was of growing concern: “It is hard to get excited
about a mid-30% labor cost in today’s environment, given the
headwinds to labor.” He reckoned automation might help.
Yet for his firm the “biggest risk we see today” is third-party delivery. Its impact on margins were puzzling. “Do you need the same square feet, same number of seats, same main-on-main location, do you have a structural offset to that margin degradation (low labor model, for example),”
he wondered.

Sanchez didn’t find the questions surprising. “I’d say the other
newer area we’ve seen people go deeper into is third-party
delivery and mobile ordering. Tat part of the restaurant
business has been changing drastically and is creating new
types of analyses,” he explained. He also offered questions
of his own: Is the incremental dollar generating profit?
Is delivery cannibalizing sales? What is the theoretical
incrementality to delivery?

While those questions are also important at CapitalSpring,
Herrmann thinks getting past the way restaurants book
third-party delivery revenue is the first order of business.
“Tat aspect of delivery muddies the water,” he declared.
Te problem, as Herrmann sees it, is accounting for delivery
sales as revenue when in fact a portion of those sales pay
the delivery provider fees. His example is a restaurant that
charges $11 for a delivery item that’s priced at $10 in the
restaurant. Despite the $2 the delivery provider charges to
take that item to a customer, the restaurant still books the
sale at $11, thereby inflating the comp.

Herrmann charged that “this phantom income” is why
the industry, “in part,” is posting positive sales comps.
Last month, research firm Black Box Intelligence reported
comparable sales climbed 1.09% on a rolling three-month
basis, adding that 153 of the 196 chain restaurants it follows
throughout the country posted positive comps — in some
regions as as high 3.3%.

“What we’re doing from a diligence perspective is really
digging to understand delivery mix, profitability and pricing
levels,” Herrmann said.

Lukianoff believes the solution to high delivery commissions
for smaller chains (which comprise the vast majority of
multi-unit systems) is to raise prices carefully. “They have to
look at a completely different price point through delivery,
and not just a delivery charge,” he suggested. “Yes, there is
a delivery fee. But yes also that prices of delivery products
should be higher.”

Brookwood Associates’ Anish Ghandi, a banker who
advises buyers and sellers in the restaurant space, chalked
up these new risk calculations to a shift in the way people
use restaurants. “The core consumer now says, ‘I want to
get everything and anything on my couch,’” he told me.
“Restaurants have be able to cater to that.”
Investors, it seems, are only now beginning to calculate the
risks involved when restaurants do.

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