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

Thank you, everybody, for joining us. I'm Sara Senatore, BofA's restaurant analyst. I'm very pleased to be joined up here by Mel Hope, CFO of First Watch. Mel comes to the company with -- came to the company in 2018 with decades of experience leading complex organizations, including Popeyes' Louisiana Kitchen. I will give you a little bit -- for those of you who don't know First Watch, talk a little bit about it. We were just talking about how delicious the food is. But before I do that, let me read the disclosure. So for those joining via the webcast, please refer to the First Watch Restaurant Group forward-looking statements disclosure posted on the IR website below the webcast link. So never read that before. Now I feel like I'm prepared for a job in IR.

So the -- so Mel, like I said, CFO, First Watch, as we were talking about, is an award-winning daytime dining restaurant concept, serving made-to-order breakfast, brunch and lunch using fresh ingredients. So you are a share gainer in what is a growing category. And I wanted -- I do want to start and talk a little bit about that. So about the daypart, about who you consider your competition and how you think about that category as a growth category itself and then the opportunity to continue to gain share, whether it's because the space is fragmented or because the existing competitors are perhaps on their back feet in terms of the offering or the -- what their -- what they -- sort of their menu or whatever it is that makes you unique.

Sure. So a little background. First Watch, I think you would probably recognize it as serving an elevated breakfast, chef-curated menu items, fresh squeezed juices. If you order juice at First Watch, it was squeezed fresh in the restaurant that morning. We've kind of a culinary forward concept with different platforms that we exercise based on the season. We say we follow the sun with fresh produce. Nobody wants us -- wants to get a strawberry that's grown in Chicago just because it's local, you want to get it fresh and that sort of thing. So our -- you talked about -- a little bit about our marketplace. The breakfast daypart is -- has been for a few years, the growing daypart in the industry in terms of dining out. Our customers and our competition when -- as we grow, most breakfast occasions are eaten at home. So I think where we are probably really trading customers are when people choose to eat out for breakfast or brunch as opposed to dining at home. Most of our competition would be sort of regional. There's a -- when we go into a new town, there's always a very famous and traditional and loyal following for a local restaurant that serves a great breakfast. So we oftentimes are moving into that kind of locally owned kind of restaurant environment. There are some larger regionals out there. Typically speaking, I think when we move into a territory, we're generally -- because of the number of breakfast occasions that are eaten at home, I think that the share seems to -- they're busy on Saturdays and Sundays, and we are too. So frankly, it hasn't been an occasion where we thought that we wish we hadn't gotten there just because there's competition there. We do quite well in most of the territories where we move in. Once we decide to -- that the customer is underserved in an area that we're looking at when we move in, we play to win and we do.

Right. And I think you've shared stats about where your highest volume restaurants are and they're sort of all over the...

That's right.

Yes. The -- across the system. So kind of, I guess, drilling down a little bit on demand and on your ability to take share. I want to talk -- I would be remiss if we didn't talk about the current environment. So I think you just reported your fourth quarter, you gave some traffic to date numbers. Obviously, you had -- there was some weather impact and your tough comparisons. But can you, I guess, maybe talk a little bit about the underlying dynamic there? How much was weather? I mean, we've heard some estimates that maybe it was 1 point to the first half of the quarter. I don't know if that sounds right to you. How much was the comparison? And how much was something that maybe is a fundamental shift in the customer? Again, just we talked earlier about this idea of February being less weather headwind, but still maybe a little choppy. So just your thoughts on the current environment.

