The franchise industry has long been fertile ground for turnaround industry professionals.
Multilocation retail concepts have
traditionally undergone boom and
bust cycles that have precipitated
alternating periods of growth and
expansion, followed by retrenchment,
consolidation, and renewal.
One of the drivers of this cyclical
profitability is the need for ongoing
capital expenditures for reimaging and
remodeling. The restaurant industry
offers a particularly clear illustration of
the impact that capital expenditures,
or the lack of them, can have on
profitability and even viability. This
article reviews the costs and benefits
of capital expenditures as well as their
very real value implications. First,
though, a quick primer on the industry
and its economics is in order.
profitability with the onset of the
recession. Beginning in the fourth
quarter of 2008, high-end chains, such
as Flemings, McCormick & Schmick’s,
and Morton’s, went through a five-quarter period during which their
year-over-year results dropped 15-20
percent. Casual dining companies,
such as Applebee’s, Chili’s, and
O’Charley’s, saw revenues drop 5-6
percent annually over the same period.
resulting from the poor economy and
the limited availability of financing
for leasehold improvements or capital
leases during the period have restricted
reinvestment in capital facilities. In
2012, turnaround professionals can
expect to see the effects of these
delays in capital expenditures.
Across the industry, revenues stabilized
a bit going into 2010 and grew more
consistently, albeit slightly, through
2011. For 2012, most sectors within the
industry expect 3-5 percent growth, with
some notable exceptions for specific
chains or concepts such as Chipotle
or McDonald’s, which continued to
grow even through the recession.
Historically organizations that do not
keep current on their upkeep and capital
expenditures are candidates for long-term decline. Many industry followers
blame the lack of funding for capital
expenditures and brand renewal for
the recent bankruptcies of Friendly’s
Ice Cream, Sbarro, Perkins & Marie
Callender’s, and Chevy’s Fresh Mex.
According to the National Restaurant
Association, U.S. restaurants are
expected to have sales of around $632
billion in 2012 and to employ 12. 9
million people. The industry has more
than 960,000 locations nationally.
Cost of Goods Sold
As with other multilocation retail
industries, one of the key indicators
of financial health in the restaurant
industry is store-level cash flow. In a
quick-service restaurant, a turnaround
professional can expect financial results
generally similar to those in Figure 1.
In restaurant terminology, prime costs
are the sum of cost of goods sold plus
payroll. As a rule of thumb, prime costs
must be below 68 percent of total
revenue. Below the store level, typically
overhead and other administrative costs
can be in the range of 5 percent of sales.
Given the long payback periods
involved, remodels and reimaging
are often perceived as economic
burdens on franchisees rather than
as financial benefits. Despite their
importance, capital expenditures are
often hidden components of occupancy
and real estate costs. Restaurants
are monitored in excruciating detail
for profitability on weekly, daily, and
sometimes hour-by-hour bases, yet
capital expenditure spending is often
overlooked because it is not included
on profit-and-loss statements.
Store-level Operating Profit 10%
Franchisor organizations like to make
over or reimage locations about every
three to four years and complete more-major remodeling every eight to 10 years.
A reimage may include repainting, new
fixtures, new menu boards, and other
simple cosmetic activities, and may
cost less than $100,000. Year-over-year
sales growth associated with a reimage
can be in the 3-5 percent range.
As Figure 1 shows, occupancy costs
(rent, utilities, and taxes) are typically
10 percent of the top line, with rent
normally falling in the range of 6-8
percent of sales. As the largest fixed cost,
occupancy costs often determine if a
location will be profitable in the long run.
Occupancy, store management, and
other fixed or relatively fixed operating
costs represent about 30 percent of
revenue. Because variable costs are
relatively high, profitability and cash
flow are largely driven by sales volume.
Remaining relevant to the customer
and maintaining consistency with
a franchise’s brand are extremely
important to both consumers
and franchisors. Refreshing and
renewing the look and feel of a
location on a timely basis can drive
profitability for a franchisee.
More-extensive remodeling may cost
$200,000-$300,000 per location. It
may include a facelift of the entire
structure, inside and out, and often is
accompanied by equipment upgrades.
For most franchisees that have stand-alone buildings, the footprint is
based on company standard-facility
requirements, regardless of a unit’s
current revenue level. As a result, the
cost to remodel tends to be consistent
across the base of locations.
The restaurant industry saw precipitous
declines in revenue and therefore
Since 2008, most franchise organizations
have had neither the capital nor the
appetite to update their establishments.