First Watch Restaurant Group, Inc. (FWRG) Earnings Call Transcript & Summary

Good afternoon, everyone. My name is Jeff Bernstein, and I'm the Restaurant and Foodservice Distribution Analyst here at Barclays. I am thrilled to introduce our next presenting company, First Watch. With us this afternoon from Bradenton, Florida, we have Mel Hope, the CFO, on stage with me. By way of background for those not familiar in the room or on the webcast. First Watch is a breakfast, brunch and lunch casual dining chain, just clearing 500 units across the U.S. with a company-owned mix of 80% and on the rise. And with a current 10% plus annual unit growth rate, management is confident long-term guidance for 2,000 U.S. system-wide units. So still a tremendous amount of room for growth, perhaps the core of the way there and growing at a double-digit annual unit growth rate. 2,200, and I said 2,000. So they're less than a quarter of the way there. And with 10%, that gives you another couple of years to build upon. You are very precise, yes. So we want to thank First Watch and Mel specifically for joining us. And I've got a handful of questions and then hope to open it up to the audience if there are any, we'll have somebody walking around with a microphone. But without further ado. Thank you, Mel.

Thank you, Jeff. I appreciate you having me.

Yes. Happy holidays.

Likewise.

So we get lots of questions, surprisingly they're not on the consumer. Restaurants have proven to be, I think most people would agree, surprisingly resilient through a lot of different times, but even the most recent period, restaurant industry sales have held up quite well. There was a little bit of a dip from broader restaurant industry data in August and September. And I think that did really raise some concerns of it's either the headwinds are finally hitting the consumer that we've talked about for so long or maybe there was a return to some form of seasonality. And we've actually heard a number of restaurants in October that actually bounced back. So I'm not looking for any data you haven't already disclosed, but I'm just curious your perspective on the consumer environment. I guess if you weren't looking at other industry data and you just looked at First Watch results, how would you say, the consumer is holding up?

Well, I don't think we would disagree with the macro decline that people are seeing. There's -- absolutely, the consumer seems to be under some pressure. Our customers have been very loyal to us. One of the things that I think probably differentiates First Watch and it really goes to the principles of how we show up in the marketplace is that we try to be sure that we're there every day with a value. And so while you can have an indulgent breakfast or brunch at First Watch, we also are very modest in our pricing, we're careful not to get out in front of the consumer. I think if you look, you'll probably see over the course of the last few years, we've probably trailed the industry in terms of taking price. We price to defend our margins to offset inflation, but we don't try to get out in front of the consumer. So we think we have a pricing advantage and that by showing up every day with value that there's something there for our customers every time. And I think that, that has been part of the secret sauce in terms of our building transactions. Because we're focused on that long-term value proposition to the customers so that we're continuing to grow the occasions, growing traffic is how we really measure how well received we are in the restaurant. Same-store sales, that's important, but really growing traffic. That's what we key on.

So have you seen what it seems like as a return to some level of normalcy with seasonality taking more of a center?

100 of our restaurants or more are located in Florida, and Florida probably benefited as much as any state from some seasonal disruption as a result of COVID, so we have seen some return to seasonality. And I think that, that, over time, that's just going to be healthy as we lap some of those, but yes.

Because I talk to friends and family all the time and I bring up First Watch and other names I cover and there are a lot of people who aren't as familiar with First Watch, which they will be over time. But maybe you could just remind us because it is breakfast, brunch and lunch, maybe your mix of sales, however you look at it between dayparts or between weekday or weekend. Like how should we think about that mix of...

We talked about lunch or we talk about weekdays as breakfast and lunch, those dayparts. And then the weekend, we just call brunch. If you've ever been to a First Watch like many breakfast spots, but First Watch, especially the weekends are Super Bowl. So it's prime hours on weekends run from 9:00 in the morning until 2:30 in the afternoon for many of our restaurants. And so we've focused really on the weekday and the weekends. And it runs about 45% as weekdays and then the remainder is that weekend brunch occasion, which is generally very celebratory, a lot of habitual behavior, a lot of returning customers on weekends, a lot of people choose to have a big breakfast at our restaurants over and over on weekends. So that seems to be a ritual in some families.

