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For simplicity, the restaurant industry can be split into quick-service restaurants (QSR, better known as fast food) and full-service restaurants. QSR patrons visit a counter where they pay and receive their meals (e.g., McDonald's and Wendy's). Full-service customers are seated at a table and place orders with a wait staff (e.g., Outback Steakhouse or Darden's Red Lobster chain). Because there aren't many ways to reinvent food service, the industry often tries new concepts with different mixes of price, food quality, level of service, menu offerings, and atmosphere.

Demographic shifts and changes in the workforce make the long-term outlook for restaurants pretty bright. Eating food prepared by restaurants is becoming a more attractive alternative to home meal preparation—with both parents working in many households, there's little time to cook and even less for grocery shopping and cleanup. The economics of meal preparation are shifting in favor of eating out as well because families are getting smaller. Consider that it takes about the same amount of time to cook for a family of six as It does for a family of four. Economy of scale for family meals just Isn't as prevalent, and for single person households, it can simply take too much time to prepare a well-balanced meal.

Investing in Restaurants: Understanding the Company Life Cycle Restaurant chains experience the business life cycle like any other business. Most new restaurant concepts start off in a speculative growth stage where managers are trying to nail down operational details and estimate growth potential for expansion. Many concepts fail; hence the term speculative growth. At this stage, most investors are happy with strong sales growth, indicating that the concept is gaining traction. Chains in this stage normally report negative or, at best, inconsistent earnings. Within a short time, they either fail or they move on and become aggressive growth companies.

In the aggressive growth stage, restaurants must be profitable on a per unit basis to support the opening of new stores. For example, the successful Cheesecake Factory chain funds all of its unit growth with profits from existing units. During this growth stage, the company is earning a profit at current units, but it's spending so fast to open new units that free cash flow is typically negative. One of the dangers is that a restaurant company outgrows its funding and balance sheet.

Even though current operations are profitable, rapid expansion often re­quires more money than the business can generate internally. Thanks to operating leases, which are akin to renting space for a business, restaurants can usually finance their expansion on a store-by-store basis and don't need to take out a huge chunk of debt at one time. However, leases aren't a panacea. Starbucks has grown so fast over the past decade that if a number of store locations were unsuccessful, the company would be forced to pay through the nose to exit the leases—most of which have terms approaching 10 or more years.

Like all companies, restaurants can't grow aggressively forever. As expansion opportunities dry up, profits from existing operations become increasingly important and managers try to drive healthy same-store sales increases. Strong same-store sales tell us that customers like what they're getting and come back for more. To keep customers interested (and boost profits), managers look for new ways to squeeze out more money. Restaurants in the slow- growth stage typically have strong free cash flows, solid returns on capital, and usually start to pay out a dividend because they're running out of investment opportunities in the business.

Few restaurants reach the slow-growth stage—most just go straight into decline. To be a successful slow-growth restaurant chain, the concept has to be ingrained in consumers. In the United States , McDonald's, Wendy's, and Red Lobster have long passed the stage where their stores were destinations or chic places to visit. However, consumers know what to expect before they walk into the stores or cruise into the drive-thru. It's up to the restaurants to maintain that familiarity with consistent advertising and service. Failure to provide the quality of food or service that people expect can bring slow- growth firms into the realm of decline.

Hallmarks of Successful Restaurants

The best restaurants have already developed a successful concept. Most restaurants fail to advance beyond the initial speculative growth stage, so those that do have already passed one of the most difficult tests of running a successful chain.

Replication is key. Investors need to determine if a restaurant's concept
can be repeated in other geographic areas. Outback Steakhouse and
Cheesecake Factory serve menus that are popular throughout the country,
but that's not the case for all chains and concepts. Darden's China Coast
concept worked on a small scale in the early 1990s, but the complications
of Mandarin Wok cooking resulted in inconsistent food service across the
chain and led to its demise.

Older chains must stay fresh, without having to reinvent themselves.
Darden remodels its Red Lobster and Olive Garden chains every seven
years or so. The process is expensive, but over the long term it's necessary
for survival, and restaurants usually throw off enough cash to cover the
remodeling costs. If a chain waits too long, it "will reach a point "where the
locations look old and unattractive—and by then, they won't be generat­
ing sufficient profits and cash flow, and the costs to resuscitate the brand
will be prohibitive.

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