RESTAURANT INSIGHTS | BROS BLACK BOOK, Note From YUM, CA AB 610

BREWING TROUBLE: WHY BROS'S OVEREXPANSION AND SHAKY FUNDAMENTALS SIGNAL A BEARISH FUTURE

We recently moved BROS up to one of the top five shorts on our Position Monitor. Reflecting on the year since our inaugural Black Book analysis, it's evident that BROS has undergone numerous transformations. These changes, paradoxically, have both enhanced and hindered the company's trajectory. Over the recent quarter, there's been a noticeable uptick in performance, yet substantial risks and pitfalls in the stock remain glaringly apparent.

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There are some Changes to the Original Short Thesis, but issues remain.

Our initial bearish stance on BROS was built on a triad of concerns: the teething troubles of rapid growth, a leadership team seemingly out of its depth, and a looming cash crunch driven by overzealous expansion. The past year has witnessed a series of strategic pivots: equity injections, a sweeping overhaul of top executives, and a more measured approach to spending, culminating in marginally improved margins in 2023. Despite these efforts, BROS's valuation, which seems to be chasing the shadow of Starbucks, is a far cry from its actual standing. The impending relocation of its headquarters to Phoenix signals yet another major shift, likely resetting the profitability equation.

Traffic Issues and it may not be cannibalization

Despite its regional charm, Dutch Brothers struggles to carve a distinct identity in a fiercely competitive, low-barrier market teeming with giants and upstart competitors vying for the same customer base. This raises a critical question: what unique competitive advantages does BROS possess to thrive in such an environment? The brand primarily appeals to younger, lower-income demographics yet faces a troubling decline in customer foot traffic. This suggests that the company's challenges may extend beyond mere market saturation.

Clever Accounting makes RLM margins and cash flow look strong.

Our initial enthusiasm at the IPO stage was fueled by promising indicators: high shop contribution margins and a robust growth algorithm. However, a closer examination reveals a clever manipulation of accounting practices, artificially inflating store-level profitability.

SUMMARY THOUGHTS

While 2023 saw a rebound in contribution margins, same-store sales growth is stifled by self-imposed strategic missteps and broader economic pressures. The valuation seems overly optimistic, given the unrealistic store-level margins. Traffic slowed significantly in 2023 and looks set to continue this trend. The company's aggressive pricing strategy in 2022 and 2023 hints at limited room for future price hikes, potentially hampering same-store sales growth. A critical factor in BROS's predicament is its rapid expansion since 2019, doubling its store count and venturing into new markets with varying consumer responses. This aggressive growth has led to a marked decline in new store average unit volumes. The company's strategy of saturating existing markets, a tactic unlikely to change, further exacerbates this issue. The question arises: why pursue such rapid expansion at the risk of future profitability? With the current growth rate and subpar margins, another potential cash shortfall seems inevitable in the coming years.

Will 2024 be the year of the BROS profitability reset? 

KFC and Taco Bell Power Yum! Brands To Beat Growth Algorithm

YUM delivered exceptional growth in 2023, exceeding all aspects of its long-term algorithm, including 6% net new unit growth, 10% system sales growth, and 12% core operating profit growth. Performance was broad-based across KFC, Taco Bell, and Pizza Hut. The company opened nearly 10,000 new restaurants over the past three years. It is on pace to reach 60,000 global restaurants in 2023, enabled by franchisee confidence in the brands' unit economics. Yum's twin brands, KFC International and Taco Bell US growth engines comprise ~70% of system sales and ~80% of operating profit. In 2022, they grew system sales by 12%. KFC Int'l opened nearly 2,700 new units to reach 10% net growth across 96 countries. Taco Bell US maintained its industry-leading margins of 24% while outpacing QSR in same-store sales. Digital sales neared $30B in 2022, up 22% with a mix of over 45%. Yum is scaling new tech platforms across 7,000+ global restaurants to optimize operations and improve unit economics. Loyalty membership also doubled as digital engagement increased. Taco Bell plans significant loyalty enhancements in 2024 to drive digital sales.

2024 Outlook: Yum provided an upbeat outlook despite macro uncertainty. It expects to deliver its long-term algorithm in 2024, including at least 8% core operating profit growth. Franchisee demand supports persisting high unit development, positive same-store sales momentum is anticipated, and G&A costs will be tightly managed. Multiple levers exist to uphold earnings growth even if sales trends moderate.

