RR Thermometer – July Wrap-Up

The Restaurant Research

Thermometer Magazine

Taking the Temperature of the Restaurant Industry

July 2013

What’s Inside?

Indicies Report Summaries Trends Analyses

Stocks

1

Applebee’s &

Subway

5

Key Corporate

Announcements

2

Leveraged Loan

Guidelines

7

Traffic

10

Remodeling

6

New Menu Products

3

Strategic Buyer

Valuations

8

Cap Rates

11

Development

6

Menu & Promotions

for July

3-4

Calculating Sales

Lifts

9

An Insider’s View of Key Industry Trends

RR Thermometer – July Wrap-Up 1

Restaurant Stocks Continue to Soar

Sell in May and go away? That is no way to keep Filet Mignon on the table! Restaurant stocks

were up +33% YTD through 7/31/13 vs. +18% for the S&P 500 and +25% for the consumer

discretionary ETF. While we remain uncertain of the exact correlation between sector stock

performance and industry fundamentals, we must admit that there may be some reasons for increased

confidence as Obamacare was pushed-off a year while consumer confidence improves. Still, striking fast

food workers looking for double the minimum wage should give investors some pause unless these

workers will spend all that increase in discretionary income at the QSR stores where they are

employed...

Not surprisingly, casual stocks fell-off -2.4% in July which is consistent with an apparent slow-

down in that segment's sales during the summer. We suspect $6.99 casual lunches and Darden's new

focus on affordability might eventually help-out here.

However, we note that casual's recent stock performance has caused an unusual phenomenon -

restaurant stocks as a whole under-performed both the S&P 500 and consumer discretionary

during this past month. For readers interested in second derivative changes, this may be a trend worth

pondering.

RR Thermometer – July Wrap-Up 2

Key Developments for $1B+ Chains during July 2013

IPOs

CKE Restaurants Holdings Inc. (parent to Carl’s Jr. and Hardee’s) is exploring a possible sale.

The affiliate of private-equity firm Apollo Global Management LLC that took CKE private three

years ago is working with Goldman Sachs Group Inc. to explore a possible sale and the company

could be valued at $1.7B+.

The Papa Murphy’s Take N’ Bake Pizza chain (owned by Lee Equity Partners) may be preparing

for an IPO.

Focus Brands (parent of Auntie Anne’s, Carvel, Moe’s Southwest Grill, Schlotzsky’s and

Cinnabon) may be preparing for an IPO.

M&A

Doherty Enterprises Inc. has acquired 38 Applebee’s and now owns 140 restaurants of which

100 are Applebee’s locations with the rest represented by the following brands: Noodles &

Company, Panera Bread, Chevys Fresh Mex, Quaker Steak & Lube, The Shannon Rose Irish Pub

and Spuntino Wine Bar & Italian Tapas.

Sun Holdings, LLC (franchisee of 400 stores in the Burger King, Popeye's, Arby's, CiCi's, Golden

Corral and Del Taco brands) acquired 3 company owned Krispy Kreme stores in Dallas and

executed a development agreement for 15 more.

Menu & Promotions

QSR is expected to shift away from dollar-menu ads towards higher-quality, brand oriented

items according to a press report.

High expectations for Wendy’s Pretzel Bacon Cheeseburger rollout which will be supported

by a “360 marketing campaign”.

MONOPOLY at McDonald's returned July 16.

Taco Bell is reportedly testing a Fiery Chicken Cool Ranch flavor.

Starbucks is testing handcrafted sodas and a “cold-foam mocha.”

Facilities

KFC plans to open a test “innovation restaurant” in a fast-casual format called “KFC eleven”.

Outback’s new prototype offers larger lounge and patio seating and reports a sizable restaurant

relocation opportunity with as many as 100 potential stores.