And how do you think that positions you the breakfast, brunch, lunch daypart? I think a lot of people think of it as maybe many people aren't going out for breakfast or brunch on a weekday or whatnot. So -- but yet everyone else I talk to is focused on lunch, happy hour dinner late nights, how do you think you're positioned relative to everyone else we call your peers?

Well, what we've seen is that over the breakfast daypart is a growing daypart and continues to be a growing daypart in the industry. Most breakfasts are still consumed at home. So when customers are shopping for a new place to eat, breakfast is becoming more and more part of the consideration set. And we think that when people are shopping for breakfast, eventually they find a First Watch, and we have a good history of converting people who are trying us out for the first time into loyal customers. So I think we're well positioned. I think I can go back to the value proposition as well. The value proposition, I think, keeps us in people's consideration set. So when folks are becoming more discriminating about where they're going to use their wallets or discriminating on where they're going to go out, I think that we may benefit from some trade up from out of dayparts. So maybe people might not do the family dinner for sushi or $150 family dinner, but they might still come and do a celebratory breakfast on Saturday morning at First Watch where the value means that they can get in and out for half that.

Right. As I think about -- we've got 30-some-odd days left in 2023, but with 2024 upon us. I mean what would you say you're most excited about for the First Watch business, looking at '24, whether it's sales, margins or otherwise?

Jeff, what I'm excited about and I think what the company is excited about is our growth. We now operate -- we're in 29 states. We're in dozens and dozens of trade areas. Every time we birth a new restaurant in the company, the whole company celebrates. We've been acquiring some of our franchisees and that frees up some more territory for us to grow in. So the enthusiasm about growing the restaurants and growing the restaurant count and growing the company, that gets me juiced and that vital part of our growth plan is something that really gets people energized in the company, and it's exciting for us.

Is there anything that -- any concerns you carry over from '23? Do you think maybe people are underappreciating that still present potential headwinds for?

Yes. I'm like anybody, I wonder exactly what -- how much under pressure the consumer is in an environment right now. I mean, people are looking for -- people are looking for softness in consumer spending and behavior. But again, I know we're positioned well when people are making that decision. I know our value proposition is there every day. And so I don't worry about that too much. Developers in order to grow new sites, I think commercial retail development may show some foot dragging either as a result of interest rates that they haven't seen in a dozen years or as a result of other brands not growing quite as quickly. And so their ability to pre-lease a new facility or new development may slow some things down a little bit. So I try to get a handle on that a little bit. But frankly, what that means for us is that our development teams just have to -- we have to manage more projects because if you are going to have some foot dragging, you're going to have some fallout. When you're in the restaurant business, you're in the real estate business, right? And you have to kiss a lot of frogs in order to find a few that turn into restaurants. So in order to get into the gestation cycle for a new restaurant, you have to have a whole lot of projects that you're managing. And so at a time when they're under stress, we're having to manage more projects and more and different venues so that the ones that complete get to maturity that we can count on and that we can stay on schedule because our job is to continue to grow, and it's very important to us.

Right. So because you mentioned that, I think of you guys with 500 units, if you're looking to maintain 10% plus unit growth, I mean that's 50 stores, which I guess we don't appreciate on the spreadsheet side of the world. But on your side, I mean how many units does that mean that -- and you don't know which 50 you're going to open next year. So you've got 100 going on where you just say some 50 you're going to fit in the there?

