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One Restaurant that Maintains Consistent Margins in Challenging Times

By Mark Lin – Mar 26, 2014 at 4:03PM

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Better cost management and a higher degree of franchised operations are the only ways to mitigate the impact of slower restaurant sales growth.

Source: Einstein Noah.

According to research by Restaurant Finance Monitor, restaurant sales have slowed considerably. While the restaurant industry has historically grown at a 6.5% CAGR, it has registered a much lower growth rate of 4.2% and 3.8% for the past 10 and three years, respectively. In such challenging times, maintaining margins is the key to sustained profitability for restaurant operators.

Einstein Noah Restaurant Group (NASDAQ: BAGL), which runs bagel specialty restaurants in the U.S., has achieved consistently high 18% to 21% gross margins and 6% to 7% operating margins since 2006. This was achieved through superior cost management and expansion of higher-margin revenue streams.

Cost management
Einstein Noah has seen its prime costs (direct materials and labor costs) as a percentage of restaurant revenue decline from 59% in 2009 to 57% in 2013. This improvement in cost efficiency is a direct result of the various cost reduction initiatives that management has undertaken in the past few years.

In 2011, it received $2.7 million in cost savings by making changes to bagel thin manufacturing and bulk bagel packaging to improve manufacturing packing efficiency. Einstein Noah added 140 basis points to its gross margin with the introduction of reusable egg boats and the closure of its commissaries in 2012.

Einstein Noah's commissaries previously generated revenue from the sale of sliced meats and dairy products to its licensees and were closed as part of supply chain streamlining initiatives. For 2013, its cost management focus was placed on coffee contract negotiations (for better prices) and the rationalization of its distribution center.

Similarly, Noah Einstein's restaurant peer Buffalo Wild Wings (BWLD), has worked hard at reducing costs. One of its notable initiatives was that of transitioning to a new model of selling wings by portion sizes in 2013, as opposed to selling them by quantities. The rationale was simple: Buffalo Wild Wings was losing money with the model, as it had to sell larger wings (which cost more) at the same prices as smaller wings.

With the change implemented, its cost of sales for the fourth quarter of fiscal 2013 dropped to 29.8% from 32% a year ago, with lower wing costs being the key contributor.

Commodity price fluctuations are also another big factor impacting restaurants' costs. Einstein Noah has put in place several strategies to manage commodity price risk.

It has secured price protections for nearly all its coffee, wheat, butter and Class III milk needs by locking in prices through long term agreements. Second, Einstein Noah's menu is diversified, with no single commodity accounting for more than 11% of cost of sales.

Source: Einstein Noah.

Higher margin revenue streams
Einstein Noah is driving restaurant unit growth primarily through franchise and license expansion, instead of company-owned stores. Einstein Noah commits minimal capital to its franchise and licensing business segment, and generates revenue from initial up-front fees and royalties. This segment provides Einstein Noah with asset-light, recurring revenue streams.

Since 2009, the number of company-owned stores has increased by 7% to 459 units in 2013; while franchise and license units have grown by 47% and 57% to 113 units and 279 units, respectively. Looking ahead, Einstein Noah is targeting 45 to 60 new franchise and license units annually, compared with 15 to 25 new company-owned stores.

Another restaurant operator that has benefited from franchised operations is Denny's (DENN 0.32%). Of the 280 Denny's restaurants opened in the past four years, more than 90% were franchised.

In addition to driving of new store openings, a highly franchised business model has helped Denny's remain profitable in times of slow revenue growth. Although Denny's registered negative same-store-sales growth in all four quarters in 2010, its profitability was hardly affected. Its gross margin actually improved from 24.3% in 2009 to 24.7% in 2010. Its operating margin declined by 180 basis points, but remained at double digit levels at 10.1%.

Foolish final thoughts
While restaurant operators have no say about the state of the economy or consumer sentiment, they have relatively greater control over their direct operating costs and preferred revenue models. Einstein Noah has achieved consistent profitability by putting a greater emphasis on franchising and licensing revenue while focusing on controlling and cutting costs.  

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Buffalo Wild Wings. The Motley Fool owns shares of Buffalo Wild Wings. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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