Valuation Guide: Fast Food Franchise

Description of the Industry

The fast food industry (SIC 5812, NAICS 722211) consists of eating establishments where customers pay before eating, including eat-in, take-out, drive-thru and delivery establishments.  Fast food franchises, carryout restaurants, delicatessens, pizzerias, and sandwich shops all fall within this category.  In general, fast food restaurants emphasize dining at a low cost with fast turnaround.  Often food is standardized and shipped from central locations to individual eateries where it is preheated or precooked and ready to eat.[1]

The U.S. fast food industry generates approximately $170 billion a year and employs over 3.5 million people.[2] The industry experienced a slight decline of –0.7 percent over the past five years as the recession caused consumers to reduce their eating out expenditures, but this trend is expected to reverse as disposable incomes begin to increase.[2]

The U.S. fast food and quick service industry has reached the mature stage in its lifecycle.  Within the U.S., most markets have reached the point of saturation.[3]  The industry is highly competitive, and this is expected to continue as companies aggressively compete for customers within a saturated market.[3]   The recession also intensified competition, as consumers cut spending and began to purchase lower price menu items.[3]   This increased competition on the basis of lower prices has in turn cut into companies’ profit margins.[3]

Fast food or quick service restaurants include national chains, regional chains, franchises, and independent operators.  Franchises and multi-establishment operators comprise approximately 10 percent of all fast food establishments, but account for 65 percent of revenue.[3]   Fast food franchises permit independent owners to use a well-known brand name and benefit from the purchasing capabilities and operational proficiency of the franchiser in exchange for a franchising fee. Franchises must adhere to quality and operational guidelines dictated by franchisers, and may have limited control over menu offerings, hours of operation, pricing, and store design. A typical fast food restaurant generates $670,000 annually, while a franchised fast food restaurant can generate $1 to $2 million.[4]

Some of the biggest players in the fast food franchise industry, both private and public, include:

1.	McDonald’s Corporation (MCD)
2.	YUM! Brands, Inc. (YUM)
		a.	Pizza Hut, Inc.
		b.	Taco Bell Corp.
		c.	KFC
		d.	Long John Silver’s
		e.	A&W All American Food
3.	Wendy’s/Arby’s Group (WEN)
4.	Burger King Holdings, Inc. (BKC)
5.	Chipotle Mexican Grill, Inc. (CMG)
6.	Panera Bread Company (PNRA)
7.	The Quiznos Corporation (Privately Owned)
8.	Doctor’s Associates, Inc. (Subway) (Privately Owned)

 

Industry Trends

Trends in the fast food industry have changed over the past several years, especially in response to shifting consumer preferences. A few of the most significant changes are:

1. The fast food industry is using technology to connect with customers
   In terms of marketing, fast food and quickservice restaurants are increasingly utilizing the Internet and online media to track and quantify marketing efforts, determine the best websites to advertise on, and quickly adapt their marketing based on the consumer response. The internet and smartphone applications are also becoming a popular method for viewing menus and placing fast food orders.  More than 25 percent of fast food customers have shown an interest in mobile payment options.[1] A study by the National Restaurant Association found that four out of 10 adults would use a self-service ordering terminal, if available[2]
2. The cost of inputs is rising
   The cost of food inputs for fast food businesses is rising, with eight out of 10 fast food operators saying they had a harder time controlling costs in 2011 than in previous years.[6]  30 percent of fast food business operators cited food costs as their number one concern in 2012.[6] Wholesale food costs are expected to continue to increase through 2013.[5]
3. International growth
   All the major market players have an abundant number of franchises strategically located throughout the US.  Some of the chains are experiencing low growth due to the increased competition and saturated market.  The focus of the franchisors in the food industry has shifted to international markets. International expansion is expected to be the largest source of industry growth for the next five years.[3] In particular, many fast food chains view China as a market with tremendous potential.[3]
4. Healthier menus
   As health awareness increases among consumers, so do their choices in fast food.  In an effort to appeal to these consumers, restaurants are offering healthier selections on their menu.[3] Fast food restaurants are offering salads, bottled water and healthier side options, especially on the children’s menu.

