Shakeout reaching peak nationwide – Second Tier

Shakeout reaching peak nationwide – Second Tier – chain restaurants

Rick Telberg


The death toll is mounting among Second Tier food-service chains as they battle for survival against the highpowered arsenals of their coast-to-coast competitors.

A brutal shakeout is reaching its peak this year in which members of the Nation’s Restaurant News Top 100 figure to lengthen their gains against fledging and midsized chains, grouped loosely into what NRN terms the Second Tier.

But tenacious operators and starry-eyed entrepreneurs continue to flood the ranks of the Second Tier to make up for losses. Second Tier chains account for one out of six restaurants in the United States, a figure that has changed little in the 1980’s, according to NRN research.

“As you go down the list from biggest chain to smallest chain,” said Carl DiBiase, chief analyst at Restaurant Trends Inc. of Middletown Township, N.J., “you see that the performance deteriorates.”

“There is a shakeout going on,” he said. “The big chains are making meat pie out of smaller chains.”

In recent months the list of failures or distress sales has lengthened. It now includes: Peoples Restaurants, Kelly-Johnston Enterprises, Good Taco, Fresher Cooker, One Potato Two, Acapulco Restaurants, Naugles and Tokyo Bowl, to name a few.

Chains finding success are carving defensible niches in parts of the business where huge chains have not yet tread: Sandwich-shop chains such as Subway, for example, or Doubletree Hotels, a hotelier that is touting its point-of-difference as stylish dining.

“You have to be an optimist in this business,” noted Sheldon Smith, chairman of Old Fashion Foods Inc. in Austell, Ga., which operates the 14-unit Mighty Casey’s hotdog chain. “The winners in this business are the ones who can offer something a little unique.”

From fast food to hotel fine dining, brave and innovative entrepreneurs are seeking the American Dream in the food-service industry. There are 2,360 companies in the nation operating fewer than 200 outlets each, according to NRN research.

The Second Tier faces increasing pressures from the nation’s biggest restaurant chains. NRN calculates that last year the Top 100 expanded its share of the food-service market to 44%, or $67.1 billion, up from 41%, or $58.1 billion, the year before.

But after formulating a winning concept, most Second Tier chains can still fail at critical junctures in their growth strategy.

“The biggest mistake operators make comes when they try to expand out of their home territory,” said Ron Paul, president of Technomic Consultants Inc. in Chicago. “There are pockets of saturation in this business, and markets are so localized that Phoenix may be unlike Tucson even if they are both in the same state.”

Robert Freeman, president of Road House Restaurants Inc. of Mill Valley, Calif., figures his five-dinnerhouse organization is reaching a critical phase he terms “The Bermuda Triangle.” “You know,” he said, defining the term, “when you go in with high hopes at one end, but you just get sucked in and never come out.”

Freeman has been there before: He was one of the founders of Victoria Station Inc., a now-ailing dinnerhouse chain with a railroad-car decor.

But now he plans to double his company’s size in one year by replicating the successful California GX Cafe concept throughout the San Francisco area. “It’s already getting hard to manage everything ourselves,” he said. “And that’s when some of the fun goes out of it.”

Fun or not, Freeman is under pressure from his financial backers. Patrick Hopf–managing director of the T. Rowe Price Threshold Fund, which invested $1.3 million in Road House–said he expects a 50% annualized return in two to five years.

But much investment in Second Tier chains has dried up in recent years as up-and-coming operations quickly went down and out.

Richard Pyle, a securities analyst who follows the restaurant industry for Piper, Jaffray & Hopwood Inc. brokerage in Minneapolis, noted, “McDonald’s spends more on advertising than Chi-Chi’s, no small player itself, has in revenues.”

Since mid-1983 Piper’s stock index of emerging chains has plummeted more than 40% with no signs of a turnaround in sight.

“When things get just a little bad for the restaurant business,” Pyle said, “they get real bad for this group.”

Times were never easy for Second Tier chains. Dun & Bradstreet Corp., the credit-rating agency, estimates that full-service restaurant companies with $10 million to $50 million in annual sales earn only 1% of sales after taxes. Companies either smaller or larger are three times more profitable.

But it is among full-service chains that Technomic’s Paul sees the greatest opportunities. “Consumers are staging a rebellion against chain restaurants in general. And that mostly means fast food,” he said. “But a regional operator who stays in touch with his customers can move quicker and easier to satisfy local tastes.”

And yet in fast food no visionary entrepreneur has yet been able to develop a coast-to-coast chain serving either Oriental or Italian food, Paul noted. “And in pizza we could yet see another national chain.”

That was Smith’s strategy when he launched Mighty Casey’s several years ago. “We try to have something the Big Macs of the world don’t,” he said, pointing to his chain’s chili dogs, fried onion rings and spicy chicken wings. “You can’t get them at McDonald’s, Wendy’s or Burger King,” he said.

But Mighty Casey’s has had its growth pains as well. Expansion was shut down for almost a year when it became clear that the sales volumes Casey’s was garnering were not enough to support the investment.

Now Smith has rekindled expansion with a building 25% smaller at 2,250 sq. ft. and $150,000 cheaper to build at about $400,000 each.

“After first starting in business,” he said, “the toughest thing is understanding how hard or expensive it’s going to be. There have been a lot of sleepless nights.”

If many analysts are correct, Smith and his Second Tier colleagues will have many more sleepless nights ahead of them. “The restaurant business has reached a stage of maturity,” DiBiase said. “A lot of the zing has gone out of it, and the competition has just gotten more intense.”

“The battle now is a lot like World War I,” he said. “It’s being fought in the trenches with a lot of bloodshed and very little real movement.”

“The successful chains are the ones that can make end runs around the big guys, as Domino’s did against Pizza Hut with its delivery system.”

Venture fund manager Hopf figures Road House can make those end runs. “They are doing a few things differently,” he said. “They have fresh fish, Cajun food, mesquite grills, a good wine list and a piano bar. But they are smart enough and small enough to change with the times when the time comes.”

Road House’s Freeman, for his part, wants to hold the reins on growth. “At Victoria Station people used to ask how big we wanted to be,” he recalled. “I’d pick a number out of the air. It shouldn’t be done that way. We have to keep our restaurants today close together, geographically, and watch out about getting too heavy with management.”

That is one reason why analyst Pyle is recommending the newly issued stock of Buffets Inc. The Wayzata, Minn., company operates 12 Old Country Buffet fixed-price cafeterias all within a day’s drive for top management. He foresees years of steady double-digit growth at Buffets until the company reaches about 80 outlets. “At that point,” he said, “management ability to deal with a new sort of corporate structure will be tested.”

“The biggest risk at any growing company,” he said, “is spreading management too thin.”

COPYRIGHT 1986 Reproduced with permission of the copyright holder. Further reproduction or distribution is prohibited without permission.

COPYRIGHT 2004 Gale Group