Foreword for Franchise Money Maker Readers

There is an unprecedented amount of negative commentary from the media, describing the economic malaise that is dragging down consumer dependent operators. This is the way the media operates. They get on a “theme” and then build the case to support it, whether it is valid or not. The following article puts the current situation in perspective, and provides a road map for restaurant, retail, and hospitality entrepreneurs to succeed.


The table below shows the most recently reported same store sales (and traffic when it has been disclosed) for most of the publicly held chains. It is pretty sobering when we see the numbers stacked up. The only real exception lately has been Domino’s, which of course dominates the pizza delivery business. Even Starbucks (with caffeine and Howard Schultz), Shake Shack (with the Danny Meyer hospitality culture) and Wingstop (with 75% takeout) who come to mind as bucking the trend, have seen their comparisons slow lately. There is, in essence, hardly any place to hide.

Every industry observer knows by this time that it has been tough out there, and the results we show below have apparently continued into April and early May. You should especially note the traffic trends which in so many cases are negative even if price increases and “menu mix” have helped the nominal same store sales. The question is why. Reasons cited, and all are valid, are: increased competition, lower mall traffic, the stretched consumer, lower grocery prices, political distractions, the weather (sometimes), and of course company specific problems at chains such as Applebee’s and Kona Grill. It has become increasingly clear that if the Millenials are going to get off their couch and take a break from binge viewing on Netflix, they are requiring an “experience” rather than a “fuel stop”. We believe that a growing number of dining customers have had enough of the institutionalized “service by rote” that is provided at so many national chains.

We believe that, after fifty years of chain restaurant growth at the expense of “independents”, the local owner/operator has a chance again. The individual proprietor doesn’t have survey cards on the table, or use anonymous shopper services to gauge the operations because he or she sees every meal that comes out of the kitchen and can watch the customer reactions in the course of the dining experience. At the national chains, how often does it happen that a service person, arriving sometimes before you have had your first bite, asks you “how is everything”. If you mention that something is wrong, they turn into a “deer in the headlights”. For this you are expected to pay a 15-25% tip. Many diners, and potential diners are finally saying “basta”. Our observation is that the chains that are doing the best are those with the superior hospitality “culture”. If I were an operator, I would be channeling Howard Schultz and Danny Meyer, who have written the book in QSR and Full Service Dining, respectively. Part of the experience can be a bit of “theatre”, as demonstrated by the assembly and cooking process at the fast casual pizza leaders such as MOD and Blaze (written up, as “Up & Comers” on our Home Page). TopGolf and Barteca (which we have also written up as “Up & Comers”) provide an unusual “experience” and are doing well. The last example of a special “culture” is a Michigan based chain, where I have recently become a Board member, called HOPCAT. The Millenials, who we all agree will drive consumer spending patterns are flocking to Hopcat, averaging over $4 million in each of twelve locations, not only because the food and drink are good, but the hospitality quotient is obvious. There are no staff uniforms, the service interactions are not “canned” and 90% of the waste is recycled. The staff and the customers really care about this stuff. They cared about it, a lot, at Chipotle, and that may be one reason that customers are returning more slowly than most of us would have forecast.

The newest challenge to the restaurant industry, while operators cope with higher labor, higher rents, potentially higher commodity prices, and the well know external factors as cited above, is how to compete with the increasingly competitive independent operators. It can be done, but not with national advertising and a “one size fits all” approach to operations. Menus must be increasingly tailored to local taste, décor should reflect the neighborhood, marketing must be increasingly directed to the surrounding communities, just to mention a few obvious considerations. As part and parcel, staff has to be chosen to provide the necessary hospitality quotient. While a publicly held chain has to be thinking strategically, they must pay increasing attention to the local detail. If I were to put it bluntly, forget about a national “footprint”. Operate the hell out of your stores market by market. Part of the traffic you are losing annually could well be the result of better performance by local competitors, and the Millenials’ inclination to support them. A historical example of a great chain (in their day) that grew in concentric circles from their Nashville base, was Shoney’s. They put the numbers on the board every quarter for twenty years without jumping across the country. Ray Danner finally retired, younger management wasn’t as disciplined, diversification cost them some focus, and the brand finally faded, but the operational example that succeeded for so long still applies.