Right. Well, first of all, we had a super fourth quarter. And I think a lot of people did. I mean, there was a lot of spending in the fourth quarter and a lot of enthusiasm. And I think what surprised people as much as anything was that January was so abruptly different and companies want to kick off the year with a fast start. We had a shift out of the first quarter into the fourth quarter of our -- what is generally our -- one of our most productive weeks of the year because we had a 53-week year last year. And so the week between Christmas and New Year's Day shifted into the fourth quarter of last year. But we attribute some of the decline to weather in the first period. I think that it shows up a little bit in a lot of people's language because folks, I think, were expecting to -- folks are -- I think every company is hoping to put COVID completely behind them and the recovery. And it seems like -- doesn't it seem like to you ever since 2020 that there's kind of been one thing after another to address that kind of feels like, well, is this a onetime event? Or is this an occasional event? And so I think everybody said, "Okay, well, 2024 is going to be the first year that we kind of lap a fairly clean 2023 and normalcy." And I think folks have focused on the weather in January, frankly, because there might be a little bit of disappointment about when you want to break out of the gate fast. We generally have a very strong January. New Year's resolutions, we've kind of got a healthy halo, a lot of protein on the menu. And so I think there is a weather impact. But there may be more going on to it. There may be some either pricing fatigue or customers. Customers may be just drawing back for some reason, there seems to be something going on. But it's been my experience that when you have an abrupt shift in your traffic as a result of either an offering that is great or you have a decline in transactions that occurs abruptly, either way that you kind of regress to the mean if it's good, and you kind of get back to the mean if it's negative, and I think that's kind of what we see going on. It's never the abrupt shift back that it was to get you where you were. This industry is really built on customer memory and being in the thought set and what are we doing today. And so that's kind of what I see going on right now that our consumer made a decision for whatever reason in January that there was going to be a little bit of a dial back and now we're earning that back. We look for check management. In our case, check management would be somebody maybe dropping a beverage off the ticket or maybe not as many shareables or something like that. We don't see that. Our average check and our per person average is still outpacing a little bit of pricing that we took. And so I feel like this is more of a temporary condition that as we earn our way back, it may take us a little bit of time to claw back to where we hope to be. But we're doing fine. It's going to -- I'm looking forward to a good year.

Yes. Well, yes, that's -- you certainly have a long precedent of growing traffic. And to your point, you're not seeing the intermediary steps of the check management that would suggest that you had seen less delivery business that has been an ongoing trend, though. And again, maybe to your point, it feels like we're still talking about normalization in some ways, but I think you -- your view is that some of that negative impact is -- that's diminishing. Is that...

That's right. Yes. Across the industry, third-party delivery, I think, has been a decline. A lot of people would point to that as sort of a new version of check management that goes on out there as people are measuring their dollars a little bit differently, and that's an expensive occasion. It's -- for us, it's been the better part of 5 quarters now that we've seen sort of a paced decline in that third-party delivery type transaction, but it's starting to playing out now. So my estimation is that the lines are going to converge sort of in the middle of the year, and we should sort of have found a new level of buoyancy on that off-prem transaction.

Right. And so just 2 things. One is that's primarily a traffic headwind, but not a mix so much. The check difference is not meaningful like it might be in a...

Right.

Okay. So that's, I guess, one clarification. And the other thing is you talked about dining traffic being positive in the fourth -- that was in the fourth quarter and actually improving sequentially. So again, I guess, as we think about the outlook from here, the sort of ideal case, right, is that, that traffic continues -- that trend continues to improve and then you have a stable off-prem price.

Right. And I think one of the things people miss about us is that even though we're new on the public stage, we've been at this for 4 decades. And one of the principles of the company has really been driving traffic, make sure we're priced for the traffic, we're priced to drive traffic so that we're in everyday value that we're driving traffic with good limited time offers. And our focus has always been on driving that dining room. And our dining rooms have continued to grow in traffic even as the off-prem has been under pressure. And I'm confident that we're going to get back to that just like we have in the past 40 years.

Right. Right. Yes. No, 40 years is probably a pretty reliable statistic then. So you have -- so you talk about off-prem, mostly delivery where there's been the traffic declines because you have a carryout business...

We do. Yes.

And I guess 2 things. One is, is carryout been a headwind as well? And I think what you've said in the past is that you tend to see a little bit more fungibility maybe between the carryout customer and the dining customer, whereas the delivery customers is separate. Is that...

Yes. Yes. It's interesting. Yes, when we talk about off-prem, we're talking about third-party delivery and just either to-go or sales through our own channel. And I had theorized last year that because our dining rooms were continuing to stand up, that, that customer who would pick up on to-go or something like that, that, that -- our own sales channel that there would be a lot of crossover. And I'm sure that there's some. But credit card data would suggest that off-prem use First Watch is largely incremental regardless of the sales channel. And again, I think there probably is some transfer from the to-go into the dining room usage that that's the same customer. But I thought it would be more, but it appears to me that it really is an incremental customer who's telling us that they want to use the restaurant for an off-prem business one way or another.

