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Overview: Assessing the restaurant industry business model

Amit Jhaveri

Must-know: Why restaurants are so important to investors (Part 2 of 11)

(Continued from Part 1)

Restaurant business

Restaurants are simple businesses. Because we have to eat every day , people often think the restaurant industry is a safe one to invest in. You can get exposure to this industry via the PowerShares Dynamic Food & Beverage ETF (PBJ) .

Perhaps restaurants are simple relative to industrial companies that are cyclical. Companies like McDonald’s (MCD), Yum! Brands (YUM), the  Cheesecake Factory (CAKE), and Darden Restaurants Inc. (DRI) operate well-established brands. But make no mistake. The  restaurant business is competitive.

High competition

To start a restaurant, all you need is some capital to purchase or rent a space, equipment, and furniture in the beginning. Some additional capital is also required to purchase ingredients, pay employees, and fund utility bills. These are called “working capital.” Because the start-up capital cost isn’t in the millions and billions, the barriers to entry are quite low. But as no brand commands a large piece of the restaurant industry, competition is fierce.

From the fall of 2011 to the fall of 2012, ~4,500 restaurants opened in the United States, according to the NPD Group. But that doesn’t account for several restaurants that end up closing—thanks to the industry’s low barriers to exit. An article on Biznik noted that 9,000 restaurants fail each year, and another from BusinessInsider  said 80% of new restaurants are likely to fail within their first five years of operation. When the economy does poorly, people will often cut back on their spending for eating out and they’ll cook more at home.

The four Ps and more

Place, product, pricing, and promotion (the four Ps) are key points that restaurant owners have to deal with regularly on top of meeting food safety standards. This means owners must understand their competitive landscape.

Investors should also know that running an independent restaurant is different from managing or operating a restaurant chain, which invites additional complications like incentive alignment, bureaucracies, growth strategy, and operational guidelines.

Continue to Part 3

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