We believe that independents are taking market share, for the first time in many decades. It only has to be two or three percent a year (one out of forty or fifty customers) but it adds up over time. You may be running a multi-unit chain, but you must compete store by store, against other chains and independents alike. That independent operator, who is feeling better these days, has his financial life on the line, doesn’t have the corporate “support” and large legal and accounting expenses that you must overcome. He can manage labor more efficiently, perhaps “off the books” with no workmen’s comp and health insurance. He will be in his store on Friday and Saturday nights, meeting and greeting his customers. Keep that in mind as you build your national footprint.

Roger Lipton’s Writeup – Domino’s Pizza

Foreword by Roger Lipton for Franchise Money Maker

The following write up about Domino’s Pizza describes a truly “Best of Breed” franchised restaurant chain. Their same store sales gains have been without peer over the last five years, store level economics are excellent. Most of the growth is overseas because the US market is largely developed and/or committed to existing US franchisees. However, there is an important lessor here, in terms of the opportunity with delivery/takeout in a consumer environment that increasingly values convenience. Small footprint locations like Domino’s are emerging as the best Franchise Money Makers among restaurant companies.

DOMINO’S PIZZA April 12, 2017 Corporate Research DOMINO’S PIZZA,
Roger Lipton

DPZ: Company Overview (2016 10-K) (Jan’17 Analyst Day Slides &16Q4 Slides)
Domino’s Pizza is an Ann Arbor, Michigan-based pizza restaurant chain, which, as of its 16Q4 operated and franchised 13,811 units globally, generating an estimated $9.5B in sales (about 1.5M pizzas/day), making it the world’s second largest pizza chain (after Pizza Hut) and the number one U.S pizza delivery company. About half (49%)the sales are produced by the 5,371 domestic stores (392 company, 4,979 franchised), while the remainder is produced by 8,440 franchised stores in over 80 markets around the world.

In 2016 DPZ’s revenues were $2.4B which were derived from company stores (17.8%), royalties and fees from franchisees (12.6% domestic, 7.2% international) , with the remaining 62.4% from sales of food supplies and equipment to company and franchise locations. We estimate the AUV’s of company units are slightly over $1.1M (or about $740/sq. ft., assuming average store size of 1,500 sq ft). We estimate domestic and international franchised unit AUV’s are about 20% and 30% lower, respectively, than domestic company locations. Disclosed average store level EBITDA of domestic franchisees is about $134K, up from $61K in 2009, about 15.2% EBITDA store level margin for domestic franchisees. (These figures are presumably net of royalties, fees and advertising fund contributions). The cash investment for leasehold improvements, furniture, fixture, equipment and signage for a new store at upper end of the range provided in Franchise Disclosure Documents and other materials is about $410K, so the $134k EBITDA store level margin would represent a 32.6% store level cash on cash return for domestic franchisees.

The supply chain provides pricing and distribution scale and uniform ingredient quality to participants. It operates 18 regional dough manufacturing and food supply chain centers in the U.S., one thin crust manufacturing center, one vegetable processing center and one center providing equipment and supplies to certain of the domestic and international stores. It also operates five dough manufacturing and food supply chain centers in Canada and leases a fleet of more than 500 tractors and trailers. As such, it makes approximately twice weekly deliveries of food supplies and equipment to over 5,600 system units, including all company stores and 99% of U.S, & Canadian franchisees. It passes through its prices paid with a small markup to participants and shares a portion of profits with franchisees, which nets out to a segment margin of about 8%. The supply chain segment’s relatively low EBIT margin and capital intensity are a drag on consolidated margins and free cash flows, making them lower than other highly franchised peers. Arguably, DPZ could boost margins by leaving supply responsibilities to franchisees, as, say, DNKN does, but it would lose scale advantages for both their own and franchised stores (less of a concern for DNKN with virtually no company stores). It would also diminish its ability to control quality. Perhaps most importantly, it would lose an important touchpoint with its franchisee partners. (We’re not so much trying to decide the correct strategy as to point out key differences in strategies from other highly franchised peers.)

