On Restaurants

Restaurants largely deserve their reputation as poor businesses. Any business with low barriers to entry will never make much more than its cost of capital*. It's capitalism 101. You don't need to read strategy guru Michael Porter to know that.

Long waits and good food don't equal a buy signal. The Cheesecake Factory, other than its bad name, is famous for it's dairy desserts and long waits. I wouldn't salivate over the stock, however. All capital expenditures, in excess of actual cash generated, are understandable plowed back into growing store count. But the incremental returns on capital are mediocre 13% / 8% (levered to unlevered).


Costs across restaurants are fairly consistent: about 1/3 of sales is food, 1/3 labor, 25-30% SG&A and other, and the other 5 cents flow to the bottom line.


Ticker ROE (ttm) ROE (w/o debt) Profit Margin


CAKE 13.0% 8.4% 4.51%
DRI 28.6% 12.6% 5.83%
EAT 24.7% 12.6% 4.71%
MCD 16.7% 10.0% 10.86%
RUTH 20.4% 9.1% 4.76%



Problems

• higher wages: minimum wages will jump 12% in some states this summer.
• low barriers to entry
• exposure to fluctuations of commodity costs while unable to pass on costs.
• consumer fundamentals: there were 524,286 eating and drinking places in the U.S. in 2006 -- a 45% increase from 1990, according to the National Restaurant Association. The U.S. population rose 20% during that period, according to census figures.**"
• People aren't eating out more frequently than 10-15 years ago.
• The solution: crimp on extras, cut hours, or offer specials.

The thought of a smaller burger patty brought by a disgruntled waiter annoys me.

In business, just like airline seats, the middle sucks. The low-cost fast food restaurant (e.g., McDonald's) or the high-end (Ruth's Chris) will be most likely to succeed in the long-term. A restaurant that can earn barely in excess of it's cost of capital is a wonderful restaurant, not a wonderful business.


Notes:
*return a firm would earn on an investment of similar risk
**Wall Street Journal
Image: http://www.shyiam.com/wp-content/uploads/2007/06/cheesecake.jpg