MUFG: Restaurants Will Face Margin Contraction, Slower M&A in Q1/22

With rising commodity prices, workforce shortages and the need for higher expenditures to attract labor in a competitive market, the restaurant industry will face continued margin contraction and, consequently, lower M&A volume in Q1/22, according to Mitsubishi UFJ Financial Group’s restaurant finance group. The group’s team provided its views on the heels of the annual Restaurant Finance and Development Conference this month in Las Vegas.

Slower M&A in Q1/22

“Despite strong sales, most restaurant companies have seen their margins erode because of higher food, fuel, labor and transportation costs,” Nick Cole, head of restaurant finance at MUFG, said. “Additionally, they face increasing difficulty in hiring staff amid persistent labor shortages, which will pose a financial burden as restaurant companies try to draw new workers and retain existing ones in a labor market that is demanding higher wages and being more selective in choosing employers.”

Cole and his team expect lower margins to slow the pace of M&A in Q1/22.

“The M&A market depends on a well-capitalized banking system flush with liquidity, which we currently have, but cash flow — and the price acquirers are willing to pay for that liquidity — are the primary drivers that attract buyers, so unless we see an improvement in margins, we expect the pullback to be significant,” Cole said.

Cole added that the generational transfer of businesses — especially in the quick-service sector — combined with extraordinary financial performance have fueled the recent boom in M&A.

Labor Scarcity and Inflation

MUFG’s restaurant finance group pointed to labor shortages and supply chain disruptions as factors that have strained restaurant operations while contributing to rising wages and inflation.

“In addition to vacancies for waiters, cashiers and kitchen staff, restaurants have had to cope with the effect of supply interruptions and worker scarcity among commodity producers and transporters that pushed up labor and food costs,” Quinn Hall, who leads loan underwriting and portfolio management for MUFG’s restaurant finance group, said, specifically highlighting the looming financial challenges restaurants face in overcoming staffing shortfalls. “Since it’s not enough to just offer higher salaries, restaurant businesses will need to consider a range of enhancements to their benefits packages and employment offerings — from health benefits to flexible work schedules — that would raise costs as well.”

Aggressive Financing Conditions … For Now

“Financing conditions for restaurants are still benefiting from a healthy supply of capital and record financial performance — particularly among quick-service establishments and restaurant operating companies — from the second quarter of 2020 through the second quarter of this year,” Hall said. “For now, banks continue to accept a higher leverage profile among borrowers and offer loose amortization, pricing and covenant terms.”

If margins continue to erode, financing terms will tighten next year — especially if interest rates rise and borrowing costs grow — and certain businesses may experience credit downgrades, Hall said.

Technology and Off-Premise Dining

Brian Geraghty, head of loan originations at MUFG, said that restaurants continue to pursue costly investments in technology to remain competitive, especially in an environment of compressing margins and labor shortages.

“Restaurants are evolving their digital platforms to offer customers the ability to order food from anywhere and on the go,” Geraghty said. “Onsite digital kiosks in certain establishments now come in the form of proprietary or third-party apps on a mobile device in everyone’s hand.”

Geraghty added that technology investments are part of a broader effort to support more business off premises, where a significant portion of ordering and dining now occur due to the COVID-19 pandemic. This effort includes the retooling of restaurant real estate to allow for more drive-through and digital pick-up lanes while deemphasizing dining room space to lower dependence on in-restaurant business.

“Over the long run, we believe you’ll see restaurants shrinking in size to reflect smaller onsite patronage but better built to support off-premise business,” Geraghty said.

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