Evolve or Die: The Digital Disruption of the Restaurant Industry

Morningstar believes restaurant operators must take the time to reinvent themselves with respect to changes in consumer eating habits, the advent of new front- and back-of- house technologies, the blurring of lines between on-premise and off-premise sales and supply chain innovations.
With counterparts from Pitchbook, they took a closer look at how restaurant and restaurant technology transactions are changing and how that may continue to evolve in the years to come in a Commercial Observer report that has an “evolve or die” theme.

Key highlights from the report include: ​

  • Expect additional restaurant closures and decelerating industry growth. We expect restaurant unit counts to decrease by 0.6 percent over the next five years in U.S. with casual dining and smaller quick-service restaurant (QSR) chains being the hardest hit. This will result in average industry sales growth slowing from four percent from 2012-2017 to 3.4 percent from 2017-2022.
  • We see growth opportunities for chains that continue to adjust to evolving consumer preferences. The blueprint to remaining relevant will differ for each company, but we believe the most successful restaurant concepts will be those that identify what consumer need they are satisfying — often boiling down to convenience versus experience — and then structuring their menu, operations, and technologies to best address these needs. Examples include Starbucks and McDonald's among public operators, and CAVA, sweetgreen, Blaze Pizza, and honeygrow among private restaurant chains.
  • Starbucks' recovery will be volatile, but there is still a long-term investment case to be made. We believe the company is positioned for a comeback through restaurant layout changes such as emphasizing mobile orders or store experience, as well as new menu innovations focusing on health/wellness and authenticity.
  • Delivery and to-go orders will become even more meaningful to restaurants in the years to come. Finding the right partner is key — especially with restaurant delivery aggregators likely to consolidate in the years to come. Recent examples of successful partnerships include McDonald's partnership with UberEats and Yum Brand's relationship with GrubHub.
  • Early technology adopters will start to see sustained guest traffic improvements…in 2019. There have been several developments on the restaurant technology front the past several years, including new point-of-sale systems, mobile ordering/delivery capabilities, mobile-enhanced loyalty programs, back-of-house solutions (including labor staffing and inventory management), and automation for food preparation processes. We anticipate more pronounced contribution in 2019 for those restaurant operators who understand their specific value proposition and have invested in appropriate front- and back-of-house technologies.

Modern Restaurant Management (MRM) magazine asked Morningstar experts RJ Hottovy and Nizar Tarhuni to elaborate on the findings.

Did any findings did surprise you? 

Even after following this space or more than a decade, I was surprised by a number of our findings from the report. To me, the biggest surprises came from three different categories: (1) health/wellness; (2) labor; an (3) technology solutions.

We see two type of restaurants in the future: 'convenience' and 'experience.'

With respect to health/wellness, we've long thought that authenticity was more important than healthy eating, just because it's so difficult to make healthy food taste good and that many consumers often pass on healthy fare when dining out. This has been historically difficult to quantify, so we were surprised when the leaders in transactions per square foot growth the past five years also had the highest correlation to the keyword 'authenticity' when we screened our sample group against a number of purchase criteria keywords using Google Trends.

Labor was also interesting discussion with many operators, as many said their sales take a hit when they cut labor while others are clearly using technology to reduce the number of employees per store. Ultimately, this got us thinking that there are multiple paths to success for restaurant operators, with "convenience" focused restaurants able to use technology while "experience" locations needing extra labor to satisfy consumers.

Lastly, we were surprised by how many technology solutions are available to restaurant operators today, and by how little operators understand what they do. We're clearly in a restaurant tech boom and even the staunchest operators are starting to embrace technology, but there is a lot of confusion about what technologies are essential for future restaurant operations and which will just incur unnecessary fees. 

Why the theme “evolve or die?”

In many ways, today's restaurant industry reminds us of the retail space about a decade ago, where many operators are going to have to make some changes to their operations to accommodate changes in consumer preferences and new sources of competition. We don't expect all restaurant chains to survive, especially those who are reluctant to make changes to their business operations. However, like the retail industry, we believe there will be some success stories that come from the concepts that adjust to these structural changes.

What role does technology play in this evolution?

Since 2014, VC investors have deployed $11.2 billion across 944 deals in the restaurant tech space.

We're in the early stages of a restaurant technology boom, with new solutions across almost every restaurant function (delivery, mobile payments, reservations, point-of-sale systems, labor staffing, inventory management, etc.). However, how restaurants deploy technology ultimately depends on what need they're serving.

We see two type of restaurants in the future: "convenience" and "experience". Convenience locations should use technology to maximize transaction throughput and delivery options, while experience locations should use technology to improve the guest experience by reducing wait times.

Some chains like Starbucks could conceivably have both types of locations, with convenience locations emphasizing mobile payments and experience locations getting creative with new drink, food, and layouts.

How does increasing use of delivery affect the restaurant forecast?

Delivery is one of the more controversial aspects in today's restaurant industry. On one hand, it does present a sizeable growth opportunity for many chains. On the other hand, there are several risks such as food quality, delivery speed, customer data ownership.

We don't believe delivery will be a fad, but we believe that certain concepts (those with national exposure and the technology/operating procedures to accommodate deliveries) will benefit longer-term. It will also be interesting to see if more restaurant chains bring the delivery function in house to avoid the steep commissions that delivery companies charge.

Why or why not are restaurants a good investment? 

We believe restaurant investors could be in for a choppy trading the next few years. Not only are restaurants facing new sources of competition and need to make changes to their business models, but their dividend/buyback programs look less attractive in a period of rising interest rates (where investors can rotate into Treasuries for low-risk yield).  

Restaurant investors could be in for a choppy trading the next few years.

While we expect continued M&A activity in the coming years, we believe investors must be selective with their investments and focus on those companies that are investing in new technology and operational solutions.

While these endeavors may be costly and weigh on results over the near-term, we believe they are necessary to compete over a longer horizon.

What can restaurants learn from the retail landscape?

I think one of the most important lessons restaurants can learn from retailers is knowing what they are and what they aren't. The most successful traditional retail stories the past several years have focused on specialization and experience, two items that are difficult for Amazon to replicate.

I see the restaurant chains that offer the most convenience or the best experience winning out and surviving the structural changes we're predicting the next several years.

What roles do companies such as Amazon play in the future of restaurants?

It will be interesting to see how Amazon's role in the restaurant space will evolve in the years to come. On one hand they're looking to be partner for restaurants through its Amazon Restaurants delivery service and a supplier through Amazon Business. However, Amazon Go stores could be potentially disruptive to restaurants, so I wouldn't be surprised to see some restaurants pushback a bit and embrace other companies for delivery and supply functions.

We expect to see restaurants accelerate their technology adoption.

“To gain a competitive edge in today’s restaurant ecosystem, owners and operators must incorporate new technologies to manage front-end guest services, staffing, kitchen operations and general business management,” added Dylan Cox, senior analyst at PitchBook.

“Over the past decade, we have seen a rapid increase in the development of restaurant technologies and venture capitalists have taken notice. Since 2014, VC investors have deployed $11.2 billion across 944 deals in the restaurant tech space.

Additionally, companies like Toast, a restaurant management platform, have achieved unicorn status by helping restaurants manage sales and front-end guest services. We expect to see restaurants accelerate their technology adoption and for investors to continue pumping capital into restaurant tech categories such as ordering/delivery, payments, marketing/CRM and kitchen operations.”