Domino’s has gone through a series of development stages since its founding in 1960. Its current stage is a brand revival which dates to the end of 2009 when it scrapped its original pizza recipe in favor of a line of premium (and distinctly better tasting) pizzas featuring higher quality ingredients and a wider variety of toppings such as roasted red peppers, spinach and feta cheese in addition to the traditional favorites. The company has gone counter to industry trends by avoiding LTOs which complicate a menu with a stream of new products. Instead it has concentrated on providing consistency and value with a limited and uncomplicated core menu of pizzas, baked sandwiches, pastas, chicken items (like wings), breads, beverages, deserts & extras (sauces). In the past 4 years DPZ has added just 3 items: Specialty Chicken in 2014 and Marbled Cookie Brownie in 2015 and salads (Classic Garden, Chicken Caesar and Chicken Apple Pecan) in August ‘16.

The current brand revival stage is also supported by DPZ’s “Pizza Theater” re-imaging of system stores (expected to be substantially complete in 2017); its innovative marketing (e.g. the iconic campaign trumpeting the scrapping of its former pizza recipe); and its use of state of the art technology to take the complexity out of operations and improve the customer experience. One of the first with on-line ordering, DPZ has since developed a digital platform, which is nearing utilization by the entire system, including international units, to manage internal operations (re-supply, scheduling, payroll, order accuracy, etc.) and customer-facing actions to simplify ordering, payment processing (with a range of payment systems in addition to credit & debit cards) and enabling order tracking (from prep through delivery) on virtually any communication device. Together with a sophisticated loyalty program, the platform provides a rich source of data for its robust marketing initiatives. Not content with 50% of domestic sales transacted via digital orders and the fast growing international acceptance, the company is continuously improving the platform. For example, in 2016 it launched a “Zero Click Ordering” app, seemingly the penultimate in ordering ease (the ultimate being that your order appears by just thinking about it).
The proof of the brand revival is in the numbers. From 2009 through 2016, domestic system revenues have grown at an 8.4% annual rate on domestic system comps averaging 7.4% (including 24 consecutive Q’s with positive comps) and 6.9% international comps (91 consecutive Q’s of positive comps!). Most of the unit growth has been international (11.0% CAGR since 2009). Although management believes there’s room for 1,000 more domestic units, it is very selective about granting new franchises and the annual domestic unit growth (company and franchised stores) since 2009 has been only 1.0%. During the same period EBIT, EBITDA and FCF have grown at annual paces of 13.0%, 12.4% and 16.5%, respectively. Long term, the company expects global retail sales will grow at 8% to 12% on domestic comps of 3-6% and international comps of 6-8%, while net global new unit growth will be 5-7%. If it achieves its top line targets, margins will continue to expand and net income and free cash flows will grow at a double digit pace.
Domino’s, like many of its highly franchised peers has borrowed heavily to finance share repurchases. The company’s ratios of total debt to 2016 EBITDA and lease adjusted debt to 2016 EBITDAR at 4.4X and 4.9X, respectively, are comparable with its peers. Cash flows from operations of $287.3M net of $58.6M cap ex, generated free cash flows of $228.7M in the year, or a FCF margin of 9.2%. DPZ returned $374.2M to shareholders in 2016, nearly $74M in dividends and $300.3M in share repurchases. In 2016 DPZ spent $300.2M to repurchase 2.8M shares (average price $106.60, or a 5.7% reduction of shares outstanding at the end of 2015) against about $15.2M proceeds from about 1M stock options (average exercise price $14.69, or a 2.1% increase in shares outstanding).

DPZ: Current Developments (16Q4 Release) (16Q4 Conf Call Transcript)

The fourth quarter provided another exceptional performance, with domestic same store sales up 12.2%, international up 4.3%. This represented the 92nd consecutive quarter internationally and 23rd for domestic locations. The full year results are noted in the table above, impacted by expenses related to the Company’s recapitalization and the 53rd week in the fourth quarter of 2015. 2016 was a record year in terms of new store growth, with 171 new domestic stores and 1110 new international locations. In the 4th quarter: 104 domestic stores opened and 6 closed. 487 international stores opened and 26 closed.