RR Thermometer – July Wrap-Up 3

Key Promotions for $1B+ Chains during July 2013

RR Thermometer – July Wrap-Up 4

Key Promotions for $1B+ Chains during July 2013

RR Thermometer – July Wrap-Up 5

Restaurant Research’s Concept Report Summaries for July

Applebee’s 2012 US System Sales: $4.5B 2012 Growth: +1.7%

Applebee's enjoys the benefit of scale as the largest casual dining chain with a 16% segment share

of the $1B+ chains that we cover. However, the entire casual segment has been challenged with a

confluence of changing demographics, economic weakness and increasing internal and external

competition that have pressured the sales performance for both Applebee's and the entire casual

segment. We believe Applebee's has done a good job of reacting to these challenges with constant

menu innovation and by sticking to an "everyday value" model that is designed to encourage repeat

business with a manageable margin impact. Also, we appreciate the chain's efforts to extend its late

night business without disrupting its core family business. We also like the express lunch test which

is designed to better address fast casual. Finally, we like Applebee's efforts to customize individual

stores to their specific neighborhoods (as much as is possible for a large, national chain). Having

said all that, we believe that the brand has more work to overcome secular and cyclical changes that

show no signs of reversing anytime soon. To this end, service quality improvements are key as the

segment leader seeks to train the millenials to sit-down for a meal. In conclusion, we believe

Applebee's is well on its way to successfully tweaking its big box format to better address 21st

century consumers which, in turn, should drive sufficient development to maintain segment share

leadership.

Subway 2012 US System Sales: $12.1B 2012 Growth: +6.1%

With $12B in domestic system sales, Subway represents a dominant force in QSR having built an

iconic brand around a very simple business model that offers customers an ability to customize sub

sandwiches which represents a welcome alternative to traditional fast-food fare. Sharp marketing

has helped establish the perception of affordable healthy and, in our opinion, Subway was really the

industry's first rendition of fast casual for the average Joe. Subway was also instrumental in re-

defining QSR value with its $5 footlong offer - essentially branding around a price point that would

be followed by $10 pizzas and the casual segment's 2 for $20 offers. From the Great Recession

through 2012, Subway's total value equation attracted trade-down from casual while simultaneously

taking QSR share. However, success has attracted increased competition from emerging sub

sandwich chains and fast casual players while economic weakness at the beginning of 2013 invited a

higher level of QSR price competition. In turn, this has prompted Subway to embrace a higher level

of price competition this year which is pressuring COGs and unit level profitability (which had

recently hit an all-time high). Perhaps Subway's 2013 challenge will be cathartic as it becomes

apparent that the system's pricing power would probably benefit from more menu innovation as it

also continues to consider new ways to increase store through-put by building on its recent

expansion into breakfast. In conclusion, it is our opinion that while Subway must currently adjust to

its new competitive realities, the big picture is that this iconic brand remains well positioned as a

key QSR leader.

RR Thermometer – July Wrap-Up 6

Restaurant Research’s Industry Data Report Summary for July

RR’s 2013 Chain Remodeling Analysis Report

RR’s 2013 Chain Remodeling Analysis Report provides the following remodel data and

analysis on 44 national chains: (1) remodel progress/system condition; (2) program

scope; (3) investment costs; (4) associated sales increases post remodel; (5) estimated

return on investment/payback period; and (6) franchisor remodel incentives.

As evident by chart below, facility condition for $1B+ chains are currently at their best

condition since the Great Recession as economic weakness has helped focus capex on

improving sales at existing stores.

Industry Development, Closures & Acquisitions

Over the last 10 years, gross development rates for franchised chains over $1B in

system sales have steadily declined as evident by the chart below.

During this same period, transfer rates (a proxy for M&A within a system), ramped-up

from low single-digits to mid-single digits.

As interest rates fell and acquisition multiples compressed after the great recession,

growth minded operators pursued M&A at the expense of development. This reflected

persistently high construction costs during this time as much as it reflected acquisition

opportunities that presented in the form of smaller, distressed, cash starved operators.

Interestingly, the 2012 transfer rate exceeded the development rate by the widest margin

in at least 10 years even as unit level valuation multiples have begun to ramp-up.

Another interesting trend worth observing is the aggregate rate of transfers and

development taken together which we believe represents a good proxy for overall

industry bullishness as it relates to capital deployment. It looks like 2011 could

represent a bottom with plenty of upside left from 2012 levels.

Source: RR

RR Thermometer – July Wrap-Up 7

Industry Implications of 2013 Leveraged Loan Guidelines

Overview U.S. banking regulators (Federal Reserve, FDIC & OCC) published guidance

for financial institutions that originate leveraged loans in March as part of an

effort to moderate debt levels for private-equity buyouts. Compliance was

effective 5/21/13.

The new guidance, which is not law, increases the analysis and monitoring on

deals with leverage levels “above industry norms”.

