Industry Watch: Casual Dining Firms Eye M & A As Internal Growth Hits the Limit

Plagued by low stock valuations, the $235 billion U.S. casual dining industry is placing its bets on consolidation in some cases and on going private in others. Until the industry gets some respect from investors, it may see as many defensive buyouts – either management-led or as private equity investments – as it does acquisitions. Should its profile rise, casual dining executives and industry analysts say that the industry’s fundamental strengths could trigger the start of a new wave of m&a activity. “Casual dining is thriving in many respects, the outlook is good, but until the market recognizes this industry’s strong fundamentals, you’re probably not going to see a big upswing in consolidation,” says Mitchell Speiser, a Lehman Brothers Inc. analyst. Speiser says that one strength of the casual dining industry is that it isn’t directly tied to economic indicators but is moved more by consumer lifestyle trends. “Casual dining is going to prosper whether the economy is growing at 6% or at 2%,” he says. Most casual dining outlets are part of large chains. Overland Park, Kansas-based Applebee’s International Inc., with some 1,200 units, is the largest. A casual dining restaurant is defined, somewhat loosely, as a restaurant where you sit down, place an order, and your food is brought to you. It is part of the full-service category, which also includes the family dining sector. The presence of alcohol is one factor that separates causal dining from the family dining category. Both the casual and family dining categories occupy a tier above the huge fast food, or QSR (quick-serve restaurant), chains like McDonald’s or Burger King. Another definition of casual dining is tied to check size. The National Restaurant Association defines the sector as having checks that range from $8 to $22. If the checks are below $8, the dining is considered family style. Yet another way causal dining can be differentiated from family-style restaurants is by the absence of breakfast. Popular family-style restaurant chains are International House of Pancakes Corp., Denny’s Inc., and Bob Evans Farms Inc. Casual dining has been outperforming its QSR competition. Last year, sales at the leading casual dining chains grew nearly 12% and the number of restaurants rose 8%, about double the growth of fast-food outlets, according to the National Restaurant Association. The performance of the casual dining segment also outstripped the family-dining sector. “Casual dining is the only one of the three categories, QSR and family dining being the others, that are showing decent growth,” says Michael Shepardson, COO of CNL Advisory Services, an Orlando, Fla.-based investment bank specializing in restaurant industry transactions. In addition to Applebee’s, industry leaders are Orlando-based Darden Restaurants Inc., among whose brands are Red Lobster and Olive Garden; Brinker International Inc., with Chili’s Bar and Grill and Romano’s Macaroni Grill; and Ruby Tuesday Inc. Overall, the U.S. restaurant industry consists of about 810,000 units, of which 30,000 to 40,000 are on the block at any given time, says Robert Wheaton, CEO of Star Buffet Inc. in Scottsdale, Ariz. Among the strategic decisions operators of casual dining chains are wrestling with are choosing between strategies that offer a single-brand approach to the market as opposed to multiple brands. Among the biggest chains, there has been a movement to sell lesser performing brands in order to concentrate on a company’s strongest restaurant concepts. Applebee’s, for example, sold its 66-unit Rio Bravo Cantina casual dining chain in February of last year. Ruby Tuesday is also focusing on its main brand. In April it announced plans to sell off its 42-restaurant American Cafe chain and its Tia’s Tex-Mex chain, which consists of 26 restaurants. In Ruby Tuesday’s case, the move represents a strategy to refocus the company from its initial placement of units primarily in shopping malls to an expansion plan that involves building more stand-alone units. Brinker International is following a different path at its approximately 1,000 locations. It is running six wholly owned concepts and three joint ventures and managing all the distinct brands well, according to Lehman’s Speiser. “Brinker is doing all the right things, it is the ultimate business model among casual dining chains,” he says. Even as Applebee’s and Ruby Tuesday are reducing their concepts among the larger chains, there is still considerable incentive for mid-level and smaller operators to diversify the concepts offered. “If you look just below the largest chains, I think we’re seeing an increase in the number of operators who have multiple brands,” says