We're approving. Our real estate committee meets monthly. I mean we look at all the new sites, and we consider -- we're underwriting to our performance criteria. And so we're looking at sites now that will have 2024, 2025, 2026 opening dates as they come forward. So we look at -- we're already planning -- I would guess we probably want to have 1/3 more than you're going to open. So if you're going to open 50 better be looking at 65 or 70 sites for a year and just knowing that things will change and things will go forward. But you -- again, you have to be -- just to get to that 75, you got to be looking at another 75 on top of that, that aren't going to be -- aren't going to fit your needs. It's -- in that respect, it's a real relationship game with -- in marketplaces. It's cultivating relationships with commercial developers. It's understanding where zip codes are growing and where tax bases are growing in order to make sure we position the restaurant in a favorable market for us.

Right. And I feel like with the 10% annual growth guidance, I'm just wondering when does the law of large numbers kick in? Is that something that you feel like for the next number of years, even on a larger and larger basis, there's more and more real estate? Or you have a better team available that 10% is not that daunting for you, even if it becomes 60 and 70 units in a year?

If we were in a confined area and we said we had to grow like that, it would make me worry, right? But we're now in so many different venues, in so many different states, so many different DMAs with so much green space in other areas plus the green space we have in the markets we're already operating in. I feel like we're seeing all the projects that we can -- that are coming up in an area that we're part of the -- we're on the role of except anybody that has a role in it anymore. We're on the call list of development companies who are looking to merchandise centers that are going to be growing next year and the year after and the year after that. So I feel like we get the call and because we have that kind of presence in so many markets, it helps to mitigate that risk that we would be trying to grow too many restaurants in too few places.

Right now I've spoken to a growth company earlier. That's always a challenge. I would think there are benefits to open up in an existing market from an economies of scale perspective and brand recognition and labor and all the other things, but yet so exciting to open up in a new market to plant a flag somewhere else. So how do you think about that over the next couple of years? I mean is this mostly infill of existing? Or do you say, no, we still want to be -- not as efficient to open up in a new market, but it opens you up to a whole other green space?

It does. And we've had some surprises in terms of that, too, on the good side, but I'll come back to that. What we typically do is try to balance our opening schedule so that we open about 1/3 in what we call our existing markets or legacy markets and then about 1/3 in emerging markets where we have a presence, but it's not nearly saturated or not close to saturation and then about 1/3 in newer markets where we have very few restaurants or brand-new markets. So that's important -- that spread is important to us as well. Because when we open a store, we open a restaurant with a veteran manager. So it means that we're pulling a manager out of one of our well-run existing legacy restaurants and that manager, she's hiring the crews, opening the restaurants and setting it up for success, which also gives us a chance to promote somebody within in the other restaurant, which is important to the career path. One of the things that we enjoy and growth companies enjoy is providing that kind of career path for people who are part of a growth company. So we spread it out a little bit. We open a new market once every, call it, we say it's 12 to 18 months. It's kind of a new market for us. It's interesting, even if it's not a new market, but it's in a new trade area, we've had some real surprises where we might underwrite a restaurant to be a, I don't know, to open at $2.1 million of annualized sales or something like that, which would be a little bit above our system average, and we wanted to grow to $2.5 million in annualized sales in about 3 years. We've had a couple of them where we've opened in a new territory, and we said, okay, we're underwriting to that. And suddenly, they've done what appears to be a $3 million restaurant, a $3.5 million restaurant. So it's in those places where we're having to learn what is it about? Has our awareness grown that people looking for First Watch in some of these new areas, even if it's not a new market, it might be a new trade area near to some of that. That's where the real joy and the surprises are where we said, boy, this really opens our eyes up to what is the possibility of some of these larger dining rooms and larger patios that we're starting to construct. Now it's a fun part of the evolution of the brand.

And being that 1/3 of your businesses in totally new markets. Just wondering how you think about it from a geographical standpoint outside of your core, what are the commonalities where you'd say we've had the greater success versus let's pull back because maybe this type of market isn't right? Like what's the diversions on your best and your worst markets?