Bank examiners will generally define high leverage as total debt-to-

EBITDA of 4.0x+ or senior debt-to-EBITDA of 3.0x+.

This definition will exclude “fallen angels” which refers to borrowers who are

not highly leveraged at the time of a loan’s origin but “migrate” into that class

at a later date because their company’s financial condition deteriorates.

While smaller financial institutions that originate only a few, relatively simple

leveraged loans will not be affected by the guidance, it will apply to small banks

(including community banks) that purchase “participations” in leveraged loans.

Analysis &

Monitoring

of Leveraged

Loans

Risk-management: The institution must identify its risk appetite for leveraged

finance, establish appropriate credit limits, and ensure prudent oversight and

approval processes.

Underwriting: Clear expectations must be defined for cash flow capacity,

amortization, covenant protection, and collateral controls. The borrower's capital

structure must be sustainable.

Valuation standards: Sound methods of determining and revalidating

enterprise value.

Risk rating leveraged loans: An institution's risk rating standards should

consider the use of realistic repayment assumptions to determine a borrower's

ability to de-lever to a sustainable level within a reasonable period of time.

Stress testing in accordance with existing interagency issuances.

Industry

Implications

Unit level valuations have been steadily ramping-up since 2010 when the US

first began to pull out of the recession.

Higher multiples are also driven by industry consolidation meant to better

address increasing cost pressures and a general lack of pricing power.

Significant refranchising over the last several years has also prompted

consolidation in an effort to create larger operator groups which can help

provide system operational leadership.

Given higher acquisition multiples at a time when existing leverage levels

approximate 4.6x total debt/EBITDA (RR estimates), we believe restaurant

franchise loans qualify as “leverage loans” according to the regulatory

definition.

Resultantly, we expect the industry will require more private equity and

mezzanine financing in order to help the banks keep their senior leverage

levels below 3.0x.

Also, we see a business model for unregulated financial institutions to once

again address franchise finance. Did someone say FMAC??

RR Thermometer – July Wrap-Up 8

Are Strategic Buyers Really Paying More?

Assuming a seller's market, our analysis below has to do with how corporate overhead

(which generally runs around 3% of sales) impacts valuations to the favor of strategic

buyers.

We define strategic buyers as those who are able to leverage their existing management

infrastructure in the purchase of incremental stores. In this case, a multi-unit operator can

acquire adjacent stores and bolt them onto their existing management systems without having

to incur incremental costs.

In our example below, the strategic buyer merely has to hire an additional area director at

$75k to oversee the additional 5 units. This equates to 1% of sales rather than 3%.

With just $75k in G&A overhead, the strategic buyer pays 5x EBITDA which represents an

additional $750k to the seller compared to the 5x EBITDA offer of the non-strategic

buyer who must factor-in the full 3% of G&A overhead into their EBITDA calculation.

Please see example below.

The net result is that the strategic buyer's offer represents a multiple premium of 0.6x

to the seller without the strategic buyer actually having to stretch on their purchase

multiple (compared to the non-strategic buyer).

Further, the strategic buyer enjoys the prospect of a higher exit multiple on their eventual

sale because of the increased scale of their enterprise (consider the multiple premium of

large, public companies compared to franchisee multiples). The potential of a higher exit

better justifies a higher acquisition multiple because of prospects of a stronger ROI.

Of course, the issue of corporate overhead also could be eliminated by the original

model of the owner/operator. In this case, individuals who plan to run their own stores

could pay more than multi-unit operators that do not qualify as strategic buyers - that is if

newbie operators without a proven track record of running multiple units were able to find

financing...

Source: RR

RR Thermometer – July Wrap-Up 9

How to Accurately Measure Remodel Sales Bumps?

The common industry practice is to analyze remodel effectiveness by calculating an

average annual volume (AUV) sales bump. But what is a sales bump?

We need to begin by considering the pre and post update sales performance of

remodeled units relative to a control group. The control is an area where the

investment didn’t occur, preferably in a DMA with close proximity to the test unit. The

bump (net of control) backs-out what would have happened without a remodel.

Consider the following example of an updated store at Year 0 which generated a comp

increase of +9.3% in the following year (Year +1).

A straight comparison of actual results would suggest that the remodel generated a +6.8%

sales bump when subtracting actual Year +1 results for the remodel unit from Year +1

results for the control DMA (+9.3% less +2.5%).