Incremental is always good. So that's the good news. So I guess you talked about value -- kind of everyday value, that sort of price certainty. People know they're going to get a good food that is high quality, taste good and a good value. 2 things on -- 2 questions on that. One is we have heard that the environment is more promotionally intensive right now. I don't -- I'm curious if you -- if that has an impact on you -- on your business on First Watch because you do have such a sustained value proposition. And then the other question I had about that is maybe we could talk a little bit about the scale advantages that allow you to have such a strong value proposition versus, for example, some regional or locals.

So first of all, the promotional piece. We -- our promotion is largely online. It's a lot of word of mouth. A lot of social media is kind of the way we promote. It's very efficient. We don't do national media. We don't -- we're not measuring TRPs or national television or anything else. But what we found over time is that when -- since most of the occasions for breakfast are eaten at home that the promotion for the breakfast brunch daypart that might come out of some brands that have very, very deep marketing budgets and they're trying to drive dayparts. When they start to press the throttle on promoting the breakfast and brunch daypart, that, that actually is helpful to us because of more occasions that they can teach customers to elect to eat away from home and eat out in time, those customers wind up trying out First Watch, and we have really good retention when we get the trial. So the promotional piece, we're delighted for people to come in the category and teach people to forego breakfast at home and go eat out. I've completely forgotten what your second question.

That was the goal, keep you on your toes. And so we -- I was curious how -- as was part of that value proposition, the -- you talked about scale and presumably some piece of this is your ability to offer such good value is that scale that you don't really have competitors at the same national, any kind of size.

So scale helps us in a couple of different ways. I do think we get -- I do think it allows us to price a little bit better. I think we get better contracts. I think what really pays off in scale is certainty of supply. Whenever there is restaurants -- and the restaurant industry is constantly in the recovery mode from one thing or another, either there's produce deliveries that are shorted or maybe a crop is shorted. A couple of years ago, we had avocado stopped at the Mexican border for some reason or another. Those sorts of interruptions -- those sorts of interruptions are something that the restaurant industry faces all the time. You don't want to change your menu. You don't want to change your recipes. What I think our scale does more than anything else is that makes sure that we're kind of on the quick call list. I don't know that we get most favored nation status for something like that. But I do know that we have great relationships with great suppliers and we can deal with the best suppliers because of our scale. And when there are times that stress either deliveries or shortages or something like that, I can tell that over the course of the last few years that we're always in the group that can expect to get the call from the developer -- from the distributor and say what we're going to recover for you, we're going to make sure that it gets there. So I really think it helps us with our consistency and reliability, and it helps with our relationships with our distribution channels.

Yes. I mean I think to your point, that's always characteristic of the industry, but it became very apparent during COVID, just to get the supply. Forget how much you were paying for it. So as you say, that in of itself is very valuable. So the -- I guess on the -- maybe on the last topic on this kind of competition and you talked about local, you're going into markets that are tougher. New England and actually, I say, look, that alone tells you how strong a concept First Watch is because most companies are steering very clear because it's hard. It's hard to operate. So maybe talk a little bit about the growth strategy you have. I know you're opening Las Vegas too, those can't be very high-volume stores. But maybe we'll use this as a transition to how do you get to those 2,200 stores that you've targeted? And how do you evaluate the markets that you're entering now?

So development for us is a very data-driven process. So our last Chicago land was the last new market that we announced a couple of years ago. We just recently announced Las Vegas and New England as our new markets. We generally are in there a couple of years before we announced the markets. And we're doing a couple of things. One is, in that time, we're identifying trade areas, we're doing site modeling, we're prioritizing trade areas, and we're making sure that there are facilities as well as the ability to operationalize our restaurants. You got to have a workforce. You got to be able to get them there. But then there's sort of this intangible that we talk about that is there a breakfast culture there? Are there -- is there a tradition of people who enjoy going out for breakfast in those markets? And if so, we believe that they're probably underserved because there are not that many breakfast locations, certainly not doing what we do and certainly not on the scale that we do it. So when we announce a market, we probably already identified what are the -- what are our sort of our top 25, 35, 55, whatever the number is, trade areas that we want to go into and we prioritize those. And what I can tell you for sure is we don't go into markets with the idea of opening 1 or 2 or 3. The way we are profitable, the way we do it well is to plan to take over the market to have a big presence so that we can solve for problems as a group as opposed to one and off kind of issues. So when we announce a new market, it's something we're really excited about. It's great for the new blood of the company, but we also know that we intend to lean into it hard and grow those markets out because that's the way we do well is to have a big presence in the markets.