The fourth quarter eps YTY gain of $0.33 (28.7%) as adjusted for the New Year’s calendar shift, included negative influences from higher interest expense ($.03/sh.), higher tax rate ($.04), foreign exchange ($.03). Positive influences were share repurchases ($.12) and improved operating results including $.02 from the calendar shift of $.31.
The company’s major initiatives continued in the fourth quarter. Capex was allocated toward aggressively building out their technology capability, 102,000 shares were repurchased (at $160/share) for $16.4M, $18.2M was returned to shareholders as dividends, and $9.6M worth of debt was repaid.

In terms of the future, the successful strategy which has produced such outstanding results, as described above, remains in place. Management provides no short term guidance, but has raised certain long term (“3-5 year outlook”) parameters slightly. Domestic same store sales growth is expected to average 3-6% annually (up from 2-5%). International same store sales growth is expected to grow at 3-6%. (unchanged). Net unit growth (overall) is expected to grow 6-8% (up from 5-7%). Global retail sales growth is expected to build at 8-12% annually (up from 7-11%).

About the Author:
Roger Lipton is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and an MBA from Harvard, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken.

Roger’s Restaurant Review, Shake Shack Writeup

Shake Shack Inc. is a New York City-based chain begun as a hot dog cart in 2001 to raise funds to renovate a city park by founder Danny Meyer, the legendary restauranteur and chairman of the Union Square Hospitality Group.

Roger’s Restaurant Review, Shake Shack Writeup, dated 3/28
By Roger Lipton with permission @

March 28, 2017 Corporate Research shak,shake shack

SHAK came public at $21 a little over two years ago, ran to a high above $90 in June of 2015, and has been in a trading range between $30 and $40 during 2016 and early 2017. The stock was “fully valued”, to say the least, at $90.00 compared to the $0.32 per share reported in 2015 and $0.46 in 2016. It is obviously more rationally valued in the low 30s versus the Street estimate of $0.51/share in 2017 (which we judge could more likely be exceeded than missed). While we are not yet ready to “pull the trigger”, there is no other publicly held restaurant company that has more well regarded management, a better store operating model, and a virtually unlimited runway for future expansion. Barring a major general market crash, we don’t expect SHAK to trade for a P/E of less than 30-40x expected earnings. Currently at 65x ’17 estimated earnings and 52x ’18 estimates, SHAK is unlikely to run away on the upside. Especially since ‘17Q1 is unlikely to surprise on the upside, with the difficult comp comparison (+9.9% in ‘16Q1), ongoing development expenses in a seasonally slow quarter, there is probably no rush at this price level. However, for all the positive reasons we have enumerated below, readers can consider SHAK to be on our active “Watch List.”

SHAK: Company Overview (2016 10-K) (Jan’17 ICR Investor Presentation)
Shake Shack Inc. is a New York City-based chain begun as a hot dog cart in 2001 to raise funds to renovate a city park by founder Danny Meyer, the legendary restauranteur and chairman of the Union Square Hospitality Group. At the end of 2016, SHAK (which came public in early 2015) operated and licensed 114 units in 16 states including Washington, D.C. and 13 countries generating system-wide sales of $403M. The company bills itself as a fine casual operator with a core menu featuring premium hormone- and antibiotic-free burgers, chicken and hot dogs, crinkle-cut fries and handmade shakes, frozen custard & specialty beverages. It also serves beer and wine.

SHAK devotes significant resources in the creation (including collaborating with top chefs) and testing of items to supplement its core menu with LTO’s and enhancements derived from seasonal and local products to provide novelty, drive return visits and also for brand awareness. For example, in April 2016, to promote the brand in the Washington DC, Maryland and Virginia area , the company teamed up with a celebrated chef of Chinese cuisine to offer “Crispy Peking Chicken” (crispy chicken breast with Maketto hoisin sauce (WTF? 😊), pickle, cucumber and scallion) on a LTO basis only in area stores. The company is also investing heavily in technology to provide customers with state of the art mobile conveniences. It is currently rolling out a mobile order –and- pay app nation-wide, which, in its first 6 weeks, accounted for 6% of sales.

