What happened?
$132 million. That’s how much BJ’s Restaurants (NASDAQ:BJRI) lost in market value on Friday, right after reporting its second-quarter 2024 results. No, the company didn’t miss estimates for the quarter. Quite the opposite. BJ’s reported revenue, EBITDA and EPS that beat analysts’ estimates by 0.5%, 9% and 4%, respectively.
Even so, a considerable number of other brokerages downgraded their ratings on BJ’s after the release, resulting in a consensus of ‘Hold’ and a target price of approximately $38.33 for the company. The result was almost 400% higher than usual volume and a drop of more than 15% at the end of the day.
We know that the environment facing the industry is turbulent. Through June, four of the six months of 2024 were marked by negative comparable sales for restaurants. The guest is not able to keep up with the price increases we saw in 2023. I have discussed this scenario at length (with a QSR focus) in this article.
Both full-service and limited-service restaurants have increased their prices in recent years, reaching nearly double digits during the first quarter of 2022. This increase was part of a necessary policy of increasing menu prices to offset operating costs. However, this came at a price. Starting in 2023, traffic began to decline and comparable sales turned negative for many operators.
The situation became unsustainable when a considerable part of this traffic began to be channeled to substitute products. Convenience stores and bakeries began to pose a real threat to restaurants. It was and still is necessary to bring these guests back. To put this in perspective, while the price of eating at home has gone up approximately 1.1% over the past 12 months cumulatively, the price of eating out has gone up 4.1% over the same period. This represents a difference of 3%, about 2.4% larger than the average difference. Of course, macroeconomic pressures and the high interest rate environment have only further accelerated this process.
Unable to use menu price increases to compensate for the lack of traffic, restaurants are increasingly turning to value. This strategy seems to have been the winner in the second quarter. In fact, I recently became aware of another study, this time from Black Box, which also corroborates this statement, highlighting the importance of a full-service restaurant gearing its promotional mix toward value, signaling to guests who are sensitive to price increases that eating out is indeed worth it for their wallets.
This was precisely my concern with concepts like First Watch (FWRG) and even Darden’s Olive Garden (DRI), which refused to engage in promotional environments. Other concepts that already have their value proposition based on value meals, like Chuy’s (CHUY), also needed to invest heavily in advertising to spread the word to potential guests, which ended up not having the expected impact when many other brands advertise their value promotions. This scenario is more difficult to interpret than what we are seeing in QSRs.
An interesting example is steakhouses. They are being affected much less than other types of concepts. The truth is that steaks work well in almost all scenarios. An example of this is Texas Roadhouse (TXRH), which has much higher traffic and comparable sales than the industry as a whole. Both Longhorn Steakhouse and Texas Roadhouse have been outperforming industry comparable sales by an absurd margin. Proof of this is Texas’ recent feat of posting an SSS 8.8% higher than the industry average during the second quarter.
I wish this was the overall picture for Q2. The truth is that the industry remains slow, with guests still wary and looking for affordable options. The good news is that Q2 was clearly better than Q1 for almost every concept and segment in terms of traffic. Some peculiarities in California, of course. The Fast Act has messed things up quite a bit there, and I need to clear up a few things before we look at BJ’s quarterly statements. I even covered some of the economic phenomena that happened there in my analysis of Jack in the Box (JACK) which I highly recommend reading.
Some thoughts on the Fast Act and how it affects full-service restaurants
The first consequence of the Fast Act for full-service restaurants is precisely the need for wage increases to maintain normal turnover. We saw Denny’s (DENN) increase its staff wages by more than 5% and incur almost 40% of its revenue in labor costs alone. Cracker Barrel (CBRL) is another full-service concept that had to close two locations in California due to high operating costs. Approximately 37% of BJ’s locations are in California (at the end of fiscal year 2023 there were 59 locations), and it is natural that we make these trends very clear.
