A slew of recent restaurant acquisitions is spurring investors to ask two questions: who’s next and what are they worth? As private equity firms consider investing in the remaining publicly-traded restaurant companies, they must consider how different business actions have the opportunity to generate increased free cash flow. For restaurants, future free cash flow hinges on the ability to increase traffic and check size through five key areas: 1) network growth and revitalization, 2) rationalizing media activity, 3) managing the menu, 4) effectively setting prices, and 5) increasing labor and operational efficiency.

1.) Network Growth and Revitalization: “If we build it, they will come.” But at what expense to the rest of the network? Will a near-term hit to free cash flows outweigh a potential long-term lift?

• As restaurants add units, it is important to measure any potential cannibalization effects to existing restaurants. For example, the hurdle rate for a new restaurant that generates $2 million/year is much higher when taking into account a potential $200 thousand cannibalization effect of the four existing restaurants in the surrounding area. The best way to understand cannibalization effects of adding restaurants is to analyze past restaurant openings as tests, and apply those learnings to your strategy as you plan future network expansion.
• If you remodel it, will they come more often or spend more? By taking a Test & Learn approach, restaurants are able to accurately understand which revitalization concepts work and where they work best. Measuring remodel impacts against a well-matched control group allows firms to better calculate a project’s NPV, as well as to prioritize capital spending based on sites that are most likely to have the greatest post-remodel lift.

2.) Rationalizing Media Growth: Understanding the isolated impact of increasing or reducing media spend by market allows restaurants to profitably increase spend in some markets, while cutting spend in others with minimal traffic impact.

• As one of the largest costs for restaurants, media expenses are a good place to target profit improvements. The key question is, how can restaurants cut costs without negatively affecting sales? The best way to answer this question is to look at past designed tests or “natural experiments” where the company may have increased or decreased media spend in specific markets but not others and understand how these changes impacted profits. Many companies have added millions to their bottom line by understanding the performance drivers of successful media campaigns.

3.) Managing the Menu: Understanding item add-on rates, guest preferences, and promotion responses allows restaurants to pare down their menu and increase margins.

• Check level data can be a gold mine for restaurant companies and their investors. As restaurants look to increase margins, they often turn to menu rationalization – but how do they know which items to cut? Low-sales items are the logical first choice, but that may not be the most profitable decision. By leveraging transaction level data, restaurants are able to identify which low-sales items are actually attached to large and profitable checks.
• Menu rationalization isn’t the only use-case for check-level data, it is also valuable when testing new menu items. For example, if restaurant X adds a $10 chicken parmesan sandwich, how many guests buying this item are actually incremental, and how many are just cannibalizing sales of the higher margin $15 chicken parmesan entrée? By utilizing check-level insights in this example, restaurants could determine the true effect of the change and not just examine guest order frequency of the new item, which could tell an incomplete story.
• Granular check data is also critical in distilling the implied cost of any given promotion. For example, what is the true cost of offering a free salad with the purchase of a sandwich? Restaurants that utilize check level data are able to measure the frequency with which guests are already purchasing a salad with their sandwich, thereby indicating how much they would essentially be “giving away” by offering the promotion. Combining these insights with a structured test allows restaurants to design smarter promotions that drive profitable growth.

4.) Effectively Setting Prices: Understanding how to set menu prices can ensure restaurants are capturing all available profits, net of traffic, halo, and cannibalization effects.

• Pricing tests are some of the most common and most profitable for restaurants that embrace experimentation. For example, Subway’s $5 Footlong went from a small scale local promotion test to a compelling national message that drove millions in incremental profits. However, measuring the effects of a price change for one item requires accurate test vs. control measurement for the whole menu. For example, if a restaurant increases the price of some items on its value menu, in order to determine true profitability, it needs to measure guest shifting behavior. Did the shift away from a $10 value entrée actually result in trades out of entrees altogether and into a lower-margin appetizer? Small in-market tests, measured against a well-matched control group, enable restaurants to learn where increasing price leads to profits/royalties, and where it doesn’t.
• Highly-franchised restaurant organizations often allow their franchisees to set their own prices on a large portion of the menu. Although this may lead to some interesting “natural experiments” to analyze, it often leaves profits on the table. Having compelling pricing data to bring to the franchisees can result in a much higher adoption rate of the best pricing strategies and flow through to increased corporate royalties.

5.) Labor and Operational Efficiency: Labor is the second largest cost for most restaurant companies – choosing strategies to increase employee satisfaction, reduce turnover, and correctly staff each daypart will turn this cost into an investment.

• High turnover should not be accepted as simply the nature of business. As restaurants implement new programs to increase retention, they must go beyond looking only at changes in labor costs and carefully analyze the bottom line impact across their network.
• Choosing the best staffing strategies by daypart and day-of-the-week is also critical to reducing costs and increasing guest and employee satisfaction. Well-designed tests allow restaurants to learn how different staffing levels affect total restaurant performance and efficiency and increase return on labor investments.

Of course restaurants have long used both gut feel and analytics to address these issues. However, these analyses often yield noisy results that leave executives wondering if their investment was actually profitable, or if confounding factors (aka “noise”), such as unseasonal weather, led to the observed result. Better analysis drives better answers, leading directly to more profitable results. To read about how some restaurants are already driving better answers, please visit our website.