Fast-Casual Is About to Dominate the Quick-Service Industry
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The classic way that long-term investors make money is by identifying a trend and jumping on the bandwagon before everyone else knows about it. Well, investors hoping to invest in the fast-casual space before it reaches the greater population's radar are out of luck -- chains like Chipotle Mexican Grill (NYSE: CMG) and Panera Bread (NASDAQ: PNRA) are already hot companies stealing share from fast-food and casual dining restaurants alike.
However, fast-casual chains are still growing faster than more traditional chains like Brinker International's (NYSE: EAT) Chili's. As a result, significant upside still remains for investors who were a little late identifying the fast-casual trend as the next big thing.
One of the most important things investors should look for in young industries that have yet to be challenged by significant competition is strong profitability and high returns on invested capital. Chipotle and Panera Bread demonstrate both of these characteristics; the two companies earn returns on invested capital in the low-to-mid 20s, while Brinker International earns a much lower 10% to 15% return.
Although Chipotle and Panera earn similar returns on capital, they achieve this feat in different ways.
Like Brinker International, a large portion of Panera's restaurants are franchises. Franchises provide the company with reliable cash flow even during deep recessions. In addition, the franchise model (about 50% of Panera's locations are franchises) lowers the company's asset-base, allowing it to earn high returns on capital.
Chipotle, on the other hand, owns and operates all of its restaurants. It earns high returns on capital due to the efficiency of its restaurants. The restaurant's assembly-line setup allows it to prepare customers' orders as quickly as a fast food chain, while at the same time serving high-quality ingredients at a lower price than a casual dining chain (Chipotle's average ticket price is $10 vs. Chili's average ticket price of $13.66).
But Chipotle's efficiency is not only apparent in its restaurant setup; it also maintains an efficient supply chain and inventory management. The company's restaurants require less inventory on hand than Panera's and Chili's restaurants, allowing Chipotle to turn inventory purchases into revenue much quicker than its peers.
In addition, Chipotle has more favorable terms with its suppliers; it extends its payment date out much further than Panera, which allows it to invest in more inventory or build more stores faster than Panera can. However, Brinker International is the king of days payable; its enormous bargaining power enables it to extend payment dates much longer out than even Chipotle. As a result, it pays for its inventory about 20 days after it sells it.
However, while Brinker may have mastered working capital management, Chipotle and Panera continue to earn much higher profit margins than the casual dining chain. Chipotle's focus on slower growth and higher profitability has allowed it to out-earn Panera and Brinker by a significant margin in recent years.
For its part, Panera simplified its menu and focused on selling higher-margin products after margins dipped in the middle part of last decade; the result is a return to ~15% operating margins.
Meanwhile, even with a strong chain like Chili's, Brinker International is unable to get the same efficiency out of its restaurants that enable Chipotle and Panera to earn such high margins. As a result, it will continue to battle in the mid-to-high single-digit operating margin range.
Chipotle and Panera are well-managed and extremely profitable fast-casual dining chains. Chili's, one of the best-run casual dining chains in the world, cannot keep pace with its up-and-coming competition. As fast-casual chains continue to steal market share from fast food and casual chains, investors would be wise to jump on the bandwagon -- even if the highest returns are already behind the industry.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!