Right. You're not going -- you're not aiming small, you're not going -- go in small, you're going in with an expectation that gets scale. And I guess on that front, maybe talk a little bit about what does scale look like in a market? At what point do you -- is it 6 or 7? Or at what point does it start to leverage that?

So it probably varies, but I would tell you that we consider it a market to be an emerging market almost until they have maybe 25 restaurants. [ And that ] our core markets probably have more and more density than that. But currently, in our world, an emerging market would be Nashville or Atlanta, where even both of those markets have somewhere between 12 and 20 restaurants, but they're still emerging for us because we have a lot more opportunity in those markets. And we've only been in those markets for the last 5 or 6 years. So those -- so in terms of when we think we're kind of there, it takes years to get there just to build the number of restaurants that we have and say, Atlanta -- I do think we've probably been in Atlanta now for 8 or 9 years with a couple of dozen restaurants. It's still a lot of green space. So it takes years to build out the markets. And we don't open entirely and -- when we go to a market. We're still opening 1/3 of our restaurants in 4 markets and 1/3 in these emerging markets and then 1/3 in the new market because we are always moving a veteran manager from one of our legacy restaurants to open the new restaurants as they open. So you don't want to overtax your existing restaurants by pulling all your seasoned managers out and putting in the new restaurants at the same time.

Right. Okay. And so -- and I think that's a good segue because one of the things that you've done is franchise acquisitions, buying back in restaurants. And one thing we talked about was the same people who train up the new restaurants also are working on those. But -- so that might affect cadence. But as you think about acquiring the franchises, is it to accelerate the point at which you get to the scale, the 25 like you're saying? Or is it -- what's the rationale behind it besides just these are great -- the economics are great and you can get them at a very attractive valuation?

The idea of acquiring in the franchisees was -- has always been the plan for the ones that we've acquired. The agreements were actually negotiated prior to our going public. So it's always been part of our strategy to acquire those in. When we do, they're, generally speaking, all well-run restaurants. I don't think people notice a difference between our franchisees who are great operators and the restaurants that they operate versus our company-owned restaurants. But it does allow us to reacquire protected territory, and we can grow faster in those territories than probably they would otherwise. So the idea that the franchisees did a great job of sort of seeding the brand in those markets and now we can come back in and we can kind of finish them out and grow. It also frees us up to kind of grow in contiguous areas as well so that our supply chain can service here, and then we can go to the next level or the next nearby markets and trade areas as well. So it's all part of what I think is a plan, I'll say, is brilliant. It preceded me, so I can say it without getting red-faced, very, very smart the way the company designed to allow the franchisees to see very prosperous areas. They did well. I don't think our franchisees are all kind of members of the family for us. And now as we acquire them, it gives us a chance to grow more territories, more base. And it's really a healthy relationship in terms of how the company grows and its ability to grow in all those areas. It's kind of fun to see.

Yes. So -- right. So these are not poorly run restaurants. These are restaurants...

Yes.

The market is attractive. I...

Yes. Like some of the restaurants that we've announced that we'll acquire in this year, some of the restaurants in that category are among some of the highest performing restaurants in the entire system.

So one of the things -- so one of the differences between acquiring versus standing up a new restaurant is the margin profile looks very different. So I'm going to use this a little bit as a transition to the margin conversation. I think when you -- in the first year, presumably a new, is it fair that a new restaurant has a lower margin in the first year?

You bet.

It's pretty typical, I think, in the industry. So as we think about your growth algorithm is -- how do you think about that drag? You're growing pretty rapidly. So presumably, it's nontrivial. And then the offsets that you might see elsewhere?