Geography doesn't have as much to do with it as site selection criteria. So our restaurants -- our top-performing restaurants, top 10% are I think, in 10 different states. So it's not geographically driven. It's more driven by the site characteristics. Is it -- are we selecting a site that is vibrant out on the 3 sides of light out in the -- into the new -- a new center, easy access ingress, plenty of rooftops, plenty of foot traffic, those characteristics tend to drive the performance of the restaurants more than whether or not it's operating in Arizona or in Jacksonville, Florida or in Baltimore, Maryland.

So there hasn't been a prevalent theme or a market where you say the brand just hasn't been accepted, real estate is the issue if there ever is an issue?

People have -- our customers have really enjoyed First Watch, almost without regard to where we put them. It's been delightful.

Looking past the top line for a moment, you haven't given much guidance for next year. But directionally speaking, I think most people think there will be less inflation across food and labor and whatnot. Is that a thesis that you would underwrite? Or do you see a big swing or something we should be aware of?

Some -- this is what I know and then this is what I feel, and I know that we've -- and we've talked about the fact that our inflation, at least on our market basket, seems to have steadied. I don't know that we're going to enjoy a lot of deflation. I've had people ask me about that before. It doesn't seem like that's how things have trended but it does seem more stable. And so stability is good. I mean at least it doesn't front run me too much on where our margins are going to go. Labor, I think, is going to continue to go up for us. We should see some inflation in our labor cost, frankly, as much as anything because of regulatory increases in minimum wage and the impacts in the restaurants of that. So I think we do have the inflation that will happen for -- on the cost side of our labor.

For '23 now ending, where did those fall out in terms of inflation for overall basket of food and labor?

Labor is running at 8% to 10% in that range, our commodity inflation, at least in the third quarter, we actually did have a little bit of maybe a basis point or slightly less deflation but we expected to have a little bit of inflation in the fourth quarter for -- on the commodity costs. But that's part of what gives me confidence as we head into 2024 that at least on the market basket that commodity inflation seems to have found a level.

Right. So hopefully, next year could be modest inflation on a lot of these, but not too crazy in favor of 8% to 10%. When I feel like some of the biggest increases of paying extra to retained workers and signing bonuses and all those other things, maybe some of that eases. So hopefully, we're in the mid -- somewhere in the single digits in that perspective.

Yes, it's interesting. We never faced the kind of labor issues that some of my peers and I have talked about across the industry. We don't do late nights. So a number of concepts, I think, struggled with labor on that late night shift. Our crews can count on 1 shift, 1 menu every day. We close at 2:30. And I think that, that's appealed to a large enough cohort of hourly workers, that are promised that they can be home for either doing homework or coaching baseball or maybe they have another gig. I think that's been part of the value proposition to the employees that has proven to keep us a little bit buffered from maybe the more challenging labor environment that others struggle with.

We get asked that a lot is 1 area that people perhaps don't fully appreciate, which is your labor model, which I want to make sure I give you a chance to explain it. The fact that it could just end by 2:30 at the end of the day, that's 1 shift. I mean, can you -- are there metrics that demonstrate the benefits of having a 1 shift model, whether it's turnover or retention or...

A couple of things on that front. One, we look closely at the manager turnover because the manager is the point guard in the restaurants. That's the person that really makes it flow. And so our manager turnover has historically been in the 40% to 45% level. I think the industry average is probably 20 basis points higher than that. Ours has been -- we've historically been lower than the industry. During -- in the aftermath of the worst of COVID, we were kind of middle of the pack, and we've been working it down, and I'm really proud of our operators who have worked down that turnover in the managers because what we really benefit from a lot of tenure at the manager level, forget turnover for just a minute. One of the things that's underappreciated is tenure. When you have a veteran manager or you have veteran staff operating in the back of the restaurant, in the front of the restaurant, their ability to solve for the crisis that happen in every shift, right? We ran out of something or we -- or somebody came in or a bus pulled up with a baseball team to feed or something like that. Those events, to have veterans who are able to manage through those times, that's really important. Our tenure of our managers is more than 5 years in the manager role, that's a useful asset of ours as we saw for that are above -- the next level up has over 10 years, above store supervision. And so that sort of thing really helps us to solve for the issues that occur in the restaurants, but also make sure that we deliver the culture of the company, which is focused on serving the customer in a really gracious and genuine way.