Given the company’s commitment to all-natural proteins that are hormone- and antibiotic-free as well as vegetarian fed and humanely raised, it has some of the same supply chain risks as Chipotle in that rapid growth could outstrip its ability to manage the quality of many small producers. At this stage of its development, the company stipulates it has established rigorous quality assurance and food safety protocols throughout its supply chain and that it further addresses its risks by limiting the number of suppliers for major ingredients. For example, in 2016 all beef patties were purchased from 7 suppliers (70% was purchased from one of them) and it has 10 butchers located throughout the country to produce burgers fresh daily. As to distribution to the stores, the company contracts with a single broadline distributor which is responsible for supplying over 80% of core food and beverage ingredients and all paper goods and chemicals to each Shack from 12 regional distribution centers.

Of the company’s $268.5M of revenues in 2016 96.6% was generated by the company’s 64 stores (all domestic), while the balance was licensing revenues from the 50 licensed units (7 domestic, 43 international). The company believes there is the potential for at least 450 domestic units. In 2016 the company units averaged $4,981K (down from $5,367K in 2012 (an average skewed by high proportion of Manhattan units with AUV’s>$7M). Indeed, the concept’s exceptional brand appeal, as evidenced by press and social media acclaim, has broadened its acceptance domestically and internationally. Moreover, even with lower AUV’s, store level profitability has improved with store-level EBITDA margins expanding 270bps in the last five years to 28.3% in 2016. Shack units, which are all leased, average 3,000-3,500 sqft (seating for 75-100) and require a cash outlay of $2.3M including our estimate of pre-opening expense. In 2017 company plans 22-23 new units generating AUV’s of “at least $3.2M and Shack-level operating profit margins of at least 21%.” Even at these modest levels of productivity, materially lower than has so far been the case, cash-on-cash returns would be about 30%.

Considering the modest number of stores in the system, and as a public company for just over 2 years, its continuing robust unit level-performance, including locations far from its NYC roots, is probably the best current gauge of SHAK’s promise. The company’s heavy SGA and pre-opening expense, typical of an early stage enterprise, still weigh on margins. To this point, the consolidated EBIT and EBITDA margins in 2016 were only 10.4% and 15.8%, respectively, down from 11.0% and 16.4%, respectively, in 2015. Similarly, ROIC, at 11.6%, while not all that impressive currently, is no doubt poised to expand rapidly as store growth allows more of their outstanding store level returns to fall to the corporate bottom line.

SHAK’s only balance sheet debt is $2M of deemed landlord financing (essentially capitalized lease obligations) added at the end of 2016 for 8 stores under construction. When added to the capitalized value of its other operating leases, SHAK’s ratio of lease-adjusted debt to EBITDAR of 2.8X in 2016 is the same as peers PNRA and SBUX. The company also has a $272.5M tax liability payable on behalf of its pre IPO Series B shareholders as they convert their shares into Series A shares. SHAK is financing its rapid growth (22-23 company stores in 2017 or ~35%) internally which consumes virtually all its cash from operations together with cash on hand. In 2016 CFO at $54.3M financed all but $0.1M of capex.

SHAK: Recent Developments (16Q4 Release) (16Q4 Conf Call)
In its 16Q4, SHAK generally met expectations for revenues, comps and EPS, though not “surprising” on the upside to the extent that it has often done in its first two years as a public company. Company revenues grew 43.5% YOY on 1.6% comps (on top of 11% in “15Q4) and 54% domestic unit growth. Since stores don’t enter the comp base until 2 years after opening, the comp base is small (only 30 of 64 US company stores). Traffic in Q4 was down 1.4%, offset by price increases of 3.0%. This pattern of higher ticket and slowing traffic is consistent with the industry, but in SHAK’s case the price increase has been relatively modest with the ticket mix boosted by premium LTO’s and the declines in traffic has been relatively modest. In terms of “prime costs”, CGS was 28.% in Q4, down 80bp, while labor and related expenses were 26.6%, up 160 bp YOY. Regarding other line items: “other operating” was up 90bp to 10.5%, occupancy and related expense was up 90bp to 8.9%. Importantly, while average weekly sales (AWS) have been expected to decline, AWS for the quarter were up 1.1% at a still very impressive $90,000. The Company continues to point out that the averages have likely been boosted by units opened in high density markets, and continues to guide to $3.2M annually for upcoming units. Sales trends were “strong throughout October, November….softened in December….holiday shift contributing about 80bp of pressure, as well as comparatively colder weather in the Northeast..”