Key Fast Food Performance Metrics

The following are performance metrics that managers in the fast food and quickservice industry use to benchmark their performance against others in the industry:

Financial Metrics:

1. Orders and sales
2. Delivery vs. carryout mix
3. Ticket dollar average
4. Food cost
5. Labor hours and cost
6. Menu mix

Customer Satisfaction Metrics:

1. “Out-the-door” time
2. Deliveries per run
3. Customer complaints

Summary of Valuation Approaches

There are four different types of valuation methods that can be used to value fast food or quickservice companies, as follows:

1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities.  This approach is also sometimes referred to as a “cost based approach”; that is, the business value is equal to the cost of acquiring its physical assets.

2. Income approach to value (capitalization of earnings): This method is most applicable to franchises that face predictable and constant growth in earnings and have a long history of operations.  The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate).

3. Income approach to value (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, but requires predicting changes in future cash flows.

4. Market approach to value: This method utilizes market indications of value based on metrics from guideline publicly traded fast food companies and privately held companies.  The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value.

Benchmark Statistics

The following benchmarking data is based on studies from various companies within the fast food industry: [4]

	2007	2008	2009	2010	2011
Gross Profit (% of Net Sales)	61.4%	60.9%	62.0%	62.3%	61.4%
Operating Profit (% of Net Sales)	4.6%	3.6%	4.7%	5.1%	4.6%
Sales/Working Capital	-39.5	-36.0	-44.5	-48.9	-51.6
% Owners Compensation/Sales	3.2	3.0	3.1	3.0	2.7
Cost of Sales/Inventory	43.2	42.2	42.3	43.6	45.6
Quick Ratio	.4	.4	.4	.5	.5

 

Most quick service or fast food restaurants are moderately leveraged. This brings a higher return but imposes a greater risk to investors.

Before using this data for specific valuation purposes it should be evaluated for appropriateness.

Industry Organizations and Publications

Some organizations that publish helpful information about fast food franchises include:

1. National Restaurant Association: www.restaurant.org, an association representing more than 380,000 businesses involved in the restaurant industry[5]
2. International Franchise Association: www.franchise.org, a source of franchise information and resources relating to franchise businesses[6]
3. American Franchisee Association: www.franchisee.org, an association of over 7,000 franchisees[7]
4. Restaurant News Resource: www.restaurantnewsresource.com, a source of restaurant industry news

Availability of Publicly Traded Comparable Companies

There are approximately 40 publicly traded fast food companies in the U.S. [8] The top five publicly traded fast food companies, ranked by market capitalization, are:[9]

1. McDonalds Corp. ($90.3 billion)
2. YUM! Brands Inc. ($31.23 billion)
3. Burger King Worldwide Inc. ($5.8 billion)
4. Arcos Dorados Holding Inc. ($2.6 billion)
5. Domino’s Pizza Inc. ($2.4 billion)

The price to earnings ratios of these companies range from 16.9 to 23.8.13  As a whole, publicly traded companies in the restaurant industry have a price to earnings ratio of 21.4.[10]

Availability of Private Purchase Transactions

In addition to public fast food companies, data regarding privately held companies can also provide a useful benchmark when valuing a fast food or quick service business.  The size and scope of private companies that have been bought and sold over the last five years varies greatly, both in terms of their sales and the purchase price paid for the companies.

Fifty-two private purchases of fast food or quick service companies occurred over the five year period from July 1, 2007 through June 30, 2012.  These transactions show the following ranges:[11]

1. Total deal values ranged from $25,000 to $1.2 million.

2. Market value of invested capital (MVIC) to net sales ranged from 0.1 to 1.0 times with a median of 0.4.

3. MVIC to earnings before interest, taxes and depreciation (EBITDA) ranged from 0.6 to 465.5 times with a median of 2.8.

This range of market multiples is too variant to be useful without further analysis. As with selecting publicly traded guideline companies, care should be given to select private transactions that share similarities with the subject company.  The financial metrics of a potential guideline transaction should be compared with those of the subject. Additionally, industry economic conditions also vary over time, which can affect fast food and quick service restaurants as investment opportunities.  Specific factors that are unique for each company must be considered.

Fulcrum Inquiry performs business appraisals for fast food franchises and other businesses.