‘Current market conditions represent interesting opportunity for investors’

The current market conditions for the restaurant industry represent an interesting opportunity for investors seeking high operational gearing as we head into recovery – but calling the timing of a trading recovery is difficult, perhaps even impossible.

At finnCap, we know what to look for when evaluating companies: proven management teams, strong brands, good margins, sensible debt profile and plenty of financial headroom to cope with shocks.

We believe that, despite some recent poor trading, there are some very interesting investment opportunities to be captured and draw inspiration from Warren Buffet’s quote: “Be fearful when others are greedy, and greedy when others are fearful”.

Changing consumer considerations

It is no surprise that the cost-of-living crisis has had an impact on the restaurant sector as people tighten their wallets and spend less. UK consumer confidence fell to an all-time low of -49 in September (from -44 in August) as households continued to struggle, according to GfK index.

As inflation continues to rise heading into the winter, consumers are increasingly faced with the choice of either cutting spending, dipping (further) into savings, or borrowing more… or any combination of the three alternatives.

UK credit card borrowing in July rose at its fastest rate since 2005, up 13% year-on-year, likely as a result of households choosing to borrow more to maintain living standards in the face of soaring inflation.

Nevertheless, we expect big-ticket items, such as cars, second holidays, consumer electricals and DIY projects to come under increasing pressure. Smaller ticket items can be more resilient (such as a cappuccino on the way to work) in a downturn – providing you still have a job.

Challenges facing restaurant operators

But it’s not just consumers feeling the pinch. The sector is facing the worst cost pressures since 2017 with costs rising sharply for labour, food and drink, energy and servicing debt. The only cost line not rising is rent; landlords are becoming increasingly concerned about retaining tenants.

Typically, it takes about 18 months for sustained cost pressures to feed through fully to company P&Ls with a combination of hedging tactics and companies digging their heels in and refusing to negotiate with suppliers.

This gives companies breathing space to seek out and implement mitigating activities to offset the cost pressures. The good news is that pubs and restaurants can cope with some inflation. The problems come when it rises sharply; in this scenario it can take up to a year for the industry to catch up.

The recent cost pressures have highlighted those companies with effective hedging strategies. Loungers, for example, is fully hedged for energy until September 2024 and so well positioned to combat these pressures, while, at the other end of the spectrum, Tortilla Mexican Grill has no hedging in place and instead has resorted to buying spot rates.

In between these two, the likes of Fulham Shore, Hostmore, The Restaurant Group and Revolution Bars have hedged most energy costs to minimise risk. Only The Restaurant Group has an interest rate cap in place.

Attractive valuations – a growth opportunity

However, it is not all doom and gloom. Despite the challenges facing operators, the UK population consumes well over an estimated one billion meals a week, with total UK expenditure on food, drink and catering totalling over £240bn in 2021, according to the Office for National Statistics. Restaurants account for a quarter of the total eating and drinking out market by turnover, equating to c.£10bn.

One of the upside opportunities for restaurant operators is that property conditions are excellent for store rollouts and expansive growth strategies. Competition is reducing. Over the past three years, restaurant supply has shrunk by c.18%, as smaller and single restaurant operators struggled with the pandemic which claimed many victims.

The cost-of-living crisis is likely to clear out further under-performing and under-capitalised brands and companies, yielding significant market share opportunities for ambitious operators, such as those referenced earlier.

The availability of high-quality new sites, at sensible rents, is increasing. Some of these sites are so good that they have not historically been affordable for the hospitality industry in general and especially for restaurant operators. Tortilla and Loungers have accelerated their capex plans, with the former planning to open between 12-15 new sites in 2023, whilst Fulham Shore, Hostmore and Restaurant Group have modest new site targets.

Employment is another key metric to consider. A resilient jobs market will be important if we do sink into a recession, as many of those who lose work should be able to find alternative employment. The UK is almost at full employment, with job vacancies now equal to the numbers unemployed.

Our universe of plc restaurant operators has seen share prices decline between -29% to -86% year-to-date. We believe that the prices now fully discount the consumer cost-of-living crisis but fail to consider the buoyant property market conditions and their gearing into recovery.

From an investor’s perspective, this is a very interesting time to go bargain hunting. We end where we started: investors should look for proven management teams, strong brands, good margins, sensible debt profile and plenty of financial headroom to cope with shocks.