However, we suggest that a more accurate way to calculate the sales bump is to start

by predicting a forecast comp value for the remodeled store during Year +1 using

linear regression - this amount represents what comp the remodeled store would have

generated without the update. In turn, we compare the forecasted comp (ex. remodel)

with the actual post remodel comp.

As evident by the example below, the sales bump for the remodeled unit was actually

+6.1% which is calculated by subtracting the Year +1 forecast (assuming no remodel)

from the actual Year +1 comp (9.3% less 3.2% = 6.1%).

In this case, we can see that the simple sales bump calculation would overstate our

forecast method by 70 bp which, in turn, renders an overstated ROI.

Special thanks to John Gordon of Pacific Management Consulting Group for his help with this analysis. He works

financial analysis, earnings and economics analytical projects, for investors, franchisees, franchisors and others who

need detailed perspective on the restaurant space. He is a Certified Forensic Financial Analyst (CFFA) and has a 35

plus year career in restaurant operations, financial management and management consulting roles. Contact him at:

619-379-5561; jgordon@pacificmanagementconsultinggroup.com; www.pacificmanagementconsultinggroup.com.

Model developed by RR

RR Thermometer – July Wrap-Up 10

Source: DelaGet

DelaGet is a trusted partner of multi-unit restaurant operators around the world, servicing more than 10,000

restaurants and processing data associated with more than four billion order items annually. By centralizing and

consolidating the data from numerous point-of-sale, back-of-house, banks, suppliers, drive-thru timers, etc., DelaGet

leverages the data to increase operator efficiency and profitability through its above-store reporting; data integration;

loss prevention; marketing measurement and planning; payroll processing; and general ledger accounting services.

Learn more at www.DelaGet.com.

DelaGet’s Industry Traffic Barometer Sit-down traffic took a spill in July according to DelaGet's data as discounting continues to moderate in

that sector. This trend parallels casual stock performance during the past month.

QSR traffic held its own in July and we also see fast-food discounting moderating according to the data.

DelaGet transaction data for large brands is aggregated

from 4,000+ QSR and 1,700+ sit-down locations

Note: In some cases, gross sales includes sales tax

RR Thermometer – July Wrap-Up 11

Marcus & Millichap’s Chain Restaurant Cap Rate Trends

The Nisbet Group has been specializing in the disposition and acquisition of Net-Leased properties for the past

15 years under the expertise of Peter Nisbet, the managing partner. By focusing exclusively on the restaurant

product type, The Nisbet Group has formed an unmatched understanding of the unique challenges that transpire

during a transaction while creating solutions to overcome them. The team is recognized as a market leader for

their superior service and outstanding performance by routinely displaying their skills at analyzing market

trends, evaluating properties and resolving issues across the transaction process. This dedicated group has closed

escrow on over 300 properties; earning clients more than $500 million. The Nisbet Group’s success is made

possible through the deployment of market segmentation, innovative approaches, detail orientation, and

cultivated relationships. The group is able to deliver unmatched service to their clients year after year.

For more information please contact Hank Wolfer of The Nisbet Group at (206) 826-5730

The 10-year Treasury Bill rate is now at the highest level since August of 2011, creating uncertainty in the

net lease market as all signs point to continued increases in interest rates.

Moving forward, properties with scheduled rental escalations in the primary lease term will be in the

highest demand as a hedge against inflation is provided.

The impact that future interest rates will have on the values of net lease properties remains the central

focus for investors.

Transaction velocity in the net lease market remains high. With substantial capital available in the

marketplace and a limited number of properties for sale, institutional buyers are exploring different

strategies for acquisitions. This includes acquiring properties with shorter term leases and properties

operated by small franchisees with solid financials.

RR Thermometer – July Wrap-Up 12

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Disclaimer of Liability: Although the information in this report has been obtained from sources Restaurant

Research® LLC believes to be reliable, RR does not guarantee its accuracy. The views expressed herein are subject

to change without notice and in no case can be considered as an offer or solicitation with regard to the purchase or

sales of any securities. Restaurant Research’s analyses and opinions are not a guarantee of the future performance of

any company or individual franchisee. RR disclaims all liability for any misstatements or omissions that occur in

the publication of this report. In making this report available, no client, advisory, fiduciary or professional

relationship is implied or established. This report is intended to provide an overview of the restaurant industry, but

cannot be used as a substitute for independent investigations and sound business judgment.