Sure. So when we do open a new restaurant, generally speaking, they open at a very high sales level, but they are inefficient, absolutely. It generally takes -- we generally plan for them to take about a year to get to mature margins. In a lot of markets, they're getting there a little bit sooner, 7 or 8 months overall. Mature margins being that kind of goal of getting in the 18% to 20% restaurant-level operating profit. Early on, they can be below 5%, 8% for a period of time, but they rapidly ramp up. But we're okay with their -- having that immature margin out of the box because new restaurants -- a typical legacy restaurant probably has a staff of maybe 26 or 28 people who do different shifts during the week. A new restaurant, we probably have, I don't know, 50 or something. But we want those new customers, new restaurants to be spoiled with over service, if you will. We want to certainly err on the high side. And then our labor generally begins to settle in at more reasonable and mature margin over the course of the next few months. So we're willing to trade off some margin early on in order to make sure that the customer is delighted when we open and that we set a good tone for the restaurant with the idea that as they begin to grow, then it settles into that more mature margin. A legacy -- kind of order of magnitude, our legacy restaurants, the restaurant-level operating profit margin last year was probably closer to 22% overall, whereas the overall system came in about 20%. So the immaturity of the noncomp restaurants kind of brings it in about that 20%, which we're happy with. I mean we're delighted with delivering a year-over-year 19%, 20% margin, even though we're opening a lot of new restaurants all the time.

Okay. So the way to think about it is at that rate, the rate of growth is pretty stable, you're going to have that kind of spread between the mature and the system-wide, but it's going to be a bigger headwind going forward...

As we get to that pretty consistently, we want to try and open above 10% in terms of the number of new system-wide restaurants every year. So I guess the order of magnitude would be we got to open more, but they're not going to overcontribute to the operating profit of the restaurants.

Right. Right. You have the bigger base to work off of. In terms of thinking about the near-term margin opportunity and maybe also some of the other top line opportunities, maybe you talk a little bit about -- you talked about pay at the table technology and how much savings. There's 30 seconds per transaction. How do you think about that technology as a driver of margins versus top line because you're getting more people seated, maybe slightly faster table turns?

So the pay at the table technology was -- it's not really intended to be a table turning device. In fact, one of the things that we -- we really tested for 3 things when we tested it. And we -- we're pretty persnickety about how we test new things. We don't -- we want to make sure that it didn't diminish the customer experience in any way. We wanted to be sure that it didn't affect the tips for our servers in the restaurants. And then lastly, we wanted to be sure that it actually didn't slow down table turns. We didn't know if customers might pay at the table. We didn't know how they react. We didn't have it before. So we didn't know if customers would pay at the table and then sit because they were cued by having a check and go to get up and go. So we tested around that very closely. We have experienced a little bit of a time savings in terms of the checkout, and we do know that it didn't slow down the table turns. So there probably is an advantage there. But the real win is to avoid the clutter in the front of the restaurants, particularly during the -- our peak hours. And so we want to do anything or we test anything that kind of reduces customer friction. And if a friction point is that a customer draws by the restaurant or maybe they, what we call, the look and leave, they look at -- they open the door, they look in, it's Saturday morning, it's 10:30, and they see 15 people sitting there and there's a clutter of people trying to check out at the host stand. If we can reduce that congestion in the front of the restaurant so that every -- so it's a little bit more of a pleasing experience and it reduces a couple of people who might look and go elsewhere as a result of it looking -- being less congested up front, that's a win for us. And that's what we hoped to do is to just make sure that we give more power to the customer to -- more power over their experience to control their own experience, just like our waitlist -- our online waitlist does. But it empowers the guest and reduces friction. That's what we go for. And that's why pay at the table is such a big win for us.

Right. So you -- that visual deterrent that is the crowded is what you're trying to solve for. Are you able to measure the people who walk away because they saw that like how many sort of save transactions...

Measuring a negative is always hard, right?

Right, the -- right. The counterfactual...

What we do know -- what we do measure is kind of the cocktail of things that we have put together, the KDS system, the changes that we make in the choreography of the restaurants in terms of more bussers or maybe a dedicated beverage stand that allows the servers to spend more time serving the tables. That kind of cocktail of things as well as the pay at the table what we're able to kind of measure sort of that efficiency. And I think that when you see part of our growing transactions, part of that story is that we're becoming increasingly efficient and we've learned and grown in confidence over the course of the last few years as we've opened restaurants that have done more and more higher volumes, they're higher-volume restaurants, partly because there's more dining room space or more patio space. Our confidence has grown and our ability to serve more demand and more customers as a result of constantly putting efficiencies in place. And I think that's part of the story of why we see our transactions continue to drive because we know we've got a great deal of demand right there at the front door. And so accelerating our throughput when we have people waiting on tables, that's really a big win for us.

