Roark Capital’s Stake in Jimmy John’s Reinvigorates PE Interest in Restaurant M&A, Says Duff & Phelps' Josh Benn

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As we enter the fourth quarter of 2016, the restaurant industry has both headwinds and opportunity. Across the industry, companies have recently reported relatively weak performance, with second quarter earnings showing disappointing same-store sales and traffic trends for many of the industry’s publicly traded chains. Importantly, performance from longtime industry darlings such as Buffalo Wild Wings (Nasdaq: BWLD), Chipotle Mexican Grill Inc. (NYSE: CMG), and Yum! Brands Inc. (NYSE: YUM) began to falter in 2016. Some industry experts and equity analysts have predicted a “restaurant recession” due to declining performance and rising labor prices. Despite these mixed results and an unclear near-term outlook, restaurant sector M&A activity remains robust.  Financial and strategic investors still see substantial opportunity for on-trend concepts with strong leadership, attractive unit economic models, and growth potential.

The key story in the restaurant landscape for a number of years has been the decline of traditional casual and quick service dining concepts as traffic and dollars shifted to emerging, trendy fast casual competitors. Fast casual concepts generally offer quality menu items at affordable pricing in a convenient format. Quick service chains have responded to traffic declines by introducing premium menu items and offering more promotions. In response, many casual dining concepts have sought to offset traffic declines by increasing check average. At the same time, across the country, new labor and minimum wage laws are squeezing profit margins for companies across the industry. This combination of negative traffic and increasing labor costs has contributed to the collapse of longstanding concepts such as Fox & Hound, Logan’s Roadhouse and Ovation Brands, whose leadership cited these challenges in their public statements.

In light of the evolving restaurant landscape, with public market valuations off of their historic highs reached in 2015, restaurant investors have shifted their focus. No longer is an investment in just any fast casual concept a safe bet for a strong return. The financial buyers that we work with continue to invest in restaurant concepts, though they have become increasingly selective about the concepts and business models they are interested in backing. Capital-efficient franchise business models have returned to focus. This month, Roark Capital Group’s acquisition of a majority stake in Jimmy John’s helped reinvigorate sentiment in the restaurant M&A marketplace. Recent acquisitions of franchise businesses, including CiCi’s Pizza, Wetzel’s Pretzels, and PepperJax Grill have added to the positive sentiment.

When looking for attractive restaurant concepts, financial buyers seek to tap into consumer trends that have the potential to drive strong growth. With the rise of the “third wave of coffee,” we have seen numerous investments in fast-growing coffee roasters across the country. This month, TPG Growth announced an investment in San Francisco-based Philz Coffee to fuel national expansion. Blue Bottle Coffee announced a third round of funding in 2015, led by Fidelity Management. Additionally, JAB Holding Company’s strategy of consolidating the retail coffee and limited service breakfast segment continued with the acquisition of Krispy Kreme Doughnuts in May 2016. Previously in late 2015, Peets Coffee & Tea, a JAB Holdings subsidiary, acquired both Intelligentsia Coffee & Tea and TSG Consumer-backed Stumptown Coffee Roasters.

Another key restaurant sub-segment with increasing M&A activity is the breakfast category. As international quick service chains like Taco Bell, Burger King, and Subway expand and introduce breakfast offerings, we are seeing growing interest in this under-exploited daypart. In February 2016, PWP Growth Equity announced a minority growth investment in the breakfast-focused Black Bear Diner. First Watch Restaurants, which was acquired by Freeman Spogli & 2012, has been consolidating the full-service breakfast restaurant segment, with recent acquisitions of The Egg & I Restaurants, Bread & Company, and Good Egg Restaurants. Another sponsor-backed breakfast concept, Snooze, an A.M. Eatery, owned by Weston Presidio, is currently in the market exploring strategic alternatives.

Investors are focused on partnering with management of differentiated concepts that offer the customer unique menus, quality food, and a superior experience. Whether the restaurants offer popular ethnic fusion cuisine (L Catterton’s investment in Velvet Taco), craft beverages (A&M Capital Partners’ acquisition of Iron Hill Brewery & Restaurant), or healthy and natural foods (Alliance Consumer Growth’s investment in Tender Greens), investors are seeking concepts that cater to key trends in the marketplace. In the current landscape, restaurants must give the customer an experience that justifies a premium price, covers rising costs, and offers an attractive return.

Strategic buyers represent a meaningful portion of recent merger activity as larger and established restaurant companies seek to drive growth and diversify platforms. While many casual dining and quick service chains are struggling to drive attractive returns within their core businesses, they are increasingly seeking to invest in growing brands that will provide top line growth and in many cases revenue and cost synergy opportunities. In early 2016, Panera Bread Co. (Nasdaq: PNRA)announced the acquisition of Tatte Bakery & Café, providing Panera with a new growth concept. Further, the national franchising business Kahala Brands announced the acquisition of Pinkberry at the end of 2015. In May 2016, MTY Food Group announced the acquisition of Kahala and followed that acquisition with the purchase of Baja Fresh earlier this month. The other key strategic development is the start of consolidation in highly fragmented, but fast-growing subsectors like fast casual pizza. In June, Pieology Pizzeria announced the acquisition of Project Pie, which is likely the first of many strategic acquisitions in the space.

An additional market that has arisen due to the recent lower valuations of restaurant companies and intermittent softness in other industries is the emergence of non-traditional corporate investments in restaurant concepts. In late 2015, Whole Foods Market Inc. (Nasdaq: WFM)  announced an investment in Mendocino Farms, its first restaurant partnership. Whole Foods’ management stated that the concept would be a growth driver for the firm as they seek to incorporate Mendocino Farms units into their retail locations. Similarly, Urban Outfitters Inc. (Nasdaq; URBN) recently announced the acquisition of Vetri Family Restaurants with a plan to build out Pizzeria Vetri locations with the intent to drive traffic to its retail stores. In both instances, these companies are willing to invest capital in already established restaurant concepts to provide both growth and cash flow.

Despite recent sentiment signaling a near-term slowdown in the restaurant industry, we have not seen a meaningful decrease in appetite from buyers across the landscape. As public restaurant company valuations have pulled back from recent highs, both financial and strategic buyers have continued to seek out acquisitions. The current marketplace is rewarding concepts that can provide a unique product and experience for consumers. These concepts offer a key value proposition that allows them to charge a premium, offsetting labor and input cost headwinds. As we look forward to the rest of 2016 and 2017, we should continue to see dollars chasing innovative growth concepts at the expense of yesterday’s casual dining and quick service chains.

Josh Benn is a managing director at Duff & Phelps and global head of the firm’s restaurant, food & beverage and consumer corporate finance practice. 

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