AI Can Help Restaurants Innovate. But Will It Deliver Profits? – Morningstar

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Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Restaurant chains that have been snacking on what technology has to offer should order a full meal plus dessert. The tech-starved industry could benefit from automating reservations, scheduling, and tip management to grow their margins. Sean Dunlop has researched how restaurant tech can create winners and losers. He is an equity analyst on the consumer team for Morningstar Research Services.

Welcome to the podcast, Sean.

Sean Dunlop: Thanks so much for having me.

Tech and the Restaurant Industry

Hampton: So, why has the restaurant industry trailed other industries in adopting technology?

Dunlop: Yeah, there are a couple of big reasons for it. So, for as long as I can remember, restaurant labor has been cheap and abundant, and it just hasn’t been an issue. Fast-forward to February 2020, everybody got sent home. We saw this massive wage inflation in the restaurant industry. So, the average hourly wage in leisure and hospitality today is 26% to 27% higher than it was in February 2020. And all of a sudden, everybody’s forced to look at this.

There are two other big reasons. One of them is that restaurant margins are notoriously tight. So, if you look at the average independent restaurant, they typically have a low-single-digit percentage margin, which really disincentivizes some of these forward-thinking investments that don’t have a clear-cut ROI, particularly for smaller operators. And then, the third component of it is access to data. So, until recently, even the biggest chains like McDonald’s only knew about 5% of their customer base. Now, as we’ve seen this proliferation of digital ordering and loyalty program penetration, it’s become much easier, and these companies have a lot more access to relevant customer data that really incentivizes some of this investment.

Can AI Speed Up Tech Evolution?

Hampton: Let’s talk about AI, or artificial intelligence. What’s the role there with that? I mean, how can AI speed up the tech evolution?

Dunlop: It has a number of interesting use cases in the restaurant space. First of all, as a cost center, there are a number of places where they can plug it into software modules and work on things like predictive scheduling or work on things like inventory management. That can really take a lot of costs out of the profit and loss statement. Secondarily, it can really serve to grow sales. So, you think about personalization in an app medium. I’m sure you’ve gotten push notifications for pizza, right, when you’re just thinking about ordering a pizza or for a burger right after the kids’ swim meet. And that’s AI. These restaurant chains have gotten extraordinarily good at segmenting consumers into cohorts. They’ve gotten extraordinarily good at serving up offers right when you want them. And they’ve gotten even better about figuring out, in terms of personalization, what you typically order with what. So, for instance, would you like to add fries to that, or would you like to upgrade to a large soft drink? So, as a sales center, AI definitely will have implications as well.

And then, in terms of line extensions, we’re starting to see companies realize when they’ve got something that could be a real hit. So, for Starbucks, for instance, 70% to 75% of beverage sales today, which is astounding, come from cold beverages, which I imagine the average listener would not have thought. I certainly wouldn’t have if I didn’t cover the company. And a big part of that is they saw the success with the cold foam cold brews, with the nitro cold brews, with the Starbucks Refreshers beverages, and they decided to say, all right, let’s lean into this and really grow that IP. I think, to summarize, it can take costs out of the equation. AI can help restaurants grow sales. And then, it can also serve really to drive menu development.

Hampton: About the cold drinks, I am very surprised. It’s going to take me some time to get used to that.

Dunlop: It’s wild, yeah. It’s not a hot coffee business.

How Digital Adoption Can Grow Bottom Lines

Hampton: You’ve written that restaurants can grow their bottom lines without raising prices on customers if they shift toward digital adoption. Explain how.

Dunlop: This became particularly pressing in 2021 and 2022, and we saw those massive wage increases. We saw a big uptick in commodity costs. Restaurants really tried to pass that through with pricing. So, there were phases where we saw 15%, 16% annual pricing in the restaurant industry. And really, it’s only been recently that consumers have started to balk at that. They’ve gotten a little bit of sticker shock. It costs more or less $4.50 more to get a quick service meal today than it does to get a similar meal in the grocery channel or in the convenience store channel. And so, we’re starting to see traffic declines industrywide. So, our recommendation is that operators take a much different tact moving forward. They lean a little bit less heavily on pricing and a little bit more heavily on using some of these restaurant technologies to really take costs out of the equation.

The three big ones that we identify are inventory management—33% to 40% of restaurant food is actually wasted. So, even just a 15% reduction can unlock 2 points of margin. We’ll get at labor scheduling. So, payroll scheduling and tip management typically takes about eight hours of general manager time per week. That can come down to 2 with some of these modules. That unlocks another 40 to 50 basis points of restaurant margin. And then, digital ordering is really, really effective for this as well because you think any order that comes through digital channel, through your Starbucks or Chipotle app, is not getting taken by somebody at a point-of-sale, at a register or in the drive-thrus. That really allows employees to focus on the customer experience and to focus on making food.

‘Tipflation’ Frustration

Hampton: And you mentioned point-of-sale. Point-of-sale tipping—it’s caused some friction, and people are referring to it as “tipflation.” Can you explain why some restaurants are leaning into this feature?

Dunlop: It’s a really effective means for restaurants to pass through some of the labor costs without having to explicitly bear them. So, from a consumer perspective, it can be very frustrating. Do I tip for a coffee that I’m taking to go? Do I tip for a burger? I never used to have to do that. And now, it seems almost ubiquitous. It’s basically included with any point-of-sale software today from Squarespace to Toast to Clover to Lightspeed POS. And in general, consumers have been willing to bear it. The average tip in the United States is still greater than 20%. We haven’t seen a massive decline in transaction frequency that could be tied to that explicitly. And people tend to mentally account for these things differently. The sticker price of the meal and the tip are almost coming out separate buckets. Now, over time, I think the consumer might react. And to the extent that restaurants saw a decline in mix—if people were buying fewer fries or less alcohol or coming less frequently, then it’d worth revisiting. But for now, I think it’s, unfortunately, from a consumer perspective, here to stay.

