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TMF: Talk about the partnership you form with managers. Next: Part 2 »
So far the growth has been impressive: sales soared from $18.4 million in 1996 to $153.2 million in 1999. Of course, oversupply is the bane of the restaurant industry and the company can only build so many P.F. Chang's outlets. Can the growth continue and for how long? Chief Financial Officer Robert Vivian talked about where the company is headed, financing needs, expected returns, new concepts, and what sets it apart.
TMF: Start by telling us how P.F. Chang's got started.
Vivian: The first one opened in 1993. Paul Fleming, who started out as a Ruth's Chris Steak House franchisee and is now a company consultant, came to Scottsdale, Arizona and couldn't find any Asian food that he liked. He didn't want to build more than one restaurant, but it went well and he ended up opening another in Newport Beach, California in 1994. He opened a few more in Southern California in 1995.
We don't want to put a P.F. Chang's on every street corner since it would begin to lose a little luster. Also, understand that we like the economics of our box, the investment we make, and the returns from each unit. With that in mind, we think we can build 125 to 150 restaurants.
At that time there were more questions than answers. The company wasn't making any money at all. We knew the concept worked in Southern California in affluent areas, but we needed to see if it would travel. In 1996 we opened a store in Las Vegas, which was kind of an anomaly, then Denver and Houston. We figured Denver and Houston would give us a good read. Fortunately they both did well. In 1997 we opened six stores along the South and southeastern coast -- Louisiana, Mississippi, Atlanta, Florida. We stretched the concept, and by the end of 1997 we're coast-to-coast with an opening in Tysons, Virginia.
TMF: What's unique about the concept?
Vivian: One of the things that's different from a traditional Chinese restaurant is that 20% of our sales come from liquor, and 10% of that is wine. Paul offered about a 40-bottle wine list and everything was available by the glass. It really raised the bar, giving the restaurant kind of a steakhouse feel. He knew people loved to drink wine and if you gave them the opportunity to try it by the glass instead of making them buy the whole bottle, people would drink more.
TMF: Did the concept take quickly everywhere?
Vivian: The customers seem to like the concept everywhere. The product mix doesn't vary too much and the drink mix doesn't vary too much. Generally when we go into a new market there's nothing else like it. People have to figure out what it is.
TMF: How do you pick properties? What qualities are you looking for?
Vivian: We don't want to put a P.F. Chang's on every street corner since it would begin to lose a little luster. Also understand that we like the economics of our box, the investment we make, and the returns from each unit. With that in mind, we think we can build 125 to 150 restaurants. We could build more but we'd start to change the economics of our box, either we'd have to reduce sales expectations or shrink the size of the box to go into smaller markets. We have 39 so far.
TMF: How much does it cost to build a store?
Vivian: It costs $2 million to build and outfit a restaurant. We don't own any of the properties since we aren't Realtors. We want to run restaurants. Of course, we look at what the real estate costs, and as a proxy for the value of that property we use the present value of our lease obligation. That's usually about $1 million, so our total investment is about $3 million.
TMF: How do you decide where to place the restaurants?
Vivian: We looked at a map of the U.S. We know our customers have household incomes of $60,000-plus so we look for that demographic. We also look for heavily trafficked areas since our restaurants are open for lunch and dinner. We drew circles in areas around the U.S. that matched these characteristics and that's how we came up with 125 to 150 restaurants. Then we just look for the best piece of real estate we can find.
TMF: So there's a lot of variety?
Vivian: We've opened 39 restaurants and they're all different. It may be in a shopping center, it may be on a freestanding pad. If we find great real estate, we'll find a way to fit our concept in there.
TMF: What's the typical size?
Vivian: Most of our restaurants are 6,000 to 7,000 sq. ft. so we need that kind of room. Beyond that, we're flexible. There are people in the restaurant industry who scratch their heads when they see some of our locations. They aren't typical.
TMF: For example?
Vivian: Our second restaurant in Newport Beach, California is on the second story of the Fashion Island mall. We replaced a Chinese restaurant that had failed. It's still our smallest space and doesn't have a lot of visibility, but it works.
TMF: What kind of return do you expect from the stores?
Vivian: Capital is a scarce resource for us. We always ask, "What is our total capitalized investment and what are the returns derived on a pre-occupancy, pre-tax basis?" In our 10-K we lay out our unit economics. Those two pages are critical because that's what we use to make our capital decisions. We think it's important, our private venture capital partners think it's important, so we thought our public shareholders would think it's important. Right now our system is generating, at the margin, about a 35% return on the total capital employed.
TMF: All your stores?
Vivian: The early stores, as you might expect, earn a much higher return. There's less capital employed, and over time the assets are depreciated. They're getting monster returns and are really carrying the water for our newer stores that aren't nearly as efficient. But on average, the bar for us is around 35%.
Right now our system is generating, at the margin, about a 35% return on the total capital employed.
Vivian: We have long been fans of Outback Steakhouse (Nasdaq: OSSI). They are the ones who unlocked the secret for the best management structure in the restaurant business. Everyone talks about instilling an entrepreneurial spirit in their managers but Outback did it. We spent a lot of time talking with them, and across the country we've used this partnership program. Our partners receive distributions as co-owners of the business.
TMF: What are the terms?
Vivian: We carve out certain geographies. Each market partner oversees the development of that geography. Now, it's not a franchise relationship. Each partner is a company employee, but we go to the partner and say, "We want you to develop the Florida market for us." They invest $50,000 for the right and sign a five-year contract. It's skin in the game. For someone to write a $50,000 check in our business, you've got to believe. In return, they receive 7% of the earnings stream of all the stores developed in that territory. It's a monthly payment. At the end of the five years we can repurchase the rights to the area if we decide to do that.
At the unit level we have an operating partner who invests $25,000 and receives 6% of the earnings. That's also a five-year contract. One thing different from Outback is that we added a second partner at the unit level, the chef. It's a culinary-driven concept and we need to match the culinary talent with the operating talent. They invest $8,300 and get a 2% interest.
TMF: It's paid off as a way to find the right managers?
Vivian: Oh yeah. For example, when we hire an operating partner we go looking for someone who wants to run a restaurant. For five years, that's all we want them to think about. In the restaurant industry everyone's always trying to move up the chain away from the customer. That's where the money and prestige is, but Outback found a way to crack that code, turn it around, and reward the people who are really running the show.
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