This week, Sam Clement and I discussed the restaurant industry on our “Trading Perspectives” podcast. Most specifically, we talked about what appears to be a significant change in consumer behavior and how this will impact the sector moving forward. In aggregate, the future isn’t necessarily bleak. Far from it.
However, there will be tough times ahead for firms which can’t figure out how to compete more effectively. You know, those companies which don’t truly understand their business models, brands and how to differentiate themselves from the pack.
In business, you compete one of two ways. Either on price or on product/service. All other companies are said to be ‘stuck in the middle,’ competing on neither whether they realize it or not. Obviously, this leaves them exposed when spending patterns, consumer preferences and even interest rates change.
So, what happens when all three hit at once? We are already finding out, and will continue to do so for the next 18-24 months. Let’s just say, you can expect a lot of empty storefronts which once held dining/drinking establishments of some sort. You will be both surprised and not surprised by the winners and losers.
Of course, due to the their hyperbolic signage, visible placement and national advertising campaigns, traditional fast-food joints will be the most noticeable when a unit shuts down. You know, places like the clown, the king, the red-haired girl, etc. What’s more, you might even be a little surprised by the closure, if not somewhat indignant.
Then you will remember you hadn’t eaten there in months or even years. To that end, IF the McDonald’s in the Eastwood area of Birmingham were to ever close, and I have no way of knowing, I will certainly say things like: “I remember being like 4 years old and playing on that playground they used to have.” That and something along the lines about how awesome it was to go to a birthday party there when I was a kid.
However, I confess I have eaten at that location in at least 2 years. I honestly can’t remember the last time even though it is the closest Golden Arches to my house. Sort of along those same lines, while I am not as nostalgic about the place, I was baffled when the Wendy’s on Highway 280 in Mountain Brook closed. After all, it was the only traditional fast-food restaurant in that section of town for years. Then, again, I almost never went there.
If you are still reading this, I am sure you have your own examples, and they don’t have to be fast food.
Now, why do you choose a particular restaurant? Could it be some combination of food and price point, with convenience sometimes being the deciding factor? Of course. However, it has to be the right combination, doesn’t it?
For instance, people don’t want to go to a place that has ‘fourth quartile’ food at ‘third or second quartile’ prices. That wouldn’t make sense. However, people will happily go a restaurant offering a ‘first quartile’ dining experience at first quartile prices. Likewise, we have all probably eaten at the complete opposite end of the spectrum.
I doubt there are many (or any) people out there who would put, say, Morton’s The Steakhouse on the same plane as your standard, fast-food burger joint. Therein lies the problem for a lot of companies/restaurants. They don’t understand how they are competing.
Picking on McDonald’s, for no other reason than everyone knows it, how would you say they compete? On product/service or on price? You have to choice one or the other, no combinations. Which will it be? I strongly suspect the overwhelming majority of people who read economic newsletters/blogs would reply the latter.
After all, do you and your spouse go to Mickey D’s for anniversaries and birthdays? Is that a special night out for you? Or is it an occasional necessity when you are driving on the interstate or have screaming kids at the house? You know, times when you need cheap, easy and fast.
Voila. That is how McDonald’s competes. Or you can come to the same conclusion another way. This being the number of competitors in the same marketplace. The more there are, the more likely it is they are competing on price. As you know, there is no shortage of places serving up burgers and fries.
Come to think of it, there is no shortage of companies serving up a lot of stuff. This is why so many established brands are having a difficult time. At some point along the way, they stopped competing on either price or product, and found themselves completely exposed.
Just this week, the last full-sized K-Mart in the United States closed its doors. In the 1970s and 1980s, that would have been an impossible statement to comprehend. However, it isn’t as mind-boggling as the following: “As of September 2024, there are nine Sears stores remaining, with eight in the mainland U.S. and one location in the U.S. Territory of Puerto Rico.” Want another one? The last, the very last, Howard Johnson’s restaurant went of business in 2022. At one point, the company was the largest restaurant chain the United States.
If you were to read business cases about those three, you would undoubtedly see things like “failure to adapt,” and a whole host of other academic terms and phrases. While technically true, a better way of describing what happened to these companies is they failed to realize how there were competing.
For instance, K-Mart was a deep discounter, period. That is why people shopped there. It wasn’t for slightly, higher-priced items by the likes of Martha Stewart, Kathy Ireland, Jaclyn Smith, Lauren Hutton, Thalia, Selena Gomez or the mysterious Joe Boxer.
There simply wasn’t any brand loyalty to K-Mart, only to the prices they charged. No matter how the company may have envisioned itself, its ‘brand’ was as a department store focusing primarily on the lowest quartile income households. Call it a ‘big box discount retailer’ if you want. A rose by any other name would smell as sweet.
As I am fast running out of space here today, I will leave the other two companies to your imagination and/or study. Simply put, both were ‘stuck in the middle.’ Sears didn’t get cheap enough to counter Walmart, and Howard Johnson’s didn’t get ‘good’ enough to compensate for the additional cost and time it spent to dine there.
The reason I bring this topic up today to put you on the lookout for changes in the American restaurant and retail spaces moving forward. There will be more stories like the one about Denny’s closing 150 units, and TGI Friday’s trying to secure financing to stave off bankruptcy. Old, familiar favorites will simply call it quits. The public will mourn some and others simply vanish….unwept, unhonored and unsung.
But why now?
Changing consumer preferences? Sure, of course. Inflation crimping household budgets? Certainly. Market saturation in may areas? Without a doubt. Higher interest rates? Um, okay, why not. Right?
First things firsts, companies borrow money. When interest rates are low, their debt service is also low. Obviously, this means more money will drop to the bottom line. In other words, when the cost of money is low, so is the necessary rate of return and/or revenue growth to make the company viable.
The inverse is also true. When borrowing costs go up, profits go down. Obviously, that isn’t acceptable. So, companies have to either generate more in revenue and/or cut expenses to maintain the desired margins. Intuitively, the more you cut expenses, the harder it is to grow the top line.
This should make sense, right? The problem is, a lot of these places operate on some pretty thin margins already. If their debt service goes up, for whatever reason, it might simply be easier for the, say, franchisee to shutter an ‘underperforming’ outlet and refocus the cost savings on a more highly performing one.
You have to remember, the Prime lending rate was 3.25% at the end of 2021. It is currently 8.0%, and has been this level or higher for around 18 months. This has had a snowball effect on borrowers, of all types, who are just now beginning to show signs of cracking. Again, this is, and will be, especially prevalent in lower-margin economic sectors.
…and all the more so for those companies who are “stuck in the middle.” It will be sort of morbidly fascinating to see how it all plays out.
If you have a prediction as to the first ‘major’ domino to fall, outside of the ones who are already tottering in the media, drop me a line at
Have a great weekend.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this and every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as well as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.