Loyalty Programs Lead to Higher Customer Spending

Hampton: Loyalty programs can lead to higher customer spending and more frequent returns. Yet, they’re not a fit for everyone. Talk about that.

Dunlop: Yeah, it’s interesting. It feels like everybody rolled out a loyalty program over the last three years, doesn’t it? There are restaurants for which it works better, there are restaurants for which it works worse. The way we sort of look at it is in terms of visit frequency and in terms of incremental profit or profit per check for the restaurant. So, the costs of actually running a loyalty program aren’t all that high. Typically, food costs for restaurants are about 30% of sales. So, if you’re offering a free entree, that’s about the only cost that you’re bearing incrementally. But the upfront costs can be quite expensive as you think about building out this program and designing it, maybe building out an app interface. Most restaurants, we believe, should take a step back and consider whether it really makes sense.

In general, we see an 18% to 30% uptake in guest frequency with loyalty program integration. So, if you’re a McDonald’s and guests are coming 25 times a year, it makes a lot of sense if you can get them to come another 15%. It makes a little bit less sense if you’re a Pizza Hut and they’re coming through four times. So, in the piece, we kind of chop that up. There are brands like Pizza Hut and like Popeyes for whom it doesn’t make much sense. If they have low guest frequency, from a consumer perspective, if I’m not getting a free entree within a year, there’s no reason for me to sign up for the loyalty program. And then, for smaller brands like a Burger King or a Wendy’s, you’re run into an issue where consumers have limited space on their screens. They’re not going to have the McDonald’s and Wendy’s and Burger King app simultaneously, and that can create structural barriers to entry, if you will.

Social Media and Advertising Buzz

Hampton: Let’s talk social media. People on social media buzzed over McDonald’s Grimace birthday promotion and a new restaurant spinoff called CosMc’s. How does social media fit into a winning digital strategy?

Dunlop: At its best, social media can really create buzz around a brand. And there is, maybe not definitively with social, but definitely with effective advertising campaigns, there’s a bit of a halo around a brand and it can really lift sales. So, McDonald’s is a good example. I was just at investor day the other day, and they’ve had a number of those sorts of marketing creative campaigns that have done very well over the past year or two. They had the Grimace promotion that you alluded to. They had Cactus Flea Plant, they had adult Happy Meals, and they’ve had Famous Orders. And the good news with a lot of those is they’ve been able to scale those globally. Famous Orders is one of those platforms that resonates in Japan and China and the U.S. and West Europe. So, the companies that do this best are able to generate media impressions with really scalable campaigns that drive comp across regions.

One last point I guess I’d add … is, it’s much easier for McDonald’s with having winnowed down their menu now, 65% of sales are coming from their core menu, and they’ve got 17 items that sell more than a billion dollars per year, which is just astounding, everything from Filet-O-Fish to the McCrispy Chicken Sandwich line.

Restaurant Industry Forecast for 2024

Hampton: You’re going to have me rethinking menus when I go into restaurants from now on, like how valuable is this one item? What is your forecast for the industry in 2024 and beyond?

Dunlop: In a sentence, I’d say in 2024 I’d expect low-single-digit nominal growth. And I think the biggest players can probably take a little bit more share than that. They’re the ones that are going to be able to continue to invest in the cycle and build new units, even in an environment where capital is tight and where restaurant margins are below historical median levels.

Now, that said, I think 2024 is going to be quite challenging for the industry. We’ve seen declining traffic for the last 18 months. In the restaurant industry more broadly, we’ve seen consumers trading down the menus. So, we would call that “mix” has declined, and that might be maybe I don’t order french fries, or maybe I order small fries instead of large fries, maybe I don’t get a combo meal. And that is pretty consistent with downturn behavior, what we usually see with consumers. We would expect, given the widening gap between the grocery and convenience store channel cost, and between restaurants, we’ll probably see a little bit more traffic shift that way in 2024. So, on balance, I would think of pricing as being sort of 2% to 4%. Mix is probably being negative, traffic is being negative, so we’re looking at low-single-digit growth.

Beyond that, I think a lot of the structural pieces are still in place. So, restaurants are—it’s been well publicized that they’re moving closer to consumers. You’ve probably seen them popping up in suburban markets. You have a lot more drive-thru concepts. They’re really much more convenient. Delivery times are faster. Access is easier through mobile order channels, through omnichannel access. And consumers are now spending about 55% of their total food budget at restaurants, up more or less 10 points since the early 2010s. So, we see no structural reason for that to change over the next few years and still think that the industry can grow faster than GDP.

Restaurant Stock Opportunities

Hampton: What names on your coverage list look like opportunities for investors?

Dunlop: The recent market rally definitely erased a lot of opportunities, but we still like Yum Brands. We’ve got an $139 intrinsic valuation. We like Wendy’s at $21 a share. And we like Toast as well at $19.20, although there’s a little bit more [hair] around that name.

Hampton: Well, thank you, Sean, for your insights into the restaurant industry.

Dunlop: You bet. Thanks so much for having me.

Hampton: That wraps up this week’s episode. You can read my full interview with Sean in this quarter’s Morningstar magazine. Subscribe to Morningstar’s YouTube channel to see new videos from our team. Thanks to Senior Video Producer Jake Vankersen. And thank you for watching Investing Insights. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

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