While the Restaurant Industry Thrives, Some Companies Are Failing

The restaurant industry has a lot going for it. Strong growth in recent years is a reflection of multi-decade trend of increasing consumer traffic at restaurants. While Chipotle Mexican Grill (NYSE: CMG  ) is reporting 20% growth and Potbelly (NASDAQ: PBPB  ) makes headlines as a hot IPO, not all restaurant chains are sharing in the industry's success. Within the past couple of weeks alone, the parent companies of well-known chains Quiznos and Sbarro filed for bankruptcy protection. 

While Quiznos and Sbarro are not publicly traded companies, there are valuable lessons for investors from these bankruptcy filings.

What went wrong?
At a very basic level, both Quiznos and Sbarro were saddled with more debt than they could handle. That's normally the reason that a company plunges into bankruptcy, so it takes a deeper analysis to identify some of the underlying causes. Here are a few that are likely behind the recent failures of Quiznos and Sbarro:

Growth financed by debt
Sbarro filed its last annual report as a public company in 2009. At the time, the company had $336 million in debt, much of which required interest payments at a rate of over 10%. There is nothing wrong with a company using debt strategically, but Sbarro's debt balance was in excess of 25 times shareholder equity and annual interest payments equated to 9% of revenue. This is a recipe for disaster, especially when considering that companies like Chipotle that have taken a disciplined approach to growth have managed to open more than 100 restaurants per year without taking on any debt.

Poor franchisee relations
Managing a successful franchise model is a delicate balance. On the one hand, the franchisor supporting franchisees and maintaining a good relationship is vital to the success of both parties. On the other hand, many holding companies that serve as franchisors derive the majority of revenue from fees paid by franchisees, creating the temptation to maximize profits by overcharging local owners.

All signs point to Quiznos following the latter path. In the process of watching its number of locations decline by more than 50%, Quiznos has been repeatedly sued by franchisees for lack of marketing support, price gouging, and other disputes. One successful class action lawsuit by franchisees resulted in Quiznos settling and agreeing to pay $95 million to franchisees. The $95 million payout is much less of a red flag than the simple fact that management didn't comprehend that mistreating its partners in the business would lead to failure over the long term.

Overexposure to specific demographics
Sbarro is usually equated with shopping mall food courts, and this association is based on the reality that Sbarro has a significant portion of its locations within malls; in the company's final 10-K, it noted that poor results were caused by "Adverse macroeconomic factors, including reduced mall traffic during the holiday shopping season and a decline in consumer spending among other factors can negatively impact our operating cash flow."

The trend away from the shopping malls that dominated the world of retail in the 1980s and 1990s has only continued in the five years since this commentary and has been led by the explosion of e-commerce and a larger shift in consumer shopping habits. Retailers have been forced to adapt and shift strategies to remain competitive, but Sbarro was complacent. A more proactive real estate planning strategy, menu item expansion, or a simple idea like the roll-out of delivery service (not exactly groundbreaking in the competitive world of pizza) would have all helped the company stay afloat.

Understanding consumer trends
Whether you are talking about pizza or sandwiches, there is plenty of competition in the world of quick service restaurants.  Papa John's International  (NASDAQ: PZZA  ) and Potbelly are just two of hundreds of companies competing for the same pool of consumer traffic. To be successful, restaurants have to find reasons to appeal to the consumer more than the competition; creative menu items and the convenience of delivery are two easy strategies to stand apart.

However, the most successful restaurant concepts like Chipotle go a step further by staying in front of the pack as consumers focus increasingly on things like nutritional information and fresh (preferably organic and sustainably sourced) ingredients. Quiznos' single most direct competitor is Subway, which prudently invested in promoting its brand as the place that olympians and everyday people like its famous spokesman Jared go to have a healthy meal. Similarly, Papa Johns has used the tag line "Better Ingredients. Better Pizza" for years to differentiate itself from the pack.

How much of the difference is real versus the product of marketing buzz is certainly up for debate, but it is clear that you don't ever see Quiznos mentioned in conversations regarding Chipotle and the other restaurants moving away from GMOs across an entire menu.

What makes a great restaurant investment
Restaurants are a particularly fun industry to assess for investment potential because the business is easy to understand and the research can taste delicious. The basics of what causes one restaurant to be packed at lunch while another is empty are easy to gauge with casual observation. Menu options, quality of ingredients, customer service, and restaurant ambiance are easy to assess qualitatively.  Add in some background research on the company's management, culture, and financial stability and it becomes obvious why companies like Papa Johns and Chipotle have thrived while Quiznos and Sbarro have failed.

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