Right. That -- serving that unmet demand. Yes, those are the -- yes, those are the worst transactions to lose, the ones that -- the people who want to...

You bet.

Yes. Want to eat at your restaurant don't...

They chose us and then we couldn't...

You couldn't, right. Yes, that's right. Those are -- yes, the good news is it's low-hanging fruit. I guess on that front, you mentioned KDS, presumably also good for the employee experience. Is that -- that's fair. And I guess one of the things that you have -- always had is this, the single shift makes it very attractive. You've had an advantage as an employer. What are you seeing? Does some of this technology improve the turnover further, I guess? And in that context, as you think about, I think it's 5% to 7%, wage inflation in 2024, are there ways to offset that, whether that's more tenure, less turnover, anything that kind of serves to be a balance...

Right. Well, we've always had a lower turnover than the industry. It kind of rose right after the worst of COVID. I keep referencing the pandemic as though we're right there. But I certainly can't shake it.

No. Right. That's right.

It affected our turnover, but it's been working its way back down. I think we're now at the same advantage that we had prior to the -- prior to COVID. But our turnover has always been good. I do think part of it is that we're busy. Servers like a busy, active, energetic restaurant that -- you're right, we do one shift. So the team is there serving one menu, getting a lot of reps in one shift. And so the choreography works, the team with a good leader, the team has a good relationship and they enjoy it. And then they're out by 2:30 or 3:00 in the afternoon. I think that's very appealing to a lot of people, and I do think that's part of the advantage. So the busier we can make the restaurants, the more efficient they are, the more training that they get on how to be more efficient, how to set up the kitchen and arrange the facilities in a way that it's more efficient. That's the constant work -- hard work of a First Watch restaurant to become more and more efficient. And I think those things like the KDS system, like the -- even pay at the table, those things were all part of what makes it more fun to be a First Watch server or a First Watch staff member.

Right. Right. So growing transactions, growing volumes, that solves a lot of problems.

Yes.

And ultimately, that's the goal. And I guess I'll use the last maybe a couple of minutes to talk about that. So as you think about the drivers of traffic and top line going forward, you obviously, as you said, you have -- there are dayparts where you have a lot of unmet demand. So some of this is going to be just -- it's just being more efficient and being able to bring those customers in. What are the other -- if you -- I don't know if you want to put in order of magnitude, but as you think about whether it's menu innovation or daypart, not expansion, but maybe midday -- midweek versus weekend, what are the other kind of key drivers as we try to build a story about comp and traffic growth for the foreseeable future?

Well, I don't think it's going away from what we've been successful doing for years. So the way the company has always driven traffic and grown its traffic has really been -- I would say it's mostly twofold. One has been culinary innovation. The -- we have 5 seasonal limited time menus, they're generally an elevated kind of product. We have things that pair well with sort of premium proteins or things that are seasonally familiar to our customers. Our customers know that those are coming. There's a lot of trial associated with them and they mix really heavy. And so that culinary innovation and occasionally, we have things on the LTM menus that earn their way to the core menu over time. Avocado Toast, for example, it's old now because it's served everywhere, but it's been on our core menu for a while, started off as a seasonal menu item years ago. But that new news is one way that the company is comfortable and has a tradition of driving traffic and attention into the restaurants. And then the other thing is that we're very careful with our pricing. I mean, frankly, I think customers trust us not to get out in front of them on cost. As we've said before, our philosophy is to price to offset inflation. We believe that we're -- that we have pricing power, but we don't exhaust it on the customers. We'd rather have that pricing power sit there unused as long as we're offsetting the inflation and defending our margins, then we're happy to deliver that way. And I think that over time, the relationship with the customer is that they expect us to be a good everyday value, and I think we deliver on that promise.

So great food, great experience, great value, it sounds easy, hard to do.

Easy is hard.

Yes, easy is hard. But I think that's a very good way for us to close out. So thank you so much for joining us. It's always a pleasure.

Sara, it's great to see you. Thank you.