Below the top line, higher expense—administrative and pre-openings—has prevented leveraging the 29% YOY quarterly growth of restaurant-level EBITDA (25.4% of shack level sales in Q4 and 28.3% in all of 2016) to the corporate bottom line. Adjusted pro forma net income was up 11.6% in Q4. At the unit level, labor costs have been up all year because of increases in the compensation structure implemented at the beginning of the year. The company proudly proclaims it already pays above current and minimum wage levels, a policy that allows it to attract and retain high caliber employees. The pre-opening expense increase was due to the accelerated opening pace in the year as well as higher unit costs incurred in entering new markets.

In the 16Q4 conference call, management again discussed its evolving LTO strategy for boosting ticket and margins. The Bacon Cheddar Shack ran successfully through Q4 into January. In Q1’17 Barbecue ShackmeisterBurger, Chick’n Shack and Barbecue Fries have been introduced. New seasonal shakes include Mud Pie, Mint Cookies and Cream, and Salted Vanilla Toffee flavors. Management continues to test breakfast at a handful of locations, such as Penn Station in Manhattan. It also testing delivery at two mid-town Manhattan locations (test including third party delivery services). The mobile app was launched in Q4, with a promotional push in January ’17. A free burger was redeemed 90,000 times through February, translating into 6% of overall sales, the average transaction has been up by 15% over normal, and over 25% of app users have already visited again. The Company notes again that these initiatives, while promising, pose execution challenges in the company’s already busy kitchens. Management points out that a core menu item is removed for each LTO addition to reduce strain on the kitchen. Internationally, it reported progress in Japan and Korea, with continued softness in the middle east, its largest non-domestic region.

Management raised guidance slightly for FY17 revenues to $349M-$353M, an increase of about 30%, on 2-3% comps, including 1.5-2.0% price. It guided to 22-23 new domestic units plus a net 11 new licensed Shacks. It also guided to continued deleverage at the unit level to EBITDA of 26.5-27.5%, primarily on higher labor costs. New locations are still expected to generate AUVs of at least $3.2M and Shack level EBITDAs of at least 21`%. G&A is expected to be $38-39M and D&A at about $22M.

Overall, we consider SHAK to be one of the best managed companies in the fast (or “fine”) casual restaurant segment, especially considering their relatively early stage which includes almost unprecedented unit growth of company stores. The “culture” is in place, but is not taken for granted by management. When unit level growth is so high, we suggest that many expenses are shuttled (or arbitrarily allocated) between unit level and corporate support. For example, trainees (charged to pre-opening) help out in existing stores (possibly reducing hours for more experienced crew), supervisors (charged to corporate) spend a lot of time in relatively young locations. The result of these examples would be store profits overstated, offset by higher pre-opening and higher corporate G&A . A “steady state” situation is not really in place, but in this case, no matter how expenses are allocated, the 2016 pre-tax operating income, at $27.8M, or 10.4% of revenues, with corporate EBITDA at 15.8% is an admirable starting point from which to leverage the situation over the long term. Store level margins will likely come down over time, on somewhat lower volumes and with not quite so much support from corporate, but the G&A percentage against higher overall sales will no doubt be reduced as well. Licensing revenue of $9.1M certainly helped, but there were no doubt material expenses against that contribution and licensing income is not going away. Putting it all together, we can’t think of another restaurant company, over the years, that has produced results this impressive at a similar stage.
SHAK stock is a somewhat different discussion. See our comments above for our current conclusion.

About the Author:
Roger Lipton
is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and an MBA from Harvard, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken.
For more information please contact: WWW.ROGERLIPTON.COM OR