The Gaucho chain of restaurants has gone into administration. Already this year other restaurant chains have announced closures – Jamie’s Italian, Prezzo and Byrons. This has been put down to “consumers changing the spending habits”.
But let’s look at this in a little more detail shall we? The service firm life cycle (SFLC) – explained on pages 72-74 of our book – identifies service firms, and especially restaurant chains, typically go through four stages of development – entrepreneurial, multi-site rationalisation, growth, and maturity. So think about how money is made at each of these stages…
In the entrepreneurial stage, the restaurant is a new concept, fresh to the market. By definition, if it is is financially successful it will go on to the next stage of the SFLC. If it does not make money it may survive for a short while, but never grow into a chain.
At the multi-site rationalisation stage, 2 or 3 more sites are selected and the concept is honed to maximise it’s potential. Even if the first site is profitable, it is unlikely to be able to generate enough cash for this investment, so this stage is typical financed by loans, secured on the success of the first restaurant. With this debt burden, this mini-chain is not likely to generate a great cash surplus. So the way you make money at this stage is to sell the business to a larger chain that wants a new concept or investors with experience of growing such chains.
Typically the growth stage is rapid. This is for two reasons. First, to beat potential competitors to the market, and second to generate economies of scale. Inevitably site selection is somewhat hit and miss. Even if detailed feasibility studies are done (often they are not) actual performance may vary significantly from what is expected. Nonetheless the financials look good, especially revenue growth, simply because new restaurants are being opened all the time.
It is only at maturity that it becomes really hard to make money out of restaurant chains. A growing debt burden and poor site selection during the growth stage undermine profitability in a business that has relatively low margins anyway. Hence changes in consumer taste and/or an economic downturn make these chains very vulnerable.