4Q Review Revenues & Sales

• System sales grew 5% in Q4, comprised of 6% net new unit growth and 1% same-store sales growth—a low single-digit percentage impacted same-store sales due to conflicts in the Middle East region.
• For 2023, system sales grew 10%, including 4% net new units and 6% same-store sales.
• Same-store sales were led by strength at Taco Bell US, which grew 3% in Q4 and 15% on a 2-year basis, outperforming the QSR industry. Digital sales mix reached 31%, a 7-point increase.
• KFC International's same-store sales grew 2% in Q4 and 7% for the entire year. Sales were impacted by conflicts in the Middle East in several key markets.
• Pizza Hut International's same-store sales were flat in Q4. The full year grew 2%.

Margins & Other

• Operating margins expanded for the year, with core operating profit up 12%. Q4 core operating profit rose 8% despite system SSS growing only 1%.
• G&A costs were tightly managed, with full-year ex-special G&A down 4% in Q4 and flat for the entire year.
• Taco Bell US margins were 24% for the year, leading the QSR industry.
• Confidence in the global development pace, with a strong pipeline and evolving asset types providing a tailwind.
• Expectation of 8% core operating profit growth in 2024, driven by solid pipelines and sequential improvement in same-store sales.
• Digital capabilities drive all elements of the growth algorithm, supporting strong unit economics and contributing to global system sales growth.
• Pizza Hut US SSS is expected to be positive for 2024, with plans for calendar events, and YUMC sees a wide runway for the Pizza Hut market.
• G&A is expected to remain flat at $1.17B on a 52-week basis in 2024.
• Taco Bell's value menu is over-indexing with low-end consumers; slight consumer behavior shifts are returning to a typical operating environment where value is essential.
• Multiple levers are available to ensure at least 8% core operating profit growth, including productivity projects and a flat G&A plan.

Balancing Act: Navigating the Complexities of California's AB 610 and the Fight for Fair Wages in the Fast-Food Industry

The introduction of AB 610 in the California legislature, aimed at broadening exemptions to the mandated $20 per hour wage for fast-food workers, presents a complex legislative and economic landscape. To dissect this topic, let's break it down into several key components:

1. Overview of the Bill (AB 610) and Proposed Exemptions:

   • AB 610 seeks to expand the categories of quick-service restaurants exempt from paying their workers a minimum of $20 per hour.
   • Exemptions include fast-food establishments in specific locations such as casinos, airports, theme parks, hotels, sports arenas, convention centers, racetracks, museums, and contractor-operated restaurants in non-commercial settings like office buildings and state-owned recreational facilities.

2. Background and Context:

   • The $20 minimum wage was established under a previous bill sponsored by Assemblyman Chris Holden as a compromise between the state's quick-service industry and organized labor.
   • This wage adjustment represents a 29% increase from the previous minimum wage, affecting California's estimated 500,000 fast-food workers.
   • The introduction of AB 610 follows contentious debates over wage regulations and the responsibilities of fast-food franchises and franchisors.

3. Implications of the Proposed Exemptions:

   • The exemptions could significantly impact the income of fast-food workers employed in the specified locations, potentially excluding many employees from the wage increase.
   • There are concerns regarding the fairness and equity of exempting workers based on their workplace's location, leading to disparities within the fast-food industry.

4. Legislative and Economic Dynamics:

   • The bill highlights the ongoing struggle between labor rights advocates, the fast-food industry, and legislative efforts to balance economic growth with workers' welfare.
   • The opposition from the restaurant industry to the initial wage increase proposal led to a compromise involving the creation of a Fast Food Council with limited powers to adjust wages and recommend workplace standards.

5. Stakeholder Perspectives:

   • Fast-food workers and labor unions likely view the wage increase as a significant victory in improving labor conditions and compensation.
   • The fast-food industry and business owners may be concerned about increased operational costs resulting from higher wages, leading to support for exemptions to mitigate financial impacts.

6. Future Developments and Political Implications:

   • Various stakeholders, including workers, employers, and policymakers, will closely watch the progression of AB 610 through the legislative process.
   • The potential referendum on the original wage law and the political negotiations surrounding labor policies in California demonstrates the complex interplay between economic interests, worker rights, and political power.