And as we think about those cost pressures hopefully less onerous in '24 than '23, but the menu pricing -- just wondering how you think about it. I know you prefer to be conservative in a value on the menu, but some restaurants will say, this is the amount of price we need to hold our margin percentage and then we're going to take it, others say, well, that's not our objective of price. Our margins could go down if it's going to help the consumer drive traffic, that's our preference and we'll make it up over time. Like how does management think about it -- think about how much price we should take next year?

I've always -- it's always been remarkable to me how simplistic people think pricing is. And then I -- sometimes I wonder if people just take the menu and they say, okay, well, you can increase that by 10% across the board, and that's what menu pricing is. It's a lot more subtle than that. But the way we think about it is our typical cadence has been to take a look at pricing in early in the first quarter. And we say, what do we think our inflation is going to be. Historically, that's run probably 2.5% on average in the first part of the year. And then based on how the year is going, we generally revisit pricing later in the year, maybe in the second quarter or possibly the third quarter to enroll it. That's generally less of an amount. But we try to focus. We haven't gone away from the philosophy that we want to drive traffic. And so we try to be sure that we're not getting ahead of the customer, that we're offsetting inflation sufficiently. But if we think that we're going to get some mix advantage or we've got some traffic increases that are sustainable and that sort of thing. Then frankly, we'll take a little bit on the margin in order to bring more -- margin percentage in order to bring more dollars to the bottom line and to continue to promote the next visit or return visits from loyal customers. But we're trying to build that traffic year-over-year-over-year. We think that's the way to win this game long term.

And when I think about brunch and lunch on the weekends, I think of alcohol mix and that would be a favorable mix, and I remember during the IPO process, it was quite surprising that most of your restaurants didn't offer alcohol. Now obviously, that's changed?

Right.

And I know you were fighting for liquor licenses in pretty much all of your stores...

Nobody signed more liquor licenses in a shorter period of time than Mel Hope.

So where are you at today in terms of the mix of stores, the percentage of sales and the margins on that versus traditional products?

We're -- I think we're about at the 90% level, is that right? And I don't know that we'll ever get too much higher than that, except over time, it's part of the consideration of how we underwrite new restaurants. But we have in a system our age, we've got restaurants that maybe they're in a center where there's a lease restriction from one of the other tenants who don't want alcohol or maybe we're across the street from an elementary school or something like that where we can't sell alcohol. So there's always going to be -- or frankly, there's some places where we can't afford the licenses. But for the most part, we're where we need to be on the current system, and we continue to consider it in every new build. Alcohol as a beverage mix is kind of in that 6% to 7% now, and we're happy with that. We think we can continue to riff on our new alcohol program. For the most part, thus far, it's been crafted cocktails with a little bit of theater when we serve it. There's a lot of different areas we can go in that, but we're in the early innings of starting to maximize that line across the board for the customer who wants to have a little bit more of a celebratory occasion.

So where -- if you're envisioning tremendous success with it, are there certain stores that are at 15%? Or do you want to become more of a liquor destination? Or are you really kind of happy with that 6% to 7%?

I don't think I -- we haven't targeted a place that we want to be. Our fresh juice program, which began now probably 8 years ago, started similarly in terms of when we rolled it out, it was like 3% or 4% mixing in the restaurants. And now our fresh juices are up here, they're mixing 13%, 14%, 15% in most of the restaurants. I don't think alcohol will ever get that high, and I'm frankly not sure that it should. We're not a place where you'd come and belly up to the bar and order drinks all afternoon. But I do think there's an opportunity for us to continue to drive news. Every beverage occasion that shifts to alcohol is more margin accretive for us. And I think it helps to eliminate kind of the -- what people call the veto when you have a variety of people who come to the restaurant, and they would choose to go elsewhere if they could get a Bloody Mary.

