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Are valuations being reset?

Steve Rockwell is Managing Direct Consumer Investment Banking focusing on restaurants at BTIG and has over 30 years of experience in the restaurant industry. He can be reached at [email protected] This article does not necessarily reflect the opinions of the editors or management of Nation’s Restaurant News.

BTIG managing director Steve Rockwell
BTIG managing director Steve Rockwell

As anyone viewing their 401K or IRA statements can attest, the stock market has been under immense pressure since hitting a peak in late July last year. January was a particularly brutal month, and restaurant stocks, with a few exceptions, McDonald’s being the most notable, have not been immune to the overall market weakness.

More broadly, investor demand for initial public offerings has dried up, and January was the first month since September 2011 that there wasn’t a single initial-public offering priced. And with only four initial public offerings completed in February, investor sentiment has clearly changed and is more cautious now than a year ago. This shift among investors in public companies is also carrying over to investors in private companies. Now the key question is whether this more negative sentiment is the new normal or is it temporary? Will valuations be able to bounce back?

The correct answer won’t be known for six months to a year, or more. However, there are a couple of macro trends that suggest a snap back in private company valuations is unlikely. Restaurant company valuations are influenced by interest rates, the predictability of cash flows, and the returns on capital, among other things. Most experts and the casual investor do not expect interest rates to rise dramatically over the next year or so. Even if they do go up, interest rates are anticipated to remain historically low over the short to intermediate term, and are likely to be neutral for valuations, in my opinion.

The predictability of cash flows is likely to decline and have a neutral to negative impact on valuations. Cash flows are dictated by sales and costs, the primary drivers being cost of sales, labor and occupancy. On balance, sales have been relatively strong recently. Furthermore, incomes are rising, and the expectation is that lower gas prices may translate into increased consumer discretionary spending, some of which could find its way to restaurants. Favorable food cost comparisons are also anticipated. Unfortunately, offsetting that are higher labor costs stemming from a combination of factors including a tightening labor market and increases in the minimum wage and benefit expenses.

Occupancy costs, largely rent, are also rising in many markets, reflecting an increased demand for locations as unit growth remains strong. Consequently, two of its four primary components are likely to be a drag on cash flow, at the very least reducing its predictability with potentially negative implications for valuations. Returns on capital are coming under pressure as well, as a result of higher real estate and construction costs. With interest rates neutral, visibility of cash flows neutral to negative, and returns on capital negative, valuations are likely to have seen their peak in this cycle.

A wild card though is investor demand, or the amount of money investors need to put to work. If a lot of cash still needs to be deployed, valuations could maintain levels higher than fundamentals warrant. There could also be a flight to quality that results in a two-tiered market that is even more pronounced than the market today. Strongly performing companies could maintain high cash-flow multiples due to multiple bidders hungry for quality investments, with companies experiencing weaker results attracting fewer bidders and commanding lower valuations.

An example of the former is Sweetgreen, a very highly regarded fast-casual brand emphasizing salads. Sweetgreen raised significant growth capital this past summer. Publically available information implies a valuation of at least $540 million, or approximately $13.5 million for each of the company’s 40 locations. While financial information is not available, in my opinion that is a high valuation by almost any measure and represents the upper tier of a two-tiered market.

Ultimately restaurant company owners need to readjust their valuation expectations in light of recent market trends. Every restaurant entrepreneur thinks their creation is the next Sweetgreen, and that it deserves a similar valuation. Even if their concept is as good, owners need to recognize that valuations are heavily influenced by the overall market, and that the market is most likely in the process of resetting valuations at lower levels. The best concepts will always command a premium valuation. The expectations of sellers of these concepts should be set in the context of the current market and not necessarily by prior deals. Sellers of companies of any quality that hold out for a higher valuation may find themselves further disappointed or needing to own their brand for longer than they had anticipated.

This information should not be regarded as a solicitation or recommendation of any particular security or to engage in a particular trading strategy. This was prepared for informational purposes only and is not believed to be sufficient on which to base an investment decision.

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