Image via California Restaurant Foundation

Restaurants will continue to see operating margins squeezed into the first quarter of the New Year, which will result in slower merger-and-acquisition (M&A) activity for the industry.

The Restaurant Finance group at Mitsubishi UFJ Financial Group (MUFG) offered its outlook on the heels of the annual Restaurant Finance and Development Conference earlier this month in Las Vegas. Rising commodity prices, workforce shortages and the need for higher expenditures to attract labor continue to eat away at revenue.

“Despite strong sales, most restaurant companies have seen their margins erode because of higher food, fuel, labor and transportation costs,” says Nick Cole, Head of Restaurant Finance at MUFG. “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 the first quarter of 2022. “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 adds that the generational transfer of businesses—especially in the quick-service sector—combined with their extraordinary financial performance have fueled the recent boom in M&A.

On the labor side, inflation pressure will only increase the cost of attracting workers, according to Quinn Hall, who leads loan underwriting and portfolio management for the MUFG Restaurant Finance group.

Hall points to 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,” he says.

The pressure of technology — and giving diners the most convenient customer experience — also eats into margins.

“Restaurants are evolving their digital platforms to offer customers the ability to order food from anywhere and on the go,” said Brian Geraghty, Head of Loan Originations at MUFG. “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 adds 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 following the 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 says.

For the moment, those who qualify have access to capital, buoyed by rising sales. But a reckoning could be on the horizon.

“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 says. “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 adds.