Yes. I'm just thinking being -- having been involved in the 2021 IPO, just it's been unusual time to go through an IPO and to be a public company. But is there -- what would you say, looking back now, you say, no, that was a learning or that's something that we were not anticipating that's totally different than we were expecting just 2 or 3 years ago?

That's interesting. I think time management has been important to us, and I'm thinking about -- one of the things that I think we've done a good job of is the restaurants don't need to care about the ownership, right? They don't need to care whether we're public or private or -- we want them to be able to efficiently and effectively serve in the restaurants. And for the most part, I think they do. I don't have managers calling me and ask me why their stock is not doing well. But I think in the -- I think what we've -- what I would say has been as challenging as anything has been, just the time management associated with adding the disciplines of periodic reporting, making sure that we're talking to a larger constituent of owners and being sure that we tell our story, even though we may be tired of telling some of the story, or being able to make sure that we're educating new folks coming in all the time to -- coming in at different places in the story or catch me up or I was looking at this a couple of years ago, but it fell off the trail during COVID or something like that. I think that challenge has probably been as remarkable as anything because everything else, our crews have continued to deliver. Our development team has continued to focus entirely on finding good sites. Don't sacrifice the principles of the company. Our chef continues to be food forward and develop attractive items. And so I think people have done a good job of staying focused on the areas that made the company successful enough so that going public even made sense. And so there was a good story to tell and people have stayed on it. It's just more than time management, I'd say.

Maybe that's what a CFO answers. We have a few more minutes, but I wanted to see if there was any questions in the audience before I continue. Looks like there's one in the front. There's a microphone coming your way.

With the advent of COVID, a lot of the large metropolitan areas like New York, the commuters aren't commuting as they were, and they're staying probably closer to where you have your restaurants. Has that -- what kind of impact has that had on your business?

Yes. It's a good question. I think we are seeing, as we talked about earlier, some -- a little bit of a -- or maybe a big return to seasonality because we did -- I do think that Florida, for example, enjoyed some traffic from people who temporarily relocated down there or maybe they just took longer periods of time on vacation in Florida and that sort of thing. We've seen a little bit of shift in terms of business. One little bit of an insider information, I would tell you is that we have noticed an uptick in alcohol incidences on Fridays. So there are more people who are extending. So there must be some folks who aren't traveling to the office in the way that they used to. But by and large, I think we've navigated that quite well, and we do have a lot of restaurants that are in neighborhoods and so much of the business is driven on that weekend. The weekends are bowl games for us, right? That's the Super Bowl every single weekend. And so that has not changed. I mean, those continue to be such robust occasions, makes a big difference to the company that we have that balance there.

With the final minute or so, I get a lot of questions when I bring up First Watch of, well, it's on the smaller cap side, which it is, and then there's often talk, and I think we've talked about before that there's still some private equity ownership. So can you just give an update on where the private equity ownership stands today? What your kind of thought process is, whether that's had an impact on how you run the business or what your outlook is for the next few years to increase the flow potentially?

Well, our equity sponsor still owns about 55% of the company. They've been for us a great partner and a great vision about the marketplace, a great source of information and support to us. So as far as the support that we get. It's a very management supportive team. They did do several block trades of southern size. They've gone to 55% from over 70% early in the year. So they've -- so there's more liquidity today than there was before. I couldn't tell you that I know what the time frame is for continued sales or something more dramatic, but they're a good partner to us. They're a good partner to the company. And I think that frankly prospers the whole investor group because of what good partners they are to us.

Yes. The reduction from the 70-plus percent to the 55%, was that anything in particular that we could say, their plan is to ultimately not be a large holder of First Watch or from -- like how do you think about the...

I think that's a better question for them than me. What I do know is that private equity companies eventually don't own everything that they own.

That will be hard to do. Well, I think we've exhausted our 40 minutes, but we wanted to thank First Watch and Mel for joining us this afternoon.

Appreciate it. It's a lot of fun.

Thank you.

Thank you all.