John Theuer, CFO at Panda Management Co. Inc., in Pasadena, Calif. Panda operates just under 300 Chinese concept restaurants. He says that in order to keep the business growing, operators need to add new brands. The Panda CFO says that five years ago 80% of all publicly traded casual dining companies operated with a single brand. Now, he estimates that the mix is down to about 65% single-brand outlets. “According to my research, between 65% and 70% of casual dining companies that chose to expand into multiple brands or to increase the number of brands in their portfolio have done so via m&a,” he says. He adds that most of the big companies have limits on the number of outlets of a given brand they can open. “Once you get to 50 or 60 outlets, it’s hard to grow further without cannibalizing your existing stores.” He adds that buying a competing chain is often the quickest way to pump up your numbers when internal growth potential has been exhausted. Theuer also says that it is rare to see a 100-unit chain for sale. More often, the properties that are on the block are 50-unit chains or smaller. For public companies, the pressure to grow earnings is a prime driver of m&a activity. “When you’ve reached the point of being built out on your original concept, you have to figure out some way to keep growing,” says David Epstein, a principal at J.H. Chapman, a Chicago investment bank that specializes in restaurant industry deals. Theuer adds that acquisitions are a logical way to grow a restaurant business, but they are only one alternative. “In most cases, it’s cheaper and less risky to buy than to build a concept.” He also says that acquisitions give the casual dining operator meaningful economies of scale that aren’t available through the internal development of additional concepts. But despite the allure of acquisitions, there are also strategic reasons why casual dining companies choose to go private. Epstein says that he expects to see more casual dining chains going private. “You have to decide whether you’re going to run your business for the stock price or for more fundamental goals,” Epstein says. With a stock price stuck in the doldrums and with a lack of potential m&a suitors on the horizon, a buyout may be the way to go for some operators of casual dining chains. Epstein points to the $151 million management buyout of Avado Brands Inc. last year as an example of management reacting to low stock prices by taking the company out of the public markets. Avado had been one of Applebee’s largest franchisees, but in 1997 it sold its Applebee’s units. This left it with four casual dining concepts, which have underperformed compared with the competition since then. In a recent private fund buyout, Caxton-Iseman Capital Inc., a New York-based private equity firm, signed a deal in which an affiliate of Caxton-Iseman will acquire Buffets Inc. for approximately $643 million. Buffets is the owner and operator of more than 400 value-oriented restaurants in 34 states under several brand names, including Old Country Buffet and HomeTown Buffet. In 1999, Buffets posted revenues of approximately $937 million. Boston Ventures Management Inc.’s acquisition of Ground Round Restaurants Inc., a 120-unit chain operating in the eastern U.S., is an another example of a private equity fund buying a casual dining company. But whether it’s a management-led deal or a financial buyout, Epstein cautions that recent, well-publicized restaurant company failures serve to put off potential investors. Epstein says that the bankruptcies of Boston Chicken Inc. and Planet Hollywood International Inc. tend to remind potential investors that the casual dining industry is not risk-free. Themed casual dining outlets like Planet Hollywood have fared especially poorly. But Epstein says that hot concepts that are growing rapidly and can dovetail with a potential partner’s need to grow will find buyers even in a flat casual dining environment. One trend he suggests might generate this kind of m&a activity is the combination of QSR and casual dining – called fast casual – that is being pioneered by small chains such as Oscar’s Inc. The eight-restaurant Oscar’s features an average check size of between $9 and $14. Customers order at a counter and the food is delivered by waiters, so it isn’t full service. Because of its higher customer turnover and low labor requirements, Epstein says that “fast casual” has the best of both the QSR and the casual dining worlds. He notes that even in the underappreciated casual dining universe, “fast casual” and other innovations are going to get attention and attract investment dollars. “If a property is hot and is at the right stage of its life cycle so that it fits with a buyer’s needs, it will still go for a premium price.”