How to Invest in the Restaurant Industry

With storied 10-baggers such as Chipotle Mexican Grill (NYSE: CMG  ) and Buffalo Wild Wings, restaurant stocks might seem like your ticket to mouthwatering returns. But intense competition and fickle customer tastes make it tough to sort this long-term winners from flops.

If you're interested in investing in restaurants, you'll want to know the right way to measure their merits. At The Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks and avoid unforced errors. Here's a checklist covering five key areas that can help you find better restaurant stocks. 

1. The customer and niche
Start your analysis with the restaurant's customers. Why do people choose this restaurant over others? Convenience? Quality? Low price? Do people travel specifically to eat at the restaurant? The answers help you sort volume-driven concepts from rate-driven restaurants, which should be analyzed differently. Volume-driven restaurants such as McDonald's (NYSE: MCD  ) compete with low prices and convenience and make money by moving a lot of low-margin product. By contrast, rate-driven restaurants like Outback, owned by Bloomin' Brands, compete on quality and atmosphere and make money by charging higher prices for lower-volume products.

2. The potential market
Once you know a bit about why customers visit the restaurant, you can get a sense who the customers are. Does the concept target a particular age group or income demographic? If the restaurant is currently contained to a single region, do you think the concept can translate to the rest of the country? Companies often talk about this in first section of their annual reports or in investor presentations. Failing that, I'd suggest visiting a location and watching who shows up. That can tell you a lot. 

After this, you can estimate how large a market a location needs to survive. Most restaurants talk about how many customers the average location serves in a year, and with a guess about how often a regular customer eats at the restaurant, you can estimate the size of the required market. Combine this with the customer demographics and you can get a size of the potential market.

Here's an example: Tex-Mex eatery Chuy's (NASDAQ: CHUY  ) serves about 400,000 customers per year, and the company targets 21- to 44-year-olds who earn between $60,000 and $80,000 a year. Assuming the average customer visits about five times each year, a location needs at least 80,000 of these potential customers within, say, 25 miles, to survive. Using census data, we can figure that about 370 towns and cities have the required customers, in sufficient density, to support a location.  

Obviously, this is some back-of-the-envelope math. Growth might be limited by regional tastes, or the availability of prime locations. But it's a great way to figure out whether management's -- or the market's -- growth expectations are reasonable.

3. Store-level metrics
After you get a sense of how large the market can be, look at how the company can make that expansion. This depends on whether they use franchise stores or company owned stores. With company-owned stores, the corporate office puts up the initial capital. Look at how much it costs to open a new location and how long it takes the company to recoup this investment. Given how much cash the company has on its books -- and how much existing locations generate -- how many new restaurants can the company open in a year? Can management meet its projections? Can (or should) the company use debt to finance additional growth?

Franchise models need a different set of questions. Here, others put up the cash for new openings, but the corporate office has less control over product quality and operations. If franchise owners aren't making money, they'll have little reason to expand, which the corporate office would like. If the company provides franchise-level data, this is simple. If not, try to figure out whether franchisees own multiple locations, or whether they're opening new ones. 

Popeye's Louisiana Kitchen (NASDAQ: PLKI  ) , for example, has grown revenue 12% annually over the past three years -- faster than comparable companies --  by providing more tools to help current franchise owners. And the results show up not just in store and revenue growth -- but also in who's creating it. In 2012, about 75% of new Popeye's U.S. locations were opened by existing franchise owners. There's a good reason for this -- they were making money and were eager to expand. 

4. Capital allocation
After you've figured out whether the company can grow quickly, ask whether it should grow quickly. We're accustomed to the get-big-fast mentality, but often there's a better use for shareholder money. The first step is to look at how new locations fare over the long term. Most restaurant chains provide restaurant-level operating data that you can use to estimate the return on invested capital for mature stores. Anything below 12% is a worrying sign that expansion isn't paying off.

Next, figure out how much the market thinks stores are worth. Divide the company's market capitalization by the number of open locations to get the market value per store. If this number his higher than the cost of opening a new store, then management should continue growing, because they can essentially "sell" new stores to the market at a higher price that it costs to build them.

If, however, the market value per store is lower than the cost of building one, then management is better off buying back stock. Why? because they can essentially buy back stores from the market, for less money than it costs to build them.

5. People and culture
Nothing kills customer satisfaction (and restaurant sales) faster than unhappy or unskilled employees. Restaurants are generally terrible places to work, but some do a better job with employee morale than others. Some companies publish employee turnover in their annual reports, and if the one you're looking at doesn't, check out ratings from Glassdoor.com. Happier employees are more motivated to satisfy customers -- and keep them coming back.

Finally, ask whether the company promotes managers from the lower ranks, and what types of job training it offers. Chipotle is famous for developing hourly employees, and it's given the company a seemingly endless supply of managerial talent. Restaurants are successful when those on the ground do their jobs well, and skilled, experienced managers can make that happen. 

Foolish bottom line
Running a restaurant is a tough business, both for owners and investors. For every highflier there are a half-dozen duds. Knowing where to look is the first step to sorting the next Chipotle from the next Red Robin

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