If you remember my last analysis of BJ’s Restaurants and other analyses where I discussed smart alternatives to deal with rising labor costs, you may remember that I talked about the new AI-based tool for optimizing people management. This is especially interesting for concepts like BJ’s that use promotional times or days (like BJ’s Happy Hour) and LTO’s to generate incremental traffic. This tool identifies specific days and times a restaurant needs to increase its service capacity a few weeks in advance, preventing potential bottlenecks in peak hour management.
Additionally, partnerships with activist PW Partners have helped the company increasingly reduce its labor costs, a counterintuitive move compared to other similar full-service restaurants. In the last quarter, labor costs represented a proportional amount of 37.1% of total revenues. Although 0.2% higher than the annualized proportion for the year 2023, it represented a decrease of 0.4% compared to 2022. This quarter we had another improvement in relation to this, but I will leave the discussion about BJ’s labor costs specifically for later.
But not all of the consequences are negative. Not at all. Despite having to raise wages to remain competitive employers, California’s full-service restaurant operators saw their traffic increase after April, when most of the costs were passed on to QSRs and fast-casuals. Take a look at this chart from Placer.AI and notice that full-service restaurants in California saw higher traffic than the national average in 8 of the 14 weeks observed:
If you’re wondering if this traffic was funneled through other channels or was just one-time restaurant guests, take a look at this other chart from Black Box. These guests who have been frequenting more full-service restaurants are coming from limited-service restaurants. Take a look:
These are simple factors to explain. While full-service restaurants increased their prices by about 5% to stabilize turnover, limited-service restaurants increased their prices considerably more to cover higher labor costs. And yes, those costs increased considerably. Compared to last year, QSRs saw a 19.5% increase in labor costs in April. That’s 15.5% more than the national average. In May, that trend continued, with QSR labor costs rising nearly 25% from the same period last year. Fast-casual restaurants also saw a sharp increase, but slightly less than QSRs.
Limited-service restaurants saw lower labor costs in April compared to 2023, and seeing the impact on turnover saw costs rise 1.1% more in May than last year. That is, while full-service restaurants nationwide saw a 4.1% increase in May compared to last year, those in California saw a 5.3% increase.
Guest perceptions of value propositions and menu price gaps drove traffic to full-service restaurants in California. It’s also interesting to note that the impacts on comparable sales at California QSRs have been minimal. Price increases there have been able to offset the decrease in traffic, at least for now.
I think these developments discussed here, and the previous analyses mentioned provide a satisfactory background for us to comment on the developments of BJ’s Restaurants. Without further ado, let’s get started.
What I saw in the second quarter at BJ’s
Stagnant sales, but a small traffic response due to extrinsic factors
Let’s start with the financial results. We’ve already said that BJ’s beat analysts’ expectations on revenue. However, this scenario is not observable when we exclude the adjustments related to accumulated tax credits. This had an effect of approximately $2 million that was not previously recognized by the company. This usually occurs when we deal with refundable tax credits or retroactive tax benefits. I am not aware of the specific case, but it is very likely that this will be addressed in the company’s subsequent legal statements.
That said, we can infer that revenue in the second quarter remained flat compared to previous quarters. In addition, the context is unfavorable both for traffic in full-service restaurants that do not opt for a value-based proposition and for the increase in the average check due to all the inflation in restaurants over the last ten years.
The lack of new openings even though it already has a tested and approved prototype (used at the Brookfield, Wisconsin unit) also contributed to this. Since the second quarter of 2023, the company has been postponing its pipeline of new openings to focus on improving its margins, which has proven successful in this regard.
In the following chart I have compiled total revenues and asset turnover on a quarterly basis:
Despite this, there were some positive developments on the sales front. The first is that BJ’s achieved a new weekly sales record during Mother’s Day. That week, average sales per restaurant hit $141,000 systemwide. That said, comparable sales were down approximately 0.6% compared to Q2 2023, a trend that had been smoothing out over the quarter and reversing in June. BJ’s comparable sales were 0.1% lower than average for Q2. This was driven by a 2% increase in average check during the period and a 2.6% decline in traffic. This trend was expected. We’ve previously discussed how restaurants are increasing menu prices much more sparingly than they were a year ago.
And yes, this situation could have been worse if not for the increase in traffic at full-service restaurants in California. These factors caused BJ’s to experience a smaller decline in traffic than in a non-government environment. The industry average for traffic was -3.1% and BJ’s experienced -2.6%.
There is actually an interesting trend that BJ’s CEO mentioned regarding this dynamic between traffic and average check per guest. During the second quarter, BJ’s restaurants began to see higher traffic during the late night hours. While this number of incremental guests is helping to increase traffic, it is also causing a drag on the average check per guest, as the average guest with this profile spends on average $10 less than a regular guest.
This change in pattern has reduced the average check per quarter by approximately 0.5%. This trend is expected to continue in the coming quarters, as it may be the result of incremental traffic coming from QSRs in California. Traditionally, these guests seek out promotions or lower-priced items during these hours, requiring the restaurant to maintain very specific upscale and cross-selling options to capture incremental dollars in each transaction.
For the next quarter, I expect this relationship to become even more conflicted. In addition to the fact that the third quarter represents the worst period for the company in the year, we have QSRs recovering some of the traffic lost from value promotions. In other words, the incremental traffic we are seeing in the second quarter will most likely not materialize during the third quarter.
Operational improvements are likely to continue into 2024 and 2025
It’s clear that throughout fiscal 2024 and the second half of fiscal 2023, BJ’s decided it was time to address operating cost containment as its most pressing task. The company was coming off the back of the pandemic with historically high costs for both food, beverage, packaging, and labor. Of course, supply chain disruptions caused disruptions in commodity prices, and internally, wage inflation was and continues to grow faster than inflation. Something had to be done.
The following chart shows the operating cost centers and the percentage each represented of total revenue:
Note that for more than two years, BJ’s has had lower labor costs than its historical average. What we saw in the second quarter of 2024 even corroborates this trend, since the difference in the last period was one negative standard deviation from the historical average.
BJ’s recently adopted an AI-based sales prediction system. This tool can detect, weeks in advance, likely days and shifts in which managers need to pay attention to staff distribution. This is a topic that I have already discussed in greater depth in other analyses, and I think it is better to focus on more recent developments here.
Another interesting development aimed at improving workforce efficiency is the redesign of some key processes in the salon, which is being dubbed the ‘Enhanced Service Model’. The new service model incorporates new operational and technological processes and tools that aim to enhance efficiency and customer experience.
The first pillar of ‘ESM’ is balancing the number of tables per waiter by introducing food runners. This will reduce the workload per waiter and help the company to provide more attentive service.
The second pillar of the strategy has to do with the involvement of managers. The introduction of food runners and the delegation of waiters to tasks more focused on hospitality allows managers to spend more time in the dining room, improving control over quality standards in service.
The third and final operational pillar has to do with service efficiency and the ability to increase table turnover if necessary. This is a clear response to the trend I mentioned earlier. With average checks per guest decreasing, BJ’s will need to deal with occasional QSR guests through fast and assertive service. Of course, while maintaining quality service, which is subsidized by the other two pillars. This is very important in California, much more so than in other locations.
Now, regarding the technological developments implemented by ESM, I highlight the adoption of Kitchen Video Display Systems, in the same way that Denny’s is doing with the help of its new cloud-based POS, developed in partnership with Xenial Enterprise Solutions. In addition, the company is making some changes to its server tablets to better fit them into its EMS program.
To ensure this plan works as intended, BJ’s will invest in revamped training focused on hospitality and sales skills to ensure that 1) Waiters who are now more focused on direct customer service are able to increase the average check per guest and increase the perceived quality of the experience; 2) Quality standards are well understood and incorporated by managers; 3) Workforce adaptation to new technology systems.
These efforts, according to management, are responsible for improving the contribution margin at the restaurant level, and consequently for improving cash flow. Everything indicates, in my view, that the company is taking certain training measures to standardize the value proposition before its expansion through its lean units. In other words, they are divisible parts of a larger plan to increase the attractiveness of investment in new units and increase profitability in general.
Before we move on to the next topic (which has a lot to do with the attractiveness of the expansion project and store-level initiatives), let’s take a look at how margins have behaved in recent years:
Based on this data, we can say that management has been successful in expanding its margins thus far. This gives me a greater degree of confidence in the operational efficiency improvements that EMS will bring. However, the market remains soft and comparable sales are expected to decline as restaurants that have opted for a more aggressive promotional mix (mostly QSRs and fast-casuals) recover traffic during the third quarter.
Unit openings: quality over quantity
When I saw the success of the Brookfield unit using the new lean footprint, costing about $1 million less and seeing the openings for 2022 and 2023, I thought the company would quickly return to 5% annual growth. I was wrong. For a year now, the company has maintained the number of 216 units unchanged, even with a prototype ready to be used.
Of course, let’s not be unfair, so far the company is focusing on its operational improvements and remodeling. BJ’s remodeled 19 restaurants this year and plans to do so in at least 5 more units, totaling 24 remodeled units this year. That’s just over 10% of the total number of units. So far, the remodeling effort that began last year aims to reach 70 units by the end of the year.
Management’s long-term plan was to grow the number of units by approximately 5% per year, but this has not been happening. As the CEO says, BJ’s is opting to grow qualitatively rather than quantitatively. For the company to grow 5% in 2024, it would have to open 11 units by the end of the year. This scenario is very different from what we have seen so far. BJ’s did not open any units in the first two quarters of this year, but it plans to open two units, one in August and another in September. This would represent growth of less than 1% in the year 2024.
The topic of new openings was mentioned a lot by analysts during the last conference call, as it is a very hot topic within the industry. Here we have two views. Those who see the ‘glass half full’ can say that at least BJ’s is not closing restaurants like Cracker Barrel, Denny’s and Outback (BLMN) that have been closing underperforming units. In fact, in 2024 one restaurant was permanently closed, which I consider to be small potatoes when compared to other concepts that are suffering from slow traffic and negative comparable sales.
When we talk about full-service restaurants, especially restaurants like BJ’s, we know that openings really need to be balanced to the point of exhaustion. The cost of developing an ‘old’ unit of the company costs approximately $7 million dollars, which can very quickly jeopardize the company if the financial feasibility study is not well calibrated.
We also have those who see the ‘glass half empty’ and simply observe that the company has not opened any restaurants in approximately a year, even with a lean unit project that would accelerate the payback and increase revenue which, as we saw previously, has been stagnant for some time. Note the growth in the number of units since 2014:
I think it would be interesting to take a look at the savings provided by lean units in the context of BJ’s unit expansion. We have some benchmarks to use against other concepts that are also adopting or planning to adopt lean units.
First, we know that while BJ’s broke its weekly sales record during Mother’s Day week with an average weekly sales of $141,000, that is not the average volume. Less than a year ago, BJ’s was reporting average weekly sales of $130,000, or $6.8 million annualized. Let’s infer that the company currently has an average annualized restaurant-level sales of $7 million, or approximately $134,000 per week. The most recent restaurant-level margin is 15.5%. Let’s take a look at the viability of the new units:
Consider the changes that a lean unit can make. The new Brookfield-style units have a 9% higher NPV, which is materially more value being created for the company’s shareholders. BJ’s lean units provide a payback period of approximately one year, reducing financial risk and increasing the margin of safety relative to the cost of capital. This relationship can best be expressed through the benefit-cost ratio, which compares future cash flows discounted to present value with the cost of the project. And last but not least, we have the internal rate of return, which increases by approximately 2.3%.
Last quarter, I conducted some similar measurements when details were released about the new lean locations of Portillo’s (PTLO) and Potbelly (PBPB). These are two fast-casual chains that are expanding rapidly. I recommend reading the articles I wrote about them. Although both rely on franchisee-driven unit development, with Portillo’s having approximately 50% franchised units and Potbelly 19% (but the latter is aiming for 85% franchised units through Franchise Growth Acceleration agreements), here’s a comparison:
Strategies for dealing with the promotional environment
Before I get into my Q3 outlook and rating on the stock, I’d like to take a moment to analyze BJ’s promotional mix and where it fits within the industry.
As I mentioned in the first section of this article, guests are definitely looking for value promotions. I recently came across a survey conducted by Black Box that compiled some key insights from guests who review restaurants online. The survey identified some recurring patterns for LSRs and QSRs. First, in both positive and negative reviews, the most important factor is price. To give you an idea, between 60% and 70% of both positive and negative factors were tied to this factor.
However, BJ’s made it clear on its most recent earnings call that it will not be jumping headfirst into promotional environments. The company’s focus is on making Pizookie a household name. In addition, the company plans to run specific promotions, such as Daily Brewhouse Specials and the Pizookie Pass. In other words, similar to what Applebee’s (DIN) is doing with its All You Can Eat in January, Applebee’s Date Night Pass in February and $0.50 Boneless Wings in March, BJ’s plans to attract incremental guests through specific LTOs. In addition, the company plans to keep menu prices relatively stable over the next few quarters.
For example, at the end of September, BJ’s plans to increase menu prices by 0.9%. Compared to last year, the company was increasing menu prices by up to 2%. However, compared to the previous scenario, BJ’s promotional mix is not focused on value, and is heavily dependent on guests perceiving the value embedded in a few items that are considered to be the best value for money. At the end of the day, this is the same problem with the promotional mix of the companies I mentioned at the beginning of this analysis, and like all of them, BJ’s will increase its advertising spend to increase incremental sales.
Considerations for the third trimester and my recommendation
Management expects cash flow margin at the restaurant level to decline approximately 3% to the 12% level. In addition, higher marketing spend will squeeze margins slightly in the upcoming quarter as the company tries to generate guest awareness of its LTOs. This is approximately 0.5% to 0.7% higher than the same quarter last year. Revenue is expected to remain flat or declining as the average check per guest continues to trend downward.
That said, and given recent developments, I am downgrading my rating on BJ’s Restaurants to ‘Hold’. Here are a few reasons why I believe the company will not perform as well during Q3 2024:
- The company’s third quarter is historically weak. I suggest you take a look at the charts where I compile both margin and revenue data and compare the third quarter results to the rest of the year. Analysts are forecasting revenue of $325 million (the lowest since Q3 2022) and EPS of $0.20;
- The traffic advantage seen during Q2 2024 is unlikely to be repeated during Q3. First, we saw that starting in June and July, several QSRs are investing heavily in value meals, which should bring back some traffic. I recently analyzed some promotions and the impact this had on traffic. The bottom line is that, yes, guests are returning to QSRs for value meals. Despite the drawbacks (the average check is decreasing as discount coupons are being used in combination with these promotions), traffic will return to these restaurants;
- The lack of a promotional mix based on value promotions goes against what we are seeing in Black Box’s traffic driving research. Advertising costs will be replicated by all restaurants, which will nullify the intended effects, especially for smaller operators like BJ’s;
- There won’t be the much-anticipated 5% growth in the number of units, at least not this year. This means that revenue will remain partially stagnant, with negative comps and declining traffic. Average check growth should increase as late-night guests return to QSRs, but this will have a direct impact on traffic.
However, I still see the restaurant in a positive light. Management is doing a great job of increasing margins to pre-pandemic levels, which is quite difficult given the conditions of wage inflation.
My biggest concern here will be how the stock will perform in a historically weak period with bears looking at the stock. It’s worth keeping an eye on this to see how far the stock will fall. There are some important supports still to be overcome